Economies of Scale
When the firm produces in large scale it will experience benefits of mass scale production and as a result average cost per unit will reduce up to a certain level of output. This reduction in average cost per unit is called as economies of scale. Economies of scale occur in long run cost behavior. Economies of scale can be in 02 different forms:
01. Internal economies of scale
02. External economies of scale.
Internal Economies of Scale
Internal economies of scale occurs due to the expansion/mass scale production within the firm. It can occur due to following reasons:
- Technical economies of scale- This is where the a reduction in average cost per unit occurs due to introduction of a new technology, use of better machines or use of productive labour. As an example, to facilitate mass production when a firm buys a machine which has high production capacity at lower cost technical economies of scale occurs.
- Managerial economies of scale- This is where the economies of scale occur due to betterment in management team. A better trained management will always utilize strategies to produce the product at a lower cost. When the management cost is shared among large amount of output management cost per unit becomes low. This situation contributes towards managerial economies of scale.
- Marketing economies of scale- Good marketing team will be able to but inputs at a lower cost and sell output at higher price. Buying in bulk will result in discounts and other better offers to the firm. Firm will be able to negotiate with suppliers and arrive at better term resulting in reduction in cost per unit.
- Financial economies of scale- This is where the economies of scale occur due to reduction in financial cost per unit. There are 02 ways in which that a company can finance its expenses. Debt financing involves payment of interest to the finance provider and when the companies is producing at a mass scale lenders will agree to lend large amount of money at a lower rate of interest. Equity financing involves payment of dividend and capital gains to fund providers. When company is producing at mass scale share prices would go up and equity holders would invest in the company at a lower cost expecting higher capital gains on their shares by share price appreciation.
- Risk bearing economies of scale- Producing at mass scale concentrating in specific business line involves accepting high risk of failure. But to achieve economies of scale company needs to accept the accept the risk of failure and continue in one business line. But when the risk is borne by the firm and production is continued they become the market leader by producing at lower cost.
- Research development economies of scale- Research and development involves huge amount of initial capital investment. It can be only borne by a firm which is producing at mass scale. When the research and development is done for large amount of output, the cost of research and development can be spread among the large quantity of output. This reduces the amount of research and development cost absorbed to one unit of output resulting in reduction in average cost per unit.
External Economies of Scale
External economies of scale refer to benefits arises to the firm as a result of expansion in industry as a whole. External economies of scale can be of following forms:
- Specialized workforce- Expansion in the industry creates a specialized work force and when firm requires more labour trained and specialized labor trained by competitors is readily available in the market. This reduce the cost of training and recruitment.
- Supporting services- When the industry expands the supporting services are made available widely and this gives an opportunity obtain support services at a lower cost. These support services include transportation, training, raw material suppliers, advertising and management consultancy.