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  • Writer's picturePeak Frameworks Team

Economies of Scale: Understanding How Bigger Can Be Better

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What are Economies of Scale?

Economies of scale are the cost advantages that companies can achieve as their scale of production or output increases. As a company's production or output increases, its fixed costs are spread over more units of output, resulting in lower average costs. This can lead to increased profitability and competitiveness for the company.

Economies of scale
Source: The Balance

Types of Economies of Scale

There are two primary types of economies of scale: internal and external.

Internal Economies of Scale

Internal economies of scale are the cost savings that a particular company enjoys as it grows and expands its operations. These savings arise from factors that are unique to the company and its operations.

Internal Economies scale
Source: The Curious Economist

One example of internal economies of scale is the spreading of fixed costs over a larger number of units of output. This can occur as a company expands its operations, invests in new technology, or increases its workforce. As a result, the fixed costs become a smaller portion of the total cost of production, leading to lower average costs per unit of output.

External Economies of Scale

External economies of scale are the cost savings that an entire industry or region enjoys as a result of its collective size and growth. These savings arise from factors that are external to any one particular company.

External Economies of Scale
Source: The Curious Economist

One example of external economies of scale is the development of a skilled workforce. As a region becomes known for a particular industry, more workers may choose to move to the area to take advantage of job opportunities.

This can lead to a larger pool of skilled workers, which can benefit all companies in the industry. A larger pool of skilled workers can also attract more investment to the region, leading to additional growth and economies of scale.

How do Economies of Scale Work?

Economies of scale can arise from a variety of factors. One important factor is the spreading of fixed costs over a larger number of units of output. For example, a company may have high fixed costs associated with building and equipping a factory or developing a new product. As the company produces more units of the product, the fixed costs are spread over a larger number of units, resulting in lower average costs.

Another factor that can lead to economies of scale is the ability to purchase inputs in larger quantities at lower prices. For example, a large retailer may be able to negotiate better prices for merchandise than a small retailer because of its larger purchasing power.

Examples of Economies of Scale

There are many examples of economies of scale in the business world. Here are just a few:

Amazon

As one of the largest e-commerce retailers in the world, Amazon enjoys significant economies of scale. By operating a vast network of warehouses and distribution centers, Amazon is able to deliver products to customers quickly and efficiently. In addition, Amazon's size and purchasing power allows it to negotiate better prices for products from suppliers, which it can then pass on to customers.

Walmart

Walmart is another example of a company that benefits from economies of scale. By operating a large number of stores and purchasing goods in large quantities, Walmart is able to offer low prices to customers. Walmart's size also allows it to negotiate better prices with suppliers, which it can then pass on to customers.

Automobile Manufacturers

Automobile manufacturers are another example of companies that benefit from economies of scale. The cost of developing new models of cars and trucks can be very high, but as the manufacturers produce more units of each model, the cost per unit decreases. In addition, automobile manufacturers can achieve economies of scale by purchasing raw materials and components in large quantities at lower prices.

Conclusion

Economies of scale are an important concept in business and finance. As companies grow larger, they often enjoy lower costs per unit of production or service output. This can lead to increased profitability and competitiveness for the company. Understanding economies of scale can help you make better investment decisions and evaluate the performance of companies in your portfolio.

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