Economy of scale

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Top Contributors Alexander Good Robert Kahn Related Articles Google (GOOG) Kraft Foods (KFT) Microsoft (MSFT)

Economies of scale is an economic term describing a business model where the long-run average cost curve declines as production increases. This phenomena is mostly associated with industries that have high fixed costs for entry.

An example of this can be found in the telecommunication industry. To service a single phone in a town costs a huge amount of money. Lines must be laid, towers constructed, and other infrastructure purchased to hook the phone up to local and long-distance lines. When the company is servicing a hundred phones, however, the cost per phone of all the infrastructure is significantly lowered.

Because the infrastructure is so costly for a small company, it may be most efficient for the entire town to be served by a single phone company. This company would then be known as a natural monopoly. In fact, a natural monopoly as a result of economies of scale is exactly the contention made about AT&T prior to the 1974 United States Department of Justice antitrust suit against the company.

Economies of scale are also present in businesses like software that have high fixed costs for marketing and development but a very low marginal cost for distribution. Naturally these lead to questions of monopoly (see Microsoft (MSFT) and Google (GOOG)).

[edit] Why Economies of Scale Happen: An In Depth Look

Corporations incur fixed costs when buying heavy machinery, buildings, or other large purchases. A fixed cost is called 'fixed' because when production increases in the short run, new buildings and machines are not immediately needed. Because fixed costs are not tied to production, firms have an incentive to produce as much as possible (assuming they can sell their product). Intuitively, a large factory should produce a large number of units to minimize its fixed cost per unit. Say that an automobile factory costs 1 million dollars. If it only produces 1000 cars, then its Fixed Cost Per Unit is 1 million dollars divided by 1000 cars, or $1000/Car.

If the factory produces 8000 cars, however, its Fixed Cost Per Unit is 1 million dollars divided by 8000 cars, or $125 per car. By producing 7000 more cars, the firm gets an 88% fixed cost reduction per car.

This graph illustrates that increased production reduces fixed costs per unit.

With fewer fixed costs per unit, firms can afford to lower per unit prices. If fixed costs are very significant to a particular firm's industry, then firms who mass produce efficiently can cut costs, extract revenues, lower prices, and therefore capture market share. Higher market share and higher revenues mean more money to spend on machinery, and expand the firm. This in turn allows further cost cutting, higher production, and the development of better products. In the long run, firms which effectively mass produce take over industries dominated by high fixed costs.

This is known as an economy of scale.

The following graph shows that success in an industry with high fixed costs is self-compounding.

But how can you tell if an industry is dominated by fixed costs?

[edit] ECONOMIES OF SCALE: TWO CULINARY EXAMPLES

Say you buy a building to start a restaurant. Even as business starts picking up, you do not need to buy a new building. Rather you need to buy more ingredients and hire more cooks (these purchases are considered Variable Costs).

People frequent restaurants because of good food, good service, convenience or other more perverse incentives like attractive waitresses. Good food, service, and convenience can be provided by good chefs, fresh ingredients, attentive servers, and efficient bus boys. Hiring the staff and buying ingredients are considered variable costs because the number of employees you need varies with your number of daily customers.

The building the restaurant is in, while important, does not define the quality of the restaurant's actual business. Because the variable costs like buying ingredients are more important to the restaurant industry than fixed costs like rent, economies of scale rarely arise. People going to restaurants expect to pay extra for their food because of the service and the taste, not because of the quality of machinery in the kitchen, or the size of the restaurant. Prices do not need to be extremely low to draw customers. Because fixed costs and low-ball pricing schemes do not dominate the restaurant industry's business, you do not see economies of scale.

On the other hand, think of the low-quality snack food industry. People looking to buy salty, fatty snacks are clearly not seeking a candlelit dining setting. Rather, they are looking to pay the lowest price for the highest short term gratification. Chefs do not prepare Cheez-Its, but rather large machines do. Machines allow major snack food conglomerates like Kraft Foods (KFT) to make tasty treats at an extremely low price. Better machines mean better made and more plentiful snacks, which mean lower pricing, greater market share, and higher revenue. Fixed costs and low-ball pricing schemes do tend to dominate the low-quality snack food industry, and so you see economies of scale.

These examples show us that the industries in which economies of scale arise are those that define their business by the use of heavy machinery, large factories, and price cutting. Price cutting strategies generally imply lower quality products. Any industry that specializes in the sale of luxury goods or services at a premium is less likely to mass produce its products, and therefore less likely to have fixed costs as the dominant business expense, and less likely to develop economies of scale.