Economy of scale

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Economies of scale, in microeconomics, refers to the cost advantages that a business obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit cost as the size of a facility and the usage levels of other inputs increase.[1] Diseconomies of scale are the opposite. The common sources of economies of scale are purchasing (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial instruments), marketing (spreading the cost of advertising over a greater range of output in media markets), and technological (taking advantage of returns to scale in the production function). Each of these factors reduces the long run average costs (LRAC) of production by shifting the short-run average total cost (SRATC) curve down and to the right. Economies of scale are also derived partially from learning by doing.

Economies of scale is a practical concept that is important for explaining real world phenomena such as patterns of international trade, the number of firms in a market, and how firms get "too big to fail". The exploitation of economies of scale helps explain why companies grow large in some industries. It is also a justification for free trade policies, since some economies of scale may require a larger market than is possible within a particular country — for example, it would not be efficient for Liechtenstein to have its own car maker, if they would only sell to their local market. A lone car maker may be profitable, however, if they export cars to global markets in addition to selling to the local market. Economies of scale also play a role in a "natural monopoly."


Natural monopoly

A natural monopoly is often defined as a firm which enjoys economies of scale for all reasonable firm sizes; because it is always more efficient for one firm to expand than for new firms to be established, the natural monopoly has no competition. Because it has no competition, it is likely the monopoly has significant market power. Hence, some industries that have been claimed to be characterized by natural monopoly have been regulated or publicly-owned.

Economies of scale and returns to scale

Economies of scale is related to and can easily be confused with the theoretical economic notion of returns to scale. Where economies of scale refer to a firm's costs, returns to scale describe the relationship between inputs and outputs in a long-run (all inputs variable) production function. A production function has constant returns to scale if increasing all inputs by some proportion results in output increasing by that same proportion. Returns are decreasing if, say, doubling inputs results in less than double the output, and increasing if more than double the output. If a mathematical function is used to represent the production function, and if that production function is homogeneous, returns to scale are represented by the degree of homogeneity of the function. Homegeneous production functions with constant returns to scale are first degree homogeneous, increasing returns to scale are represented by degrees of homogeneity greater than one, and decreasing returns to scale by degrees of homogeneity less than one.

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