Economies of scale are decreases in cost as a direct result of increase in volume. There are several types of internal economies of scale.

Technical economies of scale

When a company is large enough to purchase and run bigger, better, more efficient and more costly machinery. With this bigger machinery that can output a lot more, they can begin mass production at a lower running cost. This generally only works when a product is standardized enough for long production runs.

Managerial economies of scale

When a firm is large enough to hire specialists in various fields that are very skilled at what they do, rather than requiring more general managers. These specialists can then aim to reduce costs by applying their expertise to the company.

Marketing economies of scale

These occur when a firm is large enough to employ mass marketing strategies, such as TV advertising.

Financial economies of scale

An example of a financial economy of scale (thanks Jurph) would be a payroll department with five employees capable of doing payroll for 1 million other employees. If a company has all million employees, they are working at maximum efficiency and therefore save money.

Risk-bearing economies of scale

If a company is big enough to stomach the risk of diversifying, then it can diversify so much that it can be sure not all of its enterprises will fail.

As you can see, all of the above require a fairly big capital injection initially, but should provide more benefit in the long run. This is the principle of economies of scale.

The average total cost is used to analyse economies of scale. Average total cost is cost per unit divided by output. If there are economies of scale to be reaped, ATC will fall as output rises. If ATC rises as output rises, the company is experiencing diseconomies of scale, meaning it has gone beyond its optimum size.

Economies of scale are where you can buy multiple items for a lower per-unit price than buying single items.

Economies of scale exist in part due to the interaction of Fixed costs and Variable costs. (Note: I take fixed costs as 'costs that are fixed for a production run of any size' and variable costs as 'costs that vary with production run size'. Some people take fixed costs as 'fixed unit cost, regardless of production run size' and variale costs as 'fraction of machine costs per unit'. If you like, you can switch the words round.)

An example: Company X wants to make injection-moulded plastic widgets. They face two types of cost, fixed and variable. The fixed costs don't change much as the number of units produced increases, i.e. the cost of the injection moulding machine, rent on the factory, etc. Let's say the machine costs £10,000. The fixed costs will be the same for one unit or one thousand.

They also face Variable costs. These are the costs that vary depending on how many things they produce, i.e. the cost of plastic. Let's say each widget takes £5 or plastic.

The variable cost for each item is: £5
The fixed cost for each item is (Fixed costs)/(Number of items produced)

So, the cost of one unit is the variable costs, plus a part of the fixed costs. Consider this table:

Widgets    |   Variable   |   Fixed     |  Total 
produced:  |   cost per   |   cost per  |  cost per
           |   widget:    |   widget:   |  widget:
-----------+--------------+-------------+-----------
1          |   $5         |   £10,000   |  £10,005
10         |   £5         |   £1,000    |  £1,005
50         |   £5         |   £200      |  £205
100        |   £5         |   £100      |  £105
1,000      |   £5         |   £10       |  £15
2,000      |   £5         |   £5        |  £10
10,000     |   £5         |   £1        |  £6
           |              |             |

In this situation, it is cheaper per widget to produce 10,000 widgets, since it divides up the cost of the machine. So if you went to this company with your widget design and asked them to make you one, it would cost a lot per widget, but if you asked them to make 10,000 it would cost much less per widget.

Here is a graph:

   | *
   | *
   | **
 C |  *
   |   *
   | !  **
 O | !    **
   | !!     ***
   |  !        ***
 S |   !          *****
   |    !!            **********************
   |++++++!!++++++++++++++++++++++++++++++++
 T |        !!!
   |           !!! 
   |             !!!!!
   |                  !!!!!!!!!!!!!!!!!!!!!!
   +-----------------------------------------
      P R O D U C T I O N   Q U A N T I T Y

! - Variable Costs
+ - Fixed Costs
* - Total Cost

The situation described above is an example of Manufacturing Economies of Scale. There are other types, as enumerated by Noung above.

The opposite would be diseconomies of scale.

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