Economies of scale is a concept that arises in the context of production of a good or service, and other similar activities undertaken by a business or nonbusiness organization. "Economies of scale" refers to economic efficiency that results from carrying out a process (such as production or sales) on a larger and larger scale. The resulting economic efficiencies are usually measured in terms of the costs incurred as the scale of the relevant operation increases. Partly based on Edwin Mansfield's Principles of Microeconomics, important elements of economies of scale, necessary to gain a basic understanding of the concept, are briefly discussed in what follows.
PRODUCTION, INPUTS, COSTS, AND
ECONOMIES OF SCALE
In order to gain a reasonable understanding of economies of scale, one needs to understand a few concepts, related to the production process. These are: the production function, fixed and variable inputs, and average costs.
PRODUCTION FUNCTION AND INPUTS.
Production of a product (or a set of products) is generally based on a technological relationship—amounts of certain factors of production (inputs) are converted into a product based on some technological constraints. The technological relationship is termed by economists as the "production function." In more technical terms, the production function can be defined as the function that shows the most output that existing technology permits the manufacturing firm to extract from each quantity of inputs. The production function thus summarizes the characteristics of existing technology at a given time. This concept can be illustrated with the help of an example. Suppose Better Steel Corporation decides to produce a certain quantity of steel. It can do so in many different ways. It can choose from among available technological choices: it can use open-hearth furnaces, basic oxygen furnaces, or electric furnaces. Similarly, Better Steel Corporation can choose from various types of iron ore and coal. Given that Better Steel has decided to produce a certain quantity of steel, which production technique will it use; that is, what particular combination of inputs will it decide on? An economist's answer to this question is: the one that minimizes the firm's costs and maximizes its profits.
Given that a technology has been chosen, in general, as inputs used in the production of a commodity increase the total output increases as well. It is useful to understand different kinds of inputs.
FIXED AND VARIABLE INPUTS.
Primarily, there are two kinds of inputs—fixed and variable. A plant and a factory shed are examples of fixed inputs (or factors) of production. These inputs are called "fixed" inputs as the quantities needed of these inputs remain fixed, up to point, as the quantity produced of the product (the output) increases. Using the steel industry as an example, a blast furnace used in producing steel is considered a fixed input—Better Steel Corporation can produce more steel by using more raw materials, and get more production out of the existing blast furnace. It should be noted that fixed input does remain fixed for all levels of output produced. As the scale of production increases, the existing plant may no longer suffice. Suppose that the blast furnace chosen by the steel firm can, at the very maximum, produce 100,000 tons of steel per day. If Better Steel Corporation needs to supply 150,000 tons of steel per day (on average), it has to add to capacity—that is, it has to install a new blast furnace. Thus, even a "fixed input" does not remain fixed forever. The period over which a fixed input remains fixed is called the "short run." Over the "long run," even a fixed input varies.
Inputs that vary even in the short run are called "variable" inputs. In the above example of steel manufacturing, iron ore serves as a variable input. Given the fixed input (the blast furnace in this case), increasing the quantity of the variable input (iron ore) leads to higher levels of output (steel).
For a manufacturing firm, it is not important what combination of fixed and variable inputs are used. As a firm is interested in maximizing profits, it would like to minimize costs for any given level of output produced. Thus, costs associated with inputs (both fixed and variable) are the main concern of the firm engaged in the production of a particular commodity.
TOTAL AND AVERAGE COSTS.
A manufacturing firm, motivated by profit maximization, calculates the total cost of producing any given output level. The total cost is made up of total fixed cost (due to the expenditure on fixed inputs) and total variable cost (due to the expenditure on variable inputs). Of course, the total fixed cost does not vary over the short run—only the total variable cost does. It is important for the firm also to calculate the cost per unit of output, called the "average cost." The average cost also is made up of two components—the average fixed cost (the total fixed cost divided by the number of units of the output) and the average variable cost (the total variable cost divided by the number of units of the output). As the fixed costs remain fixed over the short run, the average fixed cost declines as the level of production increases. The average variable cost, on the other hand, first decreases and then increases—economists refer to this as the U-shaped nature of the average variable cost.
The U-shape of the average variable cost (curve) occurs because, given the fixed inputs, output of the relevant product increases more than proportionately as the levels of variable inputs used increase—this is caused by increased efficiency due to specialization and other reasons. As more and more variable inputs are used in conjunction with the given fixed inputs, however, efficiency gains reach a maximum—the decline in the average variable cost eventually comes to a halt. After this point, the average variable cost starts increasing as the level of production continues to increase, given the fixed inputs. First decreasing and then increasing average variable cost leads to the U-shape for the average variable cost (curve). The combination of the declining average fixed cost (true for the entire range of production) and the U-shaped average variable cost results in the U-shaped behavior of the average total cost (curve), often simply called the average costs.
AVERAGE COST AND ECONOMIES OF SCALE.
Economies of scale are defined in terms of the average cost per unit of output produced. When the average cost is declining, the producer of the product under consideration is reaping efficiency gains due to economies of scale. So long as the average cost of production is declining the firm has an obvious advantage in increasing the output level (provided, there is demand for the product). Ideally, the firm would like to be at the minimum average cost point. However, in the short run, the firm may have to produce at an output level that is higher than the one that yields the minimum average total cost.
When a firm has to add to production capacity in the long run, this may be done by either duplicating an existing fixed input (for instance, a plant) or increasing the size of the plant. Usually, as the plant size increases, a firm is able to achieve a new minimum average cost point (lower than the minimum average cost achieved with the previous smaller capacity) plant. For example, in the case of Better Steel Corporation, the average cost per ton of steel at the minimum average cost point with the larger blast furnace may be 20 percent less than the average cost at the minimum average cost point with smaller blast furnace. Thus, in the long run, a firm may keep switching to larger and larger plants, successively reducing the average cost. One should, however, be warned that due to technological constraints the average cost is assumed to start rising at some output level even in the long run—that is, the average cost curve is U-shaped even in the long run.
Therefore, while looking at the average cost per unit of output is the key to understanding economies of scale, it is useful to remember that the average cost declines up to a point in the short run, and it may decline even more in the long run (also up to a point), as higher and higher levels of output are produced.
