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Economies of Scale Explained | Everything You to Know in 2020

Economies of Scale | Everything You Need to Know about Economies of Scale

Economies of Scale:

What happens to output as a company adds more and more resources if a firm were to double its inputs there are only three possible things that could happen to their output?

  • Their Output Could More than Double than their Actual Output (>1)
  • It could Double up than their Actual Output (=1)
  • It could Less than Double than their Actual Output (<1)

That’s the idea of returns to scale if output more than doubles then a firm is experiencing Increasing Returns to Scale because getting bigger is better this happens because they can use mass-production techniques that smaller firms can’t if the output doubles then that company has Constant Returns to Scale so they’ve kind of maxed out on the gains of getting bigger and if that output less than doubles then they’re experiencing.

Decreasing Returns to Scale and they’re just too big so return to scale show what happened to production in the long run but what happens to cost? Have you seen the difference between a huge company like Unilever and a small company? Obviously Unilever is the one that’s millions of dollars of equipment they’re using to produce their products while the small companies using men’s power or a small machine to complete their orders.

So Unilever’s Total Cost of Producing is way higher perhaps in millions of dollars but what about their average cost producing each product, it’s way lower and that’s the idea of Economies of Scale, the long-run average costs fall as more output is produced.

Economies of Scale is the idea that getting bigger is cheaper it happens because of increasing returns of scale and other cost-saving measures companies that are producing at a larger scale can afford super productive machines and also buy resources in bulk again the total cost might be a lot higher but the average cost is lower, but often costs don’t keep falling and falling in the long run like production they often level off and this is called Constant Returns to Scale.

Economies of Scale Benefits
Economies of Scale Benefits

So when you’re producing products, there’s just no way to get your cost below a certain amount per product and eventually it’s possible for the average cost to start going up as more is produced that’s called Diseconomies of Scale.

In that situation a company becomes so big and it’s producing so much they have to hire extra managers they have to add a cafeteria to their factory or you can say that the bigger they go, the more they need to manage things better, which makes companies hire more managers which sometimes creates communication problems between the departments, conflicts of interest arise in the organization hence instead of increasing the productivity their productivity starts to declines.

So their average cost start going up now you might be thinking that a firm wants to produce where they have the lowest long-run average cost but it’s not that simple the amount of firms should produce doesn’t just look at cost it also looks at consumer demand I mean think of your local pizza restaurants the goal is it to minimize their costs make as much pizza as possible their goal is to maximize profit.

Think about it they could have advanced pizza-making robots that do all the work but they don’t sell enough pizza to make it worth it the point is concepts like Economies of Scale or ideas that help producers make decisions they don’t tell producers exactly how much to make because in real life one size doesn’t fit.

Economies of Scale
Economies of Scale

Example of Economies of Scale

Let’s say John starts a venture which involves making small wooden airplanes and selling them at $20 each for the sake of simplicity we’ll also assume with that he does everything himself be his only fixed cost is the $1000 dollars monthly, he pays to rent the space he needs with utilities included free of charge see his variable costs are the various parts he uses for his airplanes which amount to $5 dollars per plane his first month is awful with only ten orders he generates $200 but has to pay a $1050 to make those planes a thousand bucks to cover his rent and $50 in variable costs.

Revenue$200
Less: Variable Cost$50
Less: Fixed Cost$1000
Profit/Loss$850
Average Cost Per Plane$105
Example of Economies of Scale

As such he loses money because his per plane cost is a whopping a $105. (1050/10 Planes), his second month however is great with him receiving five hundred orders he generates $10,000 and pays thirty-five hundred dollars of total cost, a thousand dollars for rent and twenty-five hundred dollars in variable costs.

Revenue$10,000
Less: Variable Cost$2500
Less: Fixed Cost$1000
Profit/Loss$6500
Average Cost Per Plane$7
Example of Economies of Scale

Securing a more than decent sixty-five hundred dollar profit his per plane cost is now a much lower $7 ($3500/500 Planes) the fact that his rent didn’t go up along with the order volume so the fixed cost dimension helped a lot however economies of scale can also work in his favor by for example negotiating bulk deals on materials and bringing his variable cost down unfortunately there are limits involved such as one John eventually needing more space to his supplier running out of inventory forcing him to buy from more expensive vendors three the local market is saturated making it necessary to find customers in other regions with shipping costs added to the mix and so on.

Economies of Scale Example
Economies of Scale Example

Economies of Scale and Comparative Advantage

Let’s suppose a fellow named Abbas lives on a few acres and that he likes to grow oranges and grapes in his garden and suppose the north end of  Abbas’s garden stays a bit cooler and the south end gets more heat so where’s he going to plant his oranges well orange is like the heat so he’ll plant them in a southern end of his garden grapes grow better without so much heat so he’ll plant them in the northern end that’s the best he can do but his whole garden is still in a northern place so his garden will never produce oranges as well as it produces grapes.

Economies of Scale and Comparative Advantage Relationship with a Story:

Now suppose that Abbas takes a journey down south to visit his old friend Ali and his friend Ali lives on a few acres in the south and he too likes to grow oranges and grapes well one day Ali is showing  Abbas around his garden and  Abbas is really impressed by how well the oranges grow there and he says to Ali you know my grapes do just fine up north and my oranges do okay if I keep them in the southern end of my garden but the southern end just isn’t far enough south to grow oranges really well.

Ali says I’ve got the opposite problem oranges to grow really well here but the northern end of my garden just isn’t far enough north so my garden never grows grapes quite as well as it grows oranges now if they could just pick up land and move it they could each split their gardens in half so that both of them would get the benefit of northern sunlight on their grapes and southern sunlight on their oranges.

But there is a way that they can get exactly the same effect if Ali grew oranges for both of them and  Abbas grew grapes for both them and then they trade it that would be just like Abbas growing his oranges a lot farther south and Ali growing his grapes a lot farther north it would be as if there was one perfect garden between them with Abbas.

Looking after the northern end and Ali looking after the southern end now notice three things about this story first trade gives people the chance to specialize where their efforts have the lowest opportunity cost in other words where they have a comparative advantage every resource that Abbas devotes to growing oranges could be used more productively to grow grapes instead compared with himself.

Abbas has an advantage in growing grapes rather than oranges trade makes it possible for people to use their comparative advantage to create wealth by putting their resources to they’re more productive using trade let’s people discover how they can be of as much use to other people as they can and how they can make their local resources as useful to other people as they can second people can’t create wealth if they ignore comparative advantage.

Suppose that Abbas turned down for Kay’s offer to trade grapes and oranges and instead went on growing his own oranges he’d still keep really busy in his garden and it might even look like he was creating well but that wouldn’t be true because that would ignore the opportunity cost of the work he’s doing to have oranges even though Abbas would be working hard he’d actually be destroying well wherever wealth is being created comparative advantage is part of it and third what I didn’t tell you about Abbas and Corky but you may have guessed it from their name is that if you looked on a map you’d see a political border between them.

So when they trade they’re actually trading across a border without trading across borders people’s efforts would be duplicated all across the planet and as a species humans would waste massive inputs to get pretty meager output but by trading, we can leverage our different strengths to produce much more with much less because of comparative advantage trade is able to bring the best of the planet to all of the planets. This whole story implies that a firm with comparative advantages in product to produce in economies of scale because they are assigned to cover up a huge demand with their available resources.

Economies of Scale | Everything You Need to Know about Economies of Scale

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Muhammad Abbas

A Graduate of IQRA University, Pursuing Masters Program from IQRA University as well, Work as an Assistant Manager - Finance in Unilever Pakistan, Having Couple of Published Articles in Internationally Recognized Journals, Aim to Help the Students in Every Possible Manner to make them Achieve their Desire Goals!!! :) :) :) Keep Learning!!!

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