economies-of-scale

What Are Economies Of Scale And Why They Matter

In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies benefit from these cost advantages as they grow due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in its costs will help the organization scale further.

Economies of scale types

Economies of scale can usually be of two types:

  • Internal: or if they come from factors within the company.
  • Or external: from factors that are outside the company.

Internal

Internal factors that determine economies of scale are:

Cost efficiency coming from scale

As companies scale up, in theory, they can also offer products at a lower cost and still profit from them.

This is at the core of cost leadership, one of Porter’s generic strategies for competitive advantage.

Technological development

As companies scale, they develop proprietary technologies to tackle key aspects of the business, thus improving efficiency, optimizing processes, and productivity.

Better organizational structure

Up to a certain size, the scaled company will gain from better organizational efficiency, as management might be able to coordinate the resources of the scaled company better.

Improved financial structure

As the company scales, it might also be able to improve its financial structure (see Amazon inventory turnover).

More bargaining power

Companies that scale also have more negotiating leverage with their supplier, making it easy for them to gain better deals and pass them to final customers through lower prices and more convenience (see Amazon cash conversion cycle).

External

A company with external economies of scale can use a scale to get better treatment (perhaps from the government or regulators).

For instance, as a company creates jobs in an area, it might get advantages like tax credits, public funds, or else.

Beware of diseconomies of scale

diseconomies-of-scale
In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Diseconomies of Scale represent the opposite phenomenon instead.

Where a company has grown too large, the cost per unit increases, thus making the firm no longer able to benefit from its achieved scale.

Economies of scale and network effects

In the digital business world, moats are built on network effects.

network-effects
A network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.

In general Network Effects can be direct or indirect. Direct is also called the same side.

As an example of the direct network effect, take the case of a platform like Instagram, where the more users join, the more the platform becomes valuable to the additional user who joins the platform.

As an example of indirect network effects, take the case of LinkedIn, where the more qualified professionals join the platform, the more it becomes valuable for recruiters and vice-versa.

Network effects are typical of platform business models, which can grow non-linearly.

However, building platform business models is extremely hard, as they face two core issues:

  • Initial network effects are hard to kick off (so-called chicken and egg or cold start problems).
  • Network effects are hard to scale.
  • Network effects are hard to maintain.

That is why very few companies can build successful platform business models, and those who can do so become extremely valuable companies.

In addition to that, when a company reaches a certain level of scale, there is a sweet spot where these network effects seem almost self-reinforcing, and it doesn’t matter what; the platform can keep its momentum.

After a certain scale, though, also negative network effects might be kicked off!

negative-network-effects
In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

Network effects enable platform business models to achieve economies of scale.

vertical-integration
In business, vertical integration means a whole supply chain of the company is controlled and owned by the organization. Thus, making it possible to control each step through customers. in the digital world, vertical integration happens when a company can control the primary access points to acquire data from consumers.

Read Also: Network effects for digital platforms.

What are economies of scale?

Economies of Scale is an economic theory for which, as companies grow, they gain cost advantages thanks to increased efficiency in production, manufacturing, and organizational structure. Thus, as companies scale and increase production, a subsequent cost decrease will help the organization scale further.

What are the main types of economies of scale?

Connected Business Frameworks

AI Supply Chains

data-supply-chain
A classic supply chain moves from upstream to downstream, where the raw material is transformed into products, moved through logistics and distributed to final customers. A data supply chain moves in the opposite direction. The raw data is “sourced” from the customer/user. As it moves downstream, it gets processed and refined by proprietary algorithms and stored in data centers.

Bullwhip Effect

bullwhip-effect
The bullwhip effect describes the increasing fluctuations in inventory in response to changing consumer demand as one moves up the supply chain. Observing, analyzing, and understanding how the bullwhip effect influences the whole supply chain can unlock important insights into various parts of it.

Supply Chain

supply-chain
The supply chain is the set of steps between the sourcing, manufacturing, distribution of a product up to the steps it takes to reach the final customer. It’s the set of step it takes to bring a product from raw material (for physical products) to final customers and how companies manage those processes.

Data Supply Chains

data-supply-chain
In a data supply chain the closer the data to the customer the more we’re moving downstream. For instance, when Google produced its own physical devices. While it moved upstream the physical supply chain (it became a manufacturer) it moved downstream the data supply chain as it got closer to consumers using those devices, so it could gather data directly from the market, without intermediaries.

Last Mile Delivery

last-mile-delivery
Last-mile delivery consists of the set of activities in a supply chain that will bring the service and product to the final customer. The name “last mile” derives from the fact that indeed this usually refers to the final part of the supply chain journey, and yet this is extremely important, as it’s the most exposed, consumer-facing part.

Backward Chaining

backward-chaining
Backward chaining, also called backward integration, describes a process where a company expands to fulfill roles previously held by other businesses further up the supply chain. It is a form of vertical integration where a company owns or controls its suppliers, distributors, or retail locations.

Revenue Modeling

revenue-model-patterns
Revenue model patterns are a way for companies to monetize their business models. A revenue model pattern is a crucial building block of a business model because it informs how the company will generate short-term financial resources to invest back into the business. Thus, the way a company makes money will also influence its overall business model.

Pricing Strategies

pricing-strategies
A pricing strategy or model helps companies find the pricing formula in fit with their business models. Thus aligning the customer needs with the product type while trying to enable profitability for the company. A good pricing strategy aligns the customer with the company’s long term financial sustainability to build a solid business model.

Dynamic Pricing

static-vs-dynamic-pricing

Price Sensitivity

price-sensitivity
Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.

Price Ceiling

price-ceiling
A price ceiling is a price control or limit on how high a price can be charged for a product, service, or commodity. Price ceilings are limits imposed on the price of a product, service, or commodity to protect consumers from prohibitively expensive items. These limits are usually imposed by the government but can also be set in the resale price maintenance (RPM) agreement between a product manufacturer and its distributors. 

Price Elasticity

price-elasticity
Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It can be described as elastic, where consumers are responsive to price changes, or inelastic, where consumers are less responsive to price changes. Price elasticity, therefore, is a measure of how consumers react to the price of products and services.

Economies of Scale

economies-of-scale
In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

diseconomies-of-scale
In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Network Effects

network-effects
network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.

Negative Network Effects

negative-network-effects
In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

Read more: Diseconomies Of Scale

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