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.

ConceptEconomies of Scale is an economic concept that describes the phenomenon where the average cost per unit of production decreases as the level of output or scale of operation increases. In other words, as a company produces more, it can produce each unit more efficiently and at a lower cost. Economies of scale are a key factor in driving cost reductions in various industries and can significantly impact a company’s profitability and competitiveness.
Key CharacteristicsEconomies of Scale are characterized by the following elements:
Cost Reduction: As production levels increase, the cost per unit of production decreases.
Proportional Savings: The savings are proportionate to the increase in production.
Various Forms: Economies of scale can manifest in different ways, such as technical, managerial, or marketing efficiencies.
Impact on Pricing: Companies often pass on cost savings to consumers, leading to lower prices and increased market share.
Types of Economies of ScaleEconomies of Scale can be categorized into different types:
Technical Economies: Arise from increased specialization, automation, and the efficient use of machinery and technology.
Managerial Economies: Stem from improved organization, management, and decision-making as a company grows.
Marketing Economies: Result from larger advertising budgets, better negotiating power with suppliers, and increased brand recognition.
Financial Economies: Occur when larger firms can secure financing at lower interest rates due to reduced risk perception by lenders.
Causes and DriversSeveral factors contribute to Economies of Scale:
Specialization: Larger production volumes allow for specialized workers and machinery, reducing labor and production costs.
Bulk Purchasing: Buying raw materials or inputs in bulk quantities often leads to lower unit costs.
Improved Technology: Investments in advanced technology and machinery can enhance efficiency and reduce production costs.
Optimized Processes: As companies grow, they can refine their production processes and reduce waste.
Distribution Efficiencies: Larger firms can distribute products more efficiently, reducing transportation and storage costs.
BenefitsRealizing Economies of Scale provides several benefits:
Competitive Advantage: Companies that achieve lower production costs can offer more competitive prices or invest in quality improvements.
Increased Profit Margins: Reduced unit costs can lead to higher profit margins, boosting overall profitability.
Market Expansion: Lower prices can attract more customers and increase market share.
Sustainability: Efficient production processes often result in reduced resource consumption and environmental impact.
ChallengesAchieving Economies of Scale is not without challenges:
Upfront Investments: Expanding production capacity or investing in new technology can require significant upfront capital.
Coordination Complexity: Managing larger operations can be more complex and may require improved organizational capabilities.
Market Demand: Realizing economies of scale relies on sufficient market demand to support increased production. Overproduction can lead to excess inventory and reduced profitability.
Real-World ApplicationEconomies of Scale are observed across various industries, including manufacturing, agriculture, retail, and technology. Companies like Amazon, which operate vast distribution networks, leverage economies of scale to offer competitive prices and fast delivery.

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 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).


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

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.

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!

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.

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.

Key Highlights

Internal Factors Determining Economies of Scale:

  • Cost Efficiency from Scale: When companies scale up, they can offer products at lower costs while still being profitable. This relates to the concept of cost leadership.
  • Technological Development: Scaling allows companies to develop proprietary technologies that enhance efficiency, optimize processes, and boost productivity.
  • Better Organizational Structure: Up to a certain size, scaling enhances organizational efficiency by improving resource coordination and management.
  • Improved Financial Structure: As companies scale, they can improve financial structures, which can be seen through metrics like Amazon’s inventory turnover.
  • More Bargaining Power: Scaling grants companies increased negotiating power with suppliers, resulting in better deals and lower prices for customers.

External Factors:

  • External Economies of Scale: Scaled companies can gain advantages from external sources, such as government incentives, tax credits, or public funds, due to their impact on job creation and economic growth.
  • Beware of Diseconomies of Scale: Diseconomies of scale occur when a company becomes too large, causing costs per unit to rise due to coordination issues, management inefficiencies, and communication problems.

Network Effects and Economies of Scale:

  • Network Effects: As more users join a platform, its value increases for both existing and new users. Network effects can be direct (e.g., Instagram) or indirect (e.g., LinkedIn).
  • Platform Business Models: Building successful platform business models is challenging due to initial network effects, scalability issues, and maintenance difficulties. Few companies that overcome these challenges become highly valuable.
  • Sweet Spot and Negative Network Effects: There’s a point where network effects seem self-reinforcing for a platform, but after a certain scale, negative network effects can occur, reducing the platform’s value for users.
  • Vertical Integration in the Digital World: In the digital context, vertical integration involves controlling primary access points to acquire data from consumers, enabling better control of the supply chain and customer relationships.

Case Studies

ManufacturingIn manufacturing, economies of scale occur when increased production leads to lower production costs per unit. Larger production runs allow for better utilization of machinery, labor, and materials.– Reduces the cost per unit of production. – Enhances competitiveness and profitability. – Can lead to pricing advantages and market dominance.Car manufacturers like Toyota can produce vehicles at lower costs per unit when they achieve high production volumes, thanks to efficient assembly lines and economies of scale.
AgricultureIn agriculture, economies of scale result from larger farming operations. Farms that cultivate more land or raise more livestock can spread fixed costs over a larger output, reducing the cost of production per unit.– Increases agricultural output efficiency. – Lowers per-unit costs for crops and livestock. – Can lead to greater market access and competitiveness.Large agribusinesses can achieve economies of scale by operating extensive farms or livestock operations, reducing the cost per bushel of crops or per pound of meat produced.
RetailRetailers can achieve economies of scale by expanding their store network or online presence. Larger retailers benefit from lower per-store operating costs, better purchasing terms, and centralized distribution centers.– Reduces operational costs for individual stores. – Enhances negotiation power with suppliers. – Allows for competitive pricing and broader product offerings.Retail giants like Walmart and Amazon leverage economies of scale by operating extensive networks of stores and fulfillment centers, resulting in cost savings and competitive pricing.
TechnologyIn the technology sector, economies of scale are prevalent in the production of hardware components and software development. Larger production runs of semiconductors, for example, lower the cost per chip.– Lowers production costs for tech hardware. – Facilitates software development and maintenance. – Supports price competitiveness and market penetration.Semiconductor manufacturers like Intel can achieve economies of scale in chip production, reducing the cost per chip as production volumes increase. Software companies benefit from economies of scale by selling licenses to a large user base.
EnergyEnergy production, especially in renewable energy sources like wind and solar, exhibits economies of scale. Larger solar farms or wind turbine installations benefit from lower installation and maintenance costs per unit of energy generated.– Lowers the cost of energy production. – Encourages investment in renewable energy. – Supports sustainable energy initiatives.Solar energy companies can achieve economies of scale by building large solar farms, reducing the cost per kilowatt-hour of electricity generated. Wind energy producers benefit similarly from scaling up their installations.
AirlinesAirlines benefit from economies of scale as they expand their fleets and routes. Larger airlines can spread operational costs across more passengers and routes, leading to lower operating costs per seat-mile or seat-kilometer.– Reduces operating costs per passenger. – Supports competitive pricing and route expansion. – Enhances profitability and market share.Major airlines like Delta Air Lines or Emirates can achieve economies of scale by operating extensive fleets and serving numerous destinations, resulting in lower costs per passenger mile.
HealthcareIn the healthcare sector, economies of scale can be observed in hospitals and medical facilities. Larger hospitals often have lower per-patient treatment costs due to more efficient resource utilization and bulk purchasing of supplies.– Lowers per-patient treatment costs. – Improves healthcare facility efficiency. – Supports cost-effective healthcare delivery.Large hospital networks, such as those affiliated with academic medical centers, can achieve economies of scale by consolidating resources and achieving better cost-efficiency in patient care.
Automotive ManufacturingAutomotive manufacturers can realize economies of scale in the production of vehicle components. Large-scale production of engines, transmissions, and other parts reduces the cost per unit and enhances overall vehicle affordability.– Reduces the cost of vehicle components. – Enables competitive pricing for vehicles. – Supports efficient assembly processes.Suppliers like Bosch or Denso can achieve economies of scale in the production of automotive components, supplying parts to various automakers and benefiting from lower per-unit production costs.
BankingBanks can achieve economies of scale by expanding their branch networks and customer base. Larger banks can offer a broader range of financial services while spreading fixed costs over a larger deposit and loan base.– Lowers per-customer servicing costs. – Expands financial product offerings. – Enhances competitiveness and geographic reach.Large national or international banks, such as JPMorgan Chase or HSBC, can realize economies of scale by serving millions of customers, which helps reduce the cost per customer and offer a wide array of financial services.
Food ProcessingFood processing companies can realize economies of scale when producing packaged goods. Larger production runs lead to lower packaging and processing costs per unit, which can result in competitive pricing and profitability.– Lowers packaging and processing costs. – Supports competitive pricing and product diversification. – Enhances profitability and market share.Food processing companies like Nestlé or Tyson Foods can achieve economies of scale by producing large quantities of packaged goods, reducing the cost per unit and allowing for competitive pricing.

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 Economic Concepts

Market Economy

The idea of a market economy first came from classical economists, including David Ricardo, Jean-Baptiste Say, and Adam Smith. All three of these economists were advocates for a free market. They argued that the “invisible hand” of market incentives and profit motives were more efficient in guiding economic decisions to prosperity than strict government planning.

Positive and Normative Economics

Positive economics is concerned with describing and explaining economic phenomena; it is based on facts and empirical evidence. Normative economics, on the other hand, is concerned with making judgments about what “should be” done. It contains value judgments and recommendations about how the economy should be.


When there is an increased price of goods and services over a long period, it is called inflation. In these times, currency shows less potential to buy products and services. Thus, general prices of goods and services increase. Consequently, decreases in the purchasing power of currency is called inflation. 

Asymmetric Information

Asymmetric information as a concept has probably existed for thousands of years, but it became mainstream in 2001 after Michael Spence, George Akerlof, and Joseph Stiglitz won the Nobel Prize in Economics for their work on information asymmetry in capital markets. Asymmetric information, otherwise known as information asymmetry, occurs when one party in a business transaction has access to more information than the other party.


Autarky comes from the Greek words autos (self)and arkein (to suffice) and in essence, describes a general state of self-sufficiency. However, the term is most commonly used to describe the economic system of a nation that can operate without support from the economic systems of other nations. Autarky, therefore, is an economic system characterized by self-sufficiency and limited trade with international partners.

Demand-Side Economics

Demand side economics refers to a belief that economic growth and full employment are driven by the demand for products and services.

Supply-Side Economics

Supply side economics is a macroeconomic theory that posits that production or supply is the main driver of economic growth.

Creative Destruction

Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.

Happiness Economics

Happiness economics seeks to relate economic decisions to wider measures of individual welfare than traditional measures which focus on income and wealth. Happiness economics, therefore, is the formal study of the relationship between individual satisfaction, employment, and wealth.


An oligopsony is a market form characterized by the presence of only a small number of buyers. These buyers have market power and can lower the price of a good or service because of a lack of competition. In other words, the seller loses its bargaining power because it is unable to find a buyer outside of the oligopsony that is willing to pay a better price.

Animal Spirits

The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage.  Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.

State Capitalism

State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.

Boom And Bust Cycle

The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.

Paradox of Thrift

The paradox of thrift was popularised by British economist John Maynard Keynes and is a central component of Keynesian economics. Proponents of Keynesian economics believe the proper response to a recession is more spending, more risk-taking, and less saving. They also believe that spending, otherwise known as consumption, drives economic growth. The paradox of thrift, therefore, is an economic theory arguing that personal savings are a net drag on the economy during a recession.

Circular Flow Model

In simplistic terms, the circular flow model describes the mutually beneficial exchange of money between the two most vital parts of an economy: households, firms and how money moves between them. The circular flow model describes money as it moves through various aspects of society in a cyclical process.

Trade Deficit

Trade deficits occur when a country’s imports outweigh its exports over a specific period. Experts also refer to this as a negative balance of trade. Most of the time, trade balances are calculated based on a variety of different categories.

Market Types

A market type is a way a given group of consumers and producers interact, based on the context determined by the readiness of consumers to understand the product, the complexity of the product; how big is the existing market and how much it can potentially expand in the future.

Rational Choice Theory

Rational choice theory states that an individual uses rational calculations to make rational choices that are most in line with their personal preferences. Rational choice theory refers to a set of guidelines that explain economic and social behavior. The theory has two underlying assumptions, which are completeness (individuals have access to a set of alternatives among they can equally choose) and transitivity.

Conflict Theory

Conflict theory argues that due to competition for limited resources, society is in a perpetual state of conflict.

Peer-to-Peer Economy

The peer-to-peer (P2P) economy is one where buyers and sellers interact directly without the need for an intermediary third party or other business. The peer-to-peer economy is a business model where two individuals buy and sell products and services directly. In a peer-to-peer company, the seller has the ability to create the product or offer the service themselves.


The term “knowledge economy” was first coined in the 1960s by Peter Drucker. The management consultant used the term to describe a shift from traditional economies, where there was a reliance on unskilled labor and primary production, to economies reliant on service industries and jobs requiring more thinking and data analysis. The knowledge economy is a system of consumption and production based on knowledge-intensive activities that contribute to scientific and technical innovation.

Command Economy

In a command economy, the government controls the economy through various commands, laws, and national goals which are used to coordinate complex social and economic systems. In other words, a social or political hierarchy determines what is produced, how it is produced, and how it is distributed. Therefore, the command economy is one in which the government controls all major aspects of the economy and economic production.

Labor Unions

How do you protect your rights as a worker? Who is there to help defend you against unfair and unjust work conditions? Both of these questions have an answer, and it’s a solution that many are familiar with. The answer is a labor union. From construction to teaching, there are labor unions out there for just about any field of work.

Bottom of The Pyramid

The bottom of the pyramid is a term describing the largest and poorest global socio-economic group. Franklin D. Roosevelt first used the bottom of the pyramid (BOP) in a 1932 public address during the Great Depression. Roosevelt noted that – when talking about the ‘forgotten man:’ “these unhappy times call for the building of plans that rest upon the forgotten, the unorganized but the indispensable units of economic power.. that build from the bottom up and not from the top down, that put their faith once more in the forgotten man at the bottom of the economic pyramid.”


Glocalization is a portmanteau of the words “globalization” and “localization.” It is a concept that describes a globally developed and distributed product or service that is also adjusted to be suitable for sale in the local market. With the rise of the digital economy, brands now can go global by building a local footprint.

Market Fragmentation

Market fragmentation is most commonly seen in growing markets, which fragment and break away from the parent market to become self-sustaining markets with different products and services. Market fragmentation is a concept suggesting that all markets are diverse and fragment into distinct customer groups over time.

L-Shaped Recovery

The L-shaped recovery refers to an economy that declines steeply and then flatlines with weak or no growth. On a graph plotting GDP against time, this precipitous fall combined with a long period of stagnation looks like the letter “L”. The L-shaped recovery is sometimes called an L-shaped recession because the economy does not return to trend line growth.  The L-shaped recovery, therefore, is a recession shape used by economists to describe different types of recessions and their subsequent recoveries. In an L-shaped recovery, the economy is characterized by a severe recession with high unemployment and near-zero economic growth.

Comparative Advantage

Comparative advantage was first described by political economist David Ricardo in his book Principles of Political Economy and Taxation. Ricardo used his theory to argue against Great Britain’s protectionist laws which restricted the import of wheat from 1815 to 1846.  Comparative advantage occurs when a country can produce a good or service for a lower opportunity cost than another country.

Easterlin Paradox

The Easterlin paradox was first described by then professor of economics at the University of Pennsylvania Richard Easterlin. In the 1970s, Easterlin found that despite the American economy experiencing growth over the previous few decades, the average level of happiness seen in American citizens remained the same. He called this the Easterlin paradox, where income and happiness correlate with each other until a certain point is reached after at least ten years or so. After this point, income and happiness levels are not significantly related. The Easterlin paradox states that happiness is positively correlated with income, but only to a certain extent.

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

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.

Economies of Scope

An economy of scope means that the production of one good reduces the cost of producing some other related good. This means the unit cost to produce a product will decline as the variety of manufactured products increases. Importantly, the manufactured products must be related in some way.

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.

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. 

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. 

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