Glossary · Economic ideas

Economies of scale

Economies of scale are the savings that come with size: the more a business makes, the less each unit costs, because fixed costs are spread over more units.

Also called: economy of scale, scale economies, returns to scale, diseconomies of scale

In plain words

A bakery pays $1,000 a month for rent and its oven, whether it bakes 100 loaves or 10,000. Bake 100 and each loaf carries $10 of that cost; bake 10,000 and it carries only 10 cents. Being bigger makes each loaf cheaper. That is an economy of scale.

Size helps in other ways too: big buyers get discounts, big factories can use machines that only pay off at high volume, and big firms can borrow and advertise more cheaply for each unit they sell.

It is why a car plant makes hundreds of thousands of cars a year, why computer chips are made in a few giant factories, and why a big store chain can often sell for less than a corner shop.

Same bakery, same $1,000 of rent a month: the more loaves, the less of it each one carries.

Example

The cost of a loaf at three sizes

A bakery has fixed costs of $1,000 a month (rent, the oven, insurance) and spends $1 on ingredients for each loaf.

100 loaves a month: $1,000 ÷ 100 = $10 of fixed cost per loaf, plus $1: $11.00 a loaf.
1,000 loaves: $1 + $1 = $2.00 a loaf.
10,000 loaves: $0.10 + $1 = $1.10 a loaf.

The big bakery can sell at $1.50 and still make money; the small one needs $11 a loaf just to cover its costs.

One level deeper

The cost per unit falls as output grows as long as fixed costs are a big part of the total. Software and music are the extreme case: making the first copy is costly, and every extra copy is almost free.

Size has limits. Past some point big firms get slow: more layers of managers, more meetings, harder coordination. Costs per unit can start rising again, which economists call diseconomies of scale.

Economies of scale help explain why some industries end up with a few giants, or even one: if the biggest firm is always the cheapest, rivals can’t keep up, which is one road to a monopoly. Network effects are the same idea on the buyers’ side: a product gets more valuable the more people use it.

Why it matters

They are a big reason prices of manufactured goods fall over time, from TVs to solar panels.

They shape whole industries: where scale matters a lot, a handful of companies dominate.

They explain the hard part of being small: a small business often can’t match a chain’s prices, so it has to compete on something else.

A common mistake

Myth: Bigger is always cheaper.

In fact: Only up to a point. Huge firms can become slow and wasteful, and a small, focused business can beat a giant in a niche. Every industry has its own size at which costs per unit bottom out.

Questions people ask

What is an example of economies of scale?

A factory that makes 1 million phones spreads the cost of its machines, designs and software over 1 million units, so each phone costs far less to make than if it built only 1,000.

What are diseconomies of scale?

When growing makes each unit more expensive: too many managers, slow decisions, workers who feel like numbers. It is one reason firms don’t grow forever.

What is the difference between economies of scale and economies of scope?

Scale: savings from making more of the same thing. Scope: savings from making different things together, like a bakery that also sells coffee with the same shop and staff.

About the numbers

This page explains a term. It is not investment advice.