Economy of scale: definition, example and threshold effects

Economies of scale: what is it?

A firm realizes economies of scale when it decreases the unit cost of production by increasing the quantity produced.

• savings: reduction in unit cost,
• of scale: increase in the quantity produced.

In other words, by producing more, each unit costs less and less to produce.

This reduction in the unit cost of production is due to the presence of fixed costs. Fixed costs are payable regardless of the level of production. These are costs which cannot be reduced and which must be paid even if the level of production is zero.

Example : the rent, the price of a machine and its depreciation, subscriptions such as electricity, Internet, telephone, etc.

Variable costs vary with the level of production. This mainly concerns the purchase of raw materials. The total cost of production includes fixed costs and variable costs. At the first unit produced, the fixed costs are very high compared to the level of production. The more the level of production increases, the more the fixed costs become proportionately lower in the total cost.

>> To read also – Internal growth: definition, forms and levers

Examples of an economy of scale

Manufacture of chairs

To understand the mechanism of economies of scale, let’s take a simplified example. A company produces chairs with wood and screws. To produce, it uses premises whose rent is 1,000 euros per month, electricity with a subscription of 50 euros per month, a machine for cutting wood which cost 50,000 euros, wood and screws.

Even before starting production, its fixed costs are 51,050 euros the first month (50,000 euros of machine, 1,000 euros of premises, 50 euros of electricity).

To make 100 chairs, she needs 200 euros of wood and 20 euros of screws. These are its variable costs.

Production cost of 100 chairs

To make 100 chairs, its total cost of production is the sum of the fixed costs and the variable costs.

Total production cost = Fixed costs + Variable costs = 51,050 € + 220 € = 51,270 €.

The unit cost of production is the ratio of the total cost to the quantity produced.

Unit cost of 100 chairs = € 51,270 / 100 = € 512.70.

By making 100 chairs, the production cost of each chair is 512.70 euros.

Production cost of 200 chairs

To produce an additional 100 chairs in the same month, it has to buy back wood and screws but does not pay more fixed costs. Its total production cost is:

Total production cost = Fixed costs + Variable costs = € 51,050 + (2 x € 220) = € 51,490.

The unit cost decreases: Unit production cost = 51,490 € / 200 = 257,45 €.

By making 200 chairs, the production cost of each chair is € 257.45 euros.

Production cost of 300 chairs

To produce 300 chairs in a single month, the level of fixed costs is always the same. Only the quantities of wood and screws are increasing.

Total production cost = Fixed costs + Variable costs = € 51,050 + (3 x € 220) = € 51,710.

Unit cost decreases: Unit production cost = € 51,710 / 300 = € 172.37

By making 300 chairs, the cost of producing each chair is 172.37 euros. It achieves economies of scale. And so on with each new increase in the level of production.

Threshold effects

Economies of scale are subject to threshold effects. Indeed, beyond a certain level of production, the amount of fixed costs also increases. For example, if the level of production increases a lot, the company will need a new machine and then more space and therefore a new room.

The decrease in the unit cost of production due to economies of scale is not linear. It undergoes jolts with each new investment.