Economies of scale

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Economies of scale characterizes a production process in which an increase in the number of units produced causes a decrease in the average cost of each unit.

The increase in output from Q to Q₂ causes a decrease in the average cost of each unit from C to C₁.

For example, imagine a production line producing widgets whereby the machinery of production costs 100 currency units a week to run and the incremental cost of each widget is one currency unit. If the machine makes 50 widgets a week then the average total cost of each widget is (100+50)/50 = 3 currency units.

However, if the machine can make 100 widgets a week then the average total cost of each widget is (100+100)/100 = 2 currency units. In this example, the more widgets that are produced per week, the cheaper they are to produce and hence the process exhibits economies of scale.

This is, of course, an extremely simplistic example and, in real life, there are countering forces of diseconomies of scale. As these forces balance, an optimum production volume can be found (referred to as constant returns to scale).

This principle can be equally applied to an organization resulting in firms within a particular industry tending to be similar sizes. Economists have studied this effect in great detail under the heading Theory of the firm.