Economies of scale (EoS) are factors that drive production costs down as the volume of output increases. That means, the more output a firm produces, the lower its marginal costs of production are. We can distinguish between two main types of EoS: internal and external. Internal economies of scale are caused by factors within the firm, whereas external EoS are based on changes outside the company (see also types of external economies of scale). Starting from there, in this article, we will take a closer look at six different types of internal economies of scale: (1) technical, (2) managerial, (3) marketing, (4) financial, (5) commercial, and (6) network economies of scale.
Technical Economies of Scale
Technical economies of scale are achieved through improvements and optimizations within the production process. That means as the output increases firms can start to invest in more efficient equipment and optimize operations based on experience. In other words, a large part of these optimizations occurs based on what we call learning-by-doing.
To illustrate this, let’s look at two imaginary retail companies. One of them is a large corporation called Malwart, and the other one is a small brick and mortar store called Bob’s Sporting Goods. To keep track of its inventory and optimize distribution across its several hundred stores, Malwart has recently introduced a new sophisticated software program. By contrast, Bob’s Sporting Goods only has one location and a single employee (i.e., Bob). Bob still manages inventory and distribution manually. Although he could save some time using sophisticated software as well, it’s simply not feasible for him due to size and financial restrictions of his business.
Managerial Economies of Scale
Managerial economies of scale occur based on the employment of a specialized workforce. That means as organizations grow, they can hire more experts and create specialized business units. This results in a more efficient division of labor and more effective leadership because the employees can gain more experience and focus on what they are good at.
For example, due to its size, Malwart can easily afford to employ dedicated category managers for Football, Basketball, Baseball, and every other major sport. These category managers even lead a team of several employees who focus on spotting the newest trends, evaluating the performance of current products, and negotiating the best deals with suppliers. Meanwhile, Bob can’t afford to hire that many people, so he has to do all that by himself. As a result, he won’t be able to handle his categories as efficiently as Malwart.
Marketing Economies of Scale
Marketing economies of scale arise from the ability to spread advertising and marketing budget over an increasing output. That means, as production increases, firms can spread (fixed) marketing expenses over a larger output, which reduces per-unit costs. In addition to that, large firms often profit from a strong brand, which means they can get a higher reach and better advertising deals than smaller companies.
To illustrate this, assume that Malwart wants to buy advertising space on a billboard in Los Angeles at USD 10,000 per month. They can spread these costs over several thousand products sold each week (per store). Meanwhile, Bob’s Sporting Goods would have to pay the same price for the billboard, even though it doesn’t nearly sell as much as Malwart. Therefore, its per-unit advertising costs would be much higher, which in turn would result in a lower profit margin.
Financial Economies of Scale
Financial economies of scale are achieved through cheap access to capital and financial markets. That means as organizations grow, they are usually considered to be more creditworthy (i.e., they get a higher credit rating). This allows them to get more favorable interest rates when borrowing money from banks. In addition to that, really large firms can raise money on the stock market or by issuing bonds (see also bond market vs. stock market).
For example, Malwart can get a loan of USD 5,000,000 to open up a new store somewhere in Los Angeles from pretty much any bank at favorable interest rates. The reason for this is that Malwart’s risk of default is low because it has high cash reserves and earns several million USD in revenue every day. Meanwhile, Bob’s Sporting Goods will find it harder to get a similar loan, because as a small business it is not considered as creditworthy as Malwart.
Commercial Economies of Scale
Commercial economies of scale arise from price reductions due to discounts or bargaining power. That means large firms can buy most of the goods and services they need (i.e., their inputs) in large quantities. This, in turn, allows them to profit from bulk discounts and a strong bargaining position to negotiate lower prices. These discounts allow them to reduce the per-unit costs of the products they sell significantly. Therefore, commercial economies of scale are also sometimes referred to as purchasing economies of scale or simply monopsony power.
In the case of our example, Malwart can buy its products in vast quantities, because it operates several hundred stores across the country. That makes it an attractive and important customer for many of its suppliers. Therefore, they might offer bulk discounts or agree to price reductions to keep Malwart as a customer. Meanwhile, Bob’s Sporting Goods doesn’t account for a large share of its suppliers’ revenue. Therefore, Bob can’t profit from bulk discounts, and his bargaining power is much lower than Malwart’s.
Network Economies of Scale
Finally, network economies of scale can be achieved when the marginal costs of adding additional customers are extremely low or decreasing. That means firms who can support large numbers of new customers with their existing infrastructure can substantially increase profitability as they grow. This type of EoS occurs mostly in online businesses, such as e-commerce shops. The reason for this is that adding additional customers to an online shop costs next to nothing. Therefore the profit margin usually increases significantly when large numbers of new customers are added to the network.
For example, assume that Malwart launches an online shop. Once the infrastructure is in place, and the shop is live, the costs of adding 1,000 new users as customers are extremely low. However, each of those new customers can create additional revenue by making purchases. In addition to that, an extensive network attracts new suppliers who want to offer their products, which in turn attracts more customers, and the cycle repeats. That makes it increasingly difficult for smaller firms like Bob’s Sporting Goods to enter the market because the big players already control most of the market.
In a Nutshell
There are six types of internal economies of scale: technical, managerial, marketing, financial, commercial, and network economies of scale. Technical economies of scale are achieved through improvements and optimizations within the production process. Managerial economies of scale occur based on the employment of a specialized workforce. Marketing economies of scale arise from the ability to spread advertising and marketing budget over an increasing output. Financial economies of scale are achieved through cheap access to capital and financial markets. Commercial economies of scale arise from price reductions due to discounts or bargaining power. And finally, network economies of scale can be achieved when the marginal costs of adding additional customers are low or decreasing.