Internal economies of scale

What Is Internal Economies of Scale?

Internal economies of scale refer to the cost advantages that a company gains due to its increased production volume and efficiency within its own operations³². These cost savings are unique to a particular firm and arise from factors controllable by its management team, distinguishing them from external factors that affect an entire industry³¹. As a business expands its output, the average cost per unit of production tends to decrease. This concept is a fundamental aspect of microeconomics, illustrating how larger scale can lead to lower unit costs, which can enhance a firm's profitability and competitive advantage²⁹, ³⁰. Internal economies of scale are achieved by spreading fixed costs over a larger number of units and by improving operational efficiencies.²⁸.

History and Origin

The foundational concept underpinning economies of scale, including internal economies of scale, can be traced back to Scottish economist Adam Smith. In his seminal 1776 work, The Wealth of Nations, Smith extensively analyzed the benefits of specialization and the division of labor in increasing productivity and output²⁷. He observed that when workers focus on specific tasks within a production process, they become more proficient, leading to greater overall efficiency. This insight laid the groundwork for understanding how larger enterprises, by enabling a more profound division of labor, could achieve lower production costs per unit. British economist Alfred Marshall later formalized the distinction between internal and external economies of scale in his economic analysis.

Key Takeaways

• Internal economies of scale are cost benefits a company realizes by increasing its production scale, leading to a decrease in its average cost per unit²⁶.
• These advantages originate from within the firm, often resulting from management decisions and operational optimizations.
• Key sources include technical improvements, bulk purchasing, managerial specialization, and better access to finance²⁵.
• Achieving internal economies of scale enhances a company's efficiency and strengthens its position against competitors.
• However, beyond an optimal point, companies may face diseconomies of scale, where further growth can lead to increased average costs.

Formula and Calculation

Internal economies of scale are not represented by a single, universal formula, as they manifest through various operational improvements. However, their effect is quantifiable through the reduction in average cost. The average cost per unit of production is calculated by dividing the total cost of production by the total number of units produced.

The total cost of production consists of fixed costs and variable costs²⁴:

Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC)

The average cost (AC) per unit is then:

Where:

• ( TC ) = Total Cost of Production
• ( Q ) = Total Production Volume (number of units produced)
• ( FC ) = Fixed Costs (costs that do not change with production volume, e.g., rent, machinery depreciation)²³
• ( VC ) = Variable Costs (costs that change directly with production volume, e.g., raw materials, direct labor)

As production volume (( Q )) increases, fixed costs are spread over a larger number of units, causing the average fixed cost per unit to decline. Additionally, larger volumes can lead to lower per-unit variable costs through efficiencies like bulk purchasing or improved technical processes.²²

Interpreting the Internal Economies of Scale

Interpreting internal economies of scale involves observing how a company's per-unit production costs change as its output expands. When a firm experiences internal economies of scale, it means that for each additional unit produced, the average cost of production is decreasing²¹. This indicates that the company is becoming more efficient at utilizing its resources and processes as it grows. For instance, a declining trend in the average cost curve as production volume rises suggests the presence of these economies. This reduction in average cost can signal a healthy and growing business that is effectively leveraging its size and operational improvements to gain a cost advantage in the market²⁰. Analysts often compare a company's average costs over time or against competitors to assess the extent to which it is achieving or failing to achieve internal economies of scale.

Hypothetical Example

Consider "Alpha Autos," a hypothetical car manufacturer. Initially, Alpha Autos produces 10,000 cars per year. Their total fixed costs (factory rent, machinery leases, administrative salaries) are $50 million, and their variable costs (raw materials, direct labor) are $15,000 per car.

• Total Cost = $50,000,000 + (10,000 cars * $15,000/car) = $50,000,000 + $150,000,000 = $200,000,000
• Average Cost per car = $200,000,000 / 10,000 cars = $20,000 per car

Now, Alpha Autos invests in new assembly line technology (a form of capital expenditure) and increases its production volume to 50,000 cars per year. While fixed costs might slightly increase due to the new machinery's depreciation, let's assume they remain relatively stable at $60 million. Due to bulk purchasing of materials and greater efficiency in the automated production process, the variable cost per car drops to $14,000.

• Total Cost = $60,000,000 + (50,000 cars * $14,000/car) = $60,000,000 + $700,000,000 = $760,000,000
• Average Cost per car = $760,000,000 / 50,000 cars = $15,200 per car

In this example, Alpha Autos experienced significant internal economies of scale, reducing its average cost per car from $20,000 to $15,200 by increasing its production fivefold.

Practical Applications

Internal economies of scale manifest in various aspects of business operations and investment analysis. Companies often pursue growth strategies, such as expanding production facilities or investing in new technology, with the strategic intent of achieving these cost reductions. For instance, a large retail chain can leverage its substantial purchasing power to negotiate lower prices from suppliers when buying goods in bulk, thereby reducing its per-unit cost of inventory¹⁸, ¹⁹. This is a prime example of a purchasing economy of scale. Similarly, manufacturers can achieve technical economies of scale by investing in large-scale, automated machinery that produces goods at a lower unit cost than smaller, less efficient equipment.

Furthermore, larger firms can benefit from managerial economies by employing highly specialized managers for different functions like marketing, finance, or research and development, leading to greater efficiency and better decision-making¹⁷. The ability to spread the costs of expensive marketing campaigns or significant capital expenditure on research and development over a larger production volume can also reduce the average cost per unit, contributing to overall profitability and allowing the firm to gain market share¹⁶.

Limitations and Criticisms

While internal economies of scale offer significant benefits, they are not limitless and can eventually lead to diseconomies of scale¹⁴, ¹⁵. As a firm continues to grow, it may reach a point where increasing its scale of operations no longer yields cost advantages and, in fact, leads to increased average costs per unit.

One primary limitation stems from managerial and organizational challenges. As a company becomes very large, communication can become less effective, decision-making processes may slow down, and bureaucratic inefficiencies can emerge¹³. Coordinating vast and diverse operations can be difficult, potentially leading to breakdowns and decreased efficiency¹². For example, a massive corporation might struggle with the agility to respond quickly to market changes compared to smaller, more nimble competitors¹¹.

Technical limitations can also arise if a company's production facilities reach their optimal capacity, making further increases in production volume more expensive due to overtime, maintenance issues, or the need for entirely new, potentially costly, capital expenditure. Additionally, aggressive pursuit of internal economies of scale might lead to a lack of flexibility, making the firm less adaptable to shifts in consumer demand or the emergence of disruptive technologies, as observed in historical examples where established giants struggled against innovative newcomers¹⁰. While internal economies provide a competitive advantage, this advantage can diminish if the company overextends its scale without proper management and market foresight.

Internal Economies of Scale vs. External Economies of Scale

The primary distinction between internal and external economies of scale lies in their origin: internal economies arise from within a single firm, whereas external economies result from factors affecting an entire industry or geographic region.

Internal economies of scale offer a stronger competitive advantage because they are exclusive to the firm that achieves them. In contrast, external economies of scale benefit all industry participants, potentially leveling the playing field rather than creating a unique edge for one company. Confusion often arises because both types lead to lower average costs as output or industry size increases, but the underlying mechanisms and beneficiaries are different.

FAQs

What are the main types of internal economies of scale?

The main types of internal economies of scale include: technical economies (e.g., using large-scale machinery), purchasing economies (e.g., bulk buying for better discounts and purchasing power), managerial economies (e.g., hiring specialists), financial economies (e.g., easier access to cheaper loans due to size), and risk-bearing economies (e.g., diversifying products or markets)⁸, ⁹.

How do internal economies of scale affect pricing?

When a company achieves internal economies of scale, its average cost per unit decreases. This allows the company to potentially lower its prices, making its products more competitive in the market, or to maintain current prices and increase its profitability per unit. Businesses often analyze marginal cost alongside average cost to make informed pricing decisions.⁷

Can small businesses achieve internal economies of scale?

While typically associated with large corporations, small businesses can achieve some internal economies of scale. They might do so by pooling resources through cooperatives, outsourcing non-core functions, or by specializing in a niche market. Technology can also help small businesses by automating processes to reduce labor costs and improve supply chain management, thereby enhancing efficiency⁶.

What is the relationship between fixed costs and internal economies of scale?

Fixed costs are expenses that do not change with the level of production volume, such as rent or the cost of machinery⁴, ⁵. Internal economies of scale are significantly driven by spreading these fixed costs over a greater number of units. As more units are produced, the fixed cost allocated to each unit decreases, leading to a lower average cost of production², ³.

What is the opposite of internal economies of scale?

The opposite of internal economies of scale is diseconomies of scale. This occurs when a company grows so large that its average cost per unit starts to increase, rather than decrease, with further increases in production volume. This can be due to factors such as management inefficiencies, communication breakdowns, or coordination challenges in a very large organization¹.