Economies of scale

A business can become so large that its unit costs begin to rise. Expanding firms can experience diseconomies of scale. Causes include:

- Ineffective communication. Coordinating large numbers of staff becomes a challenge. Big businesses can develop many levels of hierarchy which slow down communication or even lead to miscommunication. - Reduced motivation. Staff can feel remote and unappreciated in a large organisation. When staff productivity begins to fall, unit costs begin to rise.

Economies of scale are the cost advantage from business expansion. As some firms grow in size their unit costs begin to fall because of:

- purchasing economies - when large businesses often receive a discount because they are buying in bulk - marketing economies - from spreading the fixed cost of promotion over a larger level of output - administrative economies - from spreading the fixed cost of management staff and IT systems over a larger level of output - research and development economies - from spreading the fixed costs of developing new or improved products over a larger level of output

It is important not to confuse total cost with average cost.

As a firm grows in size its total costs rise because it is necessary to use more resources. However, the benefits of becoming bigger can mean a fall in the average cost of making one item.

Competitive advantage

Economies of scale means large organisations can often produce items at a lower unit cost than their smaller rivals - a source of competitive advantage.

Large firms have lower unit costs than small firms because these fixed costs are spread more thinly over higher sales volumes.

For instance, take a £1 million advertising campaign. If just two items are sold the unit cost of promotion is half a million pounds. If a million items are sold the unit cost falls to just one pound. Many economies of scale are about spreading fixed costs more thinly.

Economies of scale

There are benefits and drawbacks in increasing the size of operation of a business. The cost advantage is known as economies of scale. The cost disadvantage is known as diseconomies of scale.

Small firms compete in two ways.

They either operate in service industries such as hairdressing where there are few opportunities for economies of scale, or they offer high priced, premium, niche products. Customers are prepared to pay more for exclusive goods made by small businesses.