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Unlock This CourseImagine you're making sandwiches for your friends. Making one sandwich costs you quite a bit per sandwich - you need to buy a whole loaf, butter and fillings. But if you make 20 sandwiches, the cost per sandwich drops dramatically because you're spreading those fixed costs over more sandwiches. This is exactly how economies of scale work in business!
When businesses grow larger, they often find ways to reduce their costs per unit of production. This gives them a competitive advantage and helps explain why some companies become giants in their industries.
Key Definitions:
As businesses grow, they can spread their fixed costs (like rent, machinery and management salaries) over more units of production. This means each product carries a smaller share of these costs, making the business more profitable and competitive.
Internal economies of scale come from improvements within the business itself. There are six main types that every business student needs to understand:
These occur when larger businesses can afford better, more efficient technology and production methods that smaller businesses simply cannot justify buying.
Large manufacturers can invest in expensive, high-speed production lines that produce goods much faster and more efficiently than smaller operations.
Big companies can afford specialised tools and machinery that are too expensive for smaller businesses but dramatically improve efficiency.
Large businesses can invest in robots and automated systems that work 24/7 without breaks, reducing labour costs per unit.
Amazon's massive warehouses use advanced robotics, AI-powered sorting systems and automated packaging lines. These technologies cost millions to install but allow Amazon to process thousands of orders per hour at a fraction of the cost per package compared to smaller retailers. A small online shop simply couldn't afford these systems, giving Amazon a huge technical economy of scale advantage.
Larger businesses find it easier and cheaper to borrow money and they have access to more sources of finance than smaller companies.
Why banks prefer lending to large businesses:
This means big businesses pay lower interest rates and can access finance options like issuing shares on the stock market, which small businesses cannot do.
Large businesses can afford to hire specialist managers and experts in different areas, leading to better decision-making and efficiency.
While a small business owner might have to handle marketing, finance and operations themselves, large companies can hire experts in each field. A specialist marketing manager will likely create more effective campaigns than a generalist business owner trying to do everything.
This is often the most obvious economy of scale. Large businesses can buy materials, components and supplies in bulk, getting significant discounts that smaller businesses cannot access.
How purchasing power works:
McDonald's operates over 40,000 restaurants worldwide. This massive scale allows them to negotiate incredibly low prices for ingredients. They can buy beef, potatoes and buns at prices that independent restaurants could never achieve. McDonald's also works directly with farmers and suppliers, cutting out middlemen and reducing costs further. This purchasing power is a key reason why McDonald's can offer meals at such competitive prices.
Large businesses can spread the cost of advertising and marketing over many more sales, making each marketing pound more effective.
A TV advert might cost £100,000 to make and broadcast. For a small business selling 1,000 units, that's £100 per unit. For a large business selling 1 million units, it's just 10p per unit.
Large companies can build strong brands that customers trust, reducing the need for expensive marketing to convince people to buy.
Big businesses can afford sophisticated online marketing tools and data analysis that help them target customers more effectively.
Large businesses can spread risk across different products, markets and activities. If one area performs poorly, others can compensate.
How large businesses manage risk:
A small business selling just one product is much more vulnerable than a large corporation with hundreds of different revenue streams.
While economies of scale provide many benefits, businesses can become too large. When this happens, average costs start to rise again, creating diseconomies of scale.
Communication becomes difficult in huge organisations, decision-making slows down, employees feel disconnected from management and coordination between departments becomes challenging. These issues can outweigh the benefits of being large.
Tesco vs Independent Corner Shops: Tesco can negotiate better prices with suppliers, invest in efficient distribution systems and spread advertising costs across thousands of stores. This allows them to offer lower prices than independent shops, even while making healthy profits.
Netflix vs Traditional TV: Netflix's massive subscriber base allows them to spend billions on original content because they can spread these costs across millions of viewers worldwide. A traditional TV channel serving just one country couldn't justify such huge investments.
Apple's Manufacturing: Apple orders components in such vast quantities that suppliers give them preferential treatment and lower prices. They also invest heavily in research and development, spreading these costs across millions of devices sold globally.
Walmart is the world's largest retailer and economies of scale are central to their success. They use their massive purchasing power to negotiate the lowest possible prices from suppliers. Their sophisticated distribution network and inventory management systems reduce costs. They can afford to invest in technology that smaller retailers cannot. However, Walmart also faces challenges from diseconomies of scale, including difficulty managing such a vast workforce and maintaining consistent customer service across thousands of locations.
Understanding economies of scale helps explain why certain industries are dominated by large companies and why small businesses often struggle to compete on price. It also explains business strategies like mergers and acquisitions, where companies combine to achieve greater scale.
For entrepreneurs and small business owners, recognising these challenges is crucial for finding ways to compete - perhaps through superior customer service, niche products, or local market knowledge that large companies cannot replicate.
Remember: economies of scale are not automatic. Businesses must actively manage their growth to capture these benefits while avoiding the pitfalls of becoming too large and unwieldy.