Examples of Internal Economies of Scale

Internal economies of scale arise when the cost of producing an item that your business sells decreases as the size of your business expands. That is, as a company grows larger and larger, overall expenses are bound to increase. However, the unit cost of producing each item falls as you discover increasing economies of scale.

The concept of economies of scale offers a good explanation of why consumers can expect to find lower prices at big-box stores, like IKEA and Walmart, than they might at a small neighborhood outlet. The larger operations can put goods on the shelf at lower overall costs due to economies of scale.

Internal Economies of Scale

Economists recognize both external and internal economies of scale. “External” applies to an industry as a whole. As the automobile industry in a country grows larger, for example, it’s possible that average costs in the industry will decrease as suppliers to the industry lower the costs of their supplies as they compete with one another.

Internal economies of scale, on the other hand, apply to an individual business. An increase in the overall size of operation – more staff, more facilities, more equipment and larger purchasing orders – can, under the right circumstances, lead to lower per-unit production costs.

Internal economies of scale can happen across multiple areas of business operations.

Technical Economies of Scale

As a company grows, it is increasingly able to take advantage of the latest technological advances. A large factory can invest in robotic machinery that reduces the cost of labor, for example, but the same investment might have been out of reach when the firm was smaller.

Market Economies of Scale

As companies make larger and larger purchases, their ability to negotiate favorable prices increases. Amazon can command cheaper shipping rates from delivery service firms, for example, than can a small business shipping out an occasional product. Raw materials purchased in bulk can be had at a cheaper cost than small-quantity purchases. The same holds true for marketing costs for things such as the cost of television spots and other advertising. Larger companies can generally negotiate lower pricing than their smaller competitors.

Savings from Workforce Specialization

Adam Smith, the patriarch of modern capitalism, described the benefits of the division of labor in his classic work, The Wealth of Nations. Having workers specialize in a particular task typically allows for greater productivity than when workers are asked to do many different tasks to bring a product to market. Henry Ford capitalized on this and other internal economies of scale when he created the first modern automobile assembly line in the early 20th century. Specialization continues to drive productivity increases in the modern age.

The advantages of division of labor are not limited to the assembly line, however. Managerial specialization also drives economies of scale. This is the case because each manager can focus on their particular area of specialty (e.g., human resources, information technology, sales) rather than being expected to act as a Jack-or-Jill-of-all-trades.

Financial Economies of Scale

As firms grow larger, their access to funds increases as well, often at better rates and more favorable terms than smaller firms. Even the avenues of financial opportunity change, as large businesses gain access to private investors and investment bank services that are not typically available to smaller firms.

Diseconomies of Scale

Not every aspect of business growth automatically leads to internal economies of scale. A growing business can easily grow itself right out of its existing quarters or find itself faced with equipment and a workforce that is seriously undersized relative to the needs of the growing demand for the product. These types of shortcomings can mean large expenses that don’t immediately produce the kinds of savings associated with economies of scale.