Economies of scale are a cost advantage by producing more units, and there is an inverse relationship between cost and quantity. So when the quantity of output that's produced goes up, the per unit fixed cost goes down, and the average variable cost goes down as well. So essentially, having economies of scale means greater operational efficiency and synergy.
Let's look at a chart. that displays what economies of scale looks like. The orange line is the long run average cost of production.
We've got the cost plotted on the vertical axis and output on the horizontal axis. Let's look at a first data point here, where the cost is very high and the quantity is very low. As this company produces more units, it lowers its cost and produces more.
and you can see that the long run average cost comes down. and reaches a low point here. At point Q2 we have the lowest cost of production.
Producing further beyond that can actually lead to dis-economies of scale, which we will discuss later. Let's look at the types of economies of scale. There are generally two types.
The first is internal economies of scale. These are unique to the firm. For example, they have a patent, they have a special type of machine, a special type of technology, etc. The other type of economies of scale are external, and these are applied to an entire industry.
For an example, a change in government taxation. Now let's look at the sources of economies of scale. Generally speaking, there are a few categories. The first is purchasing.
Companies are able to get lower prices the more they buy. It's like a bulk discount. Another source of economies of scale is in a managerial capacity.
capacity. Companies that have better management structures are more efficient, and being more efficient means you can lower your costs. And lastly, technological advances.
If you have a technological edge, you're able to be more efficient, more productive, and have lower costs. So these are the three sources of economies of scale that are internal to a company. Now let's look at diseconomies of scale.
Disseconomies occur when the average cost actually increases as production goes up. Referring back to our long run average cost here, you can see that there's a third data point that could be Q3, where the cost actually gets higher. Examples of diseconomies of scale could occur if complexity increases, as more volume needs to be produced, or if more fixed costs need to be added when the company tips beyond a certain production point. Thank you for joining us for this economies of scale tutorial.