Economy of scale refers to cost advantages that a firm experiences by increasing its scale of operation. Larger size of firms helps in achieving lower cost of production per unit of output.
Economies of scale can be divided into two categories: (a) Real economies and (b) Pecuniary economies.
A. Real economies:
Real economies are the benefits resulting from bulk production and cause reduction in average cost of production. There are various sources of real economies of scale. Some of the important sources of real economies are described below:
1. Indivisibilities of Factors of Production:
Most factors of production are indivisible to a large extent. Suppose, the capacity of the smallest machine available for producing of a particular product is 1000 units per day. Even if a firm requires to produce only 100 units per day, that firm will have to use this machine.
It is not possible for the firm to use one-tenth of the machine to match its scale of operation. Obviously, unit cost of using this machine is higher for this firm than the firm which can utilise 80-90% of its capacity.
For firms producing small quantities of output, rent of machine and its maintenance cost are spread over smaller number of units, thereby causing increase in per unit cost of production. This is also true for certain raw materials, which are not available in small quantities. Thus, large-scale production helps in reducing average cost due to indivisibilities of the factors of production.
2. Reserve Machine and Inventory of Spare Parts:
Every production unit keeps some important machines in reserve so that the production process remains uninterrupted even if one or two of the machines break down. The number of reserve machines does not increase in proportion to the number of machines in use.
For example, when ten machines of a particular type are in use, may be two extra machines are enough to be kept in reserve, but when the number of machines in use is only one, number of reserve machines cannot be reduced in proportion. That is, for one machine in operation, the number of standby machine must be atleast one. It is also valid for maintaining inventory of spare parts.
Advertising expenditure per unit of output is smaller for larger firms. This is because of two things: (a) advertising cost does not change significantly with variation in output; and (b) in some cases advertising costs are also indivisible. For example, there is a minimum size of advertisement for print media and a minimum duration for the audio (e.g., radio) and audio-visual (e.g. TV) madia.
4. Storage Costs:
A storage cost per unit of output is smaller for larger firms. Because even if a small quantity is to be stored, the entire warehouse would be required. Under-utilisation of this indivisible factor leads to increase in average cost. Obviously, storage costs are likely to decline with increase in scale of operation.
5. Transport Cost:
Transport cost per unit of output gets reduced till the full capacity of vehicles is utilized. Moreover, large volume of finished goods requires larger vehicles, which also reduces average transport costs. Undoubtedly, average cost of transport increases if quantity of output exceeds capacity of vehicles marginally, because for that extra quantity another vehicle needs to be hired.
B. Pecuniary economies:
Pecuniary economies are the benefits derived from paying lower prices for the factors used in production and distribution of the product, because as the size of operation increases, a firm purchases in bulk quantities and acquires bargaining power.
i) Bulk producers find an opportunity to bargain with suppliers and settle their deals at lower rates.
ii) Advertising agencies often pass on a part of their commission obtained from the media to the big clients.
iii) Transport agents also charge lower rates from the large scale producers since they get regular orders from them.