What is... 'economies of scale'?

Imagine a firm which makes bricks. The current plant has a maximum capacity of 100,000 bricks per week and the total costs are £200,000 per week. The average cost for each brick, therefore, is £2.

The firm then expands. It doubles the size of its plant. The total costs, obviously, increase - they are now using more land and putting up more buildings, as well as hiring extra labour and buying more equipment and raw materials. All of this expansion doubles the total cost (although it should be pointed out that such a neat figure is unlikely in real life).

TC is now £400,000 per week. The expansion of the plant means that the firm can reorganise and use its capacity more effectively. Total output now rises to 220,000 bricks per week. The proportionate increase in the total costs is less than the proportionate increase in output. Total costs has risen 100% and total output by 120%, which means that the average cost per brick is now 400,000 / 220,000 = £1.81 per brick.

The firm now has two scenarios.

Scenario 1

The firm could charge the same amount as before to its customers but widen its profit margin by 19p per brick, which would give it a much healthier profit.

Scenario 2

Alternatively, the firm could reduce the price compared to its competitors and gain some competitive advantage.

Economies of scale therefore occur where the proportionate rise in output as a result of the expansion or growth of the firm is greater that the proportionate rise in costs as a result of the expansion.