Question

Economies of scale can arise from many different sources."

Explain the above sentence explaining what is meant by the "economies of scale" and the different sources that allow firms to have the economies of scale. Give examples.

Answer 1

Economies of scale, refers to the phenomenon where cost of production decreases with increase in the level of output. Here, proportional increase in output is more than the proportional increase in input factors of production. It helps firms achieve output at lower cost and increase the profit margin. Economies of scale is one reason a firm can create natural monopoly.

Economies of scale can arise from different sources. The first source is the huge capital investments that reduce the cost of operation significantly as well as reduction in the variable cost. The example of it, is the investments made by the oil and gas exploration and processing companies. It makes then invest heavily in the beginning, but later on, they have lower variable cost to be incurred, achieving economies of scale. The second source is the superior productivity level of the factors of production. It increases the marginal products of the factors of production and cost decreases. So, economy of scale is created. The third source is the reduced level of cost of production in terms of lower wages or lower cost of input materials. For example, factoring in China are operating at lower wage rates and lower cost of input. The fourth source is technological advancements that increase the efficiency and productivity to increase the rate of output at relatively lower cost. It also creates economy of scale. For example, the innovation and technology driven firms use technology as a tool to achieve economy of scale.