Economies of Scale

Economies of scale refer to the reduction of average production costs over the long term as a result of boosted output. As production increases, either within a firm or within an industry, a comparatively lower level of investment is required for each individual unit. The utility of the production process is thereby rendered more efficient as its application is spread over a wider range. The competitive attractiveness of building economies of scale lies in the fact that they allow firms to pass their cost savings on to customers, thereby lowering prices and undercutting competitors without damaging profit margins.

Scale economies also tend to heighten barriers to market entry, as smaller competitors find it increasingly difficult to cut costs to the levels possible for larger firms (made possible by their economies of scale). In this way, larger firms see economies of scale as an attractive business strategy, since it keeps new competitors from sapping their customer bases and profit margins. On the other hand, progressively cheaper technologies can pull against the advantages of economies of scale by lowering the barriers to entry and leveling the investment required to compete in a given industry.

Amazon.com is a prime example of a dot-com firm that created an economy of scale. Amazon used the strong revenues it generated as an online book merchant to escalate its size as quickly as possible. The company built large warehouses to stock its inventory and to enable it to purchase books directly from publishers, thereby bypassing its reliance on wholesalers and dramatically expanding its product line. While Amazon.com clearly built a scale economy, the strategy backfired in 2000 and 2001. The main reason for this was that the strategy banked on sustained growth in e-commerce, an assumption that proved faulty when the tech market stock bubble burst in March 2000.

As economists note, bigger doesn't always mean better. Business analysts coined the term "diseconomies of scale" to describe those conditions in which expanded production actually contributes to rising production costs and declining productivity. Usually, this is caused by excessive bureaucratization within an organization and the use of too many people in the production process, which entails more training to bring people up to speed and winds up using time and money inefficiently.