June 23, 2017 

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RISK POOLING: Combining the uncertainty of individuals into a calculable risk for large groups. For example, you may or may not contract the flu this year. However, if you're thrown in with 99,999 other people, then health-care types who spend their lives measuring the odds of an illness, can predict that 1 percent of the group, or 1,000 people, will get the flu. The uncertainty is that they probably don't know which 1,000 people, they only know the number afflicted. This little bit of information is what makes risk pooling possible. If the cost is $50 per illness, then an insurance company can insure your 100,000-member group against flu if they collect $50,000 ($50 x 1,000 sick people), or 50 cents per person. By agreeing to pay the cost of each sick person in exchange for the 50 cent payments, the insurance company has effectively pooled the risk of the group.

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Declining long-run average cost that occurs as a firm increases all inputs and expands its scale of production. Economies of scale result from increasing returns to scale and are graphically illustrated by a negatively-sloped long-run average cost curve. Economies of scale usually occur for relatively small levels of production and are then overwhelmed by diseconomies of scale for relatively large production levels. Together, economies of scale and diseconomies of scale create a U-shaped long-run average cost curve.
Long-Run Average Cost
Long-Run Average Cost Curve
Economies of scale exist when the expansion of all inputs, especially labor and capital, result in a decrease in long-run average cost. In effect, as a firm increases its scale of operations by adding more workers to a given factory and by building a larger factory, average production cost declines.

Economies of scale are the result of: (1) increased resource specialization, (2) decreased resource prices, (3) increased bi-product use, (4) increased auxiliary activities, and (5) the geometric relation between volume and area.

Increased Resource Specialization

As an activity expands, production activities are often divided into distinctive specialized tasks that can be performed by specialized resources. Consider, for example, the production of Wacky Willy Stuffed Amigos (those cute and cuddly armadillos and tarantulas). With a small scale of production, one worker might use a simple sewing machine. However, larger scale production might involve several different types of sewing machines (one for the seams, one to attach the eyes, one to embroider the Wacky Willy logo). Workers are also likely to be specialized in the operation of each machine.

This specialization enhances the productivity of both labor and capital. The average cost of producing a Stuffed Amigo with one "generic" worker using a "generic" sewing machine might be $1. However, 10 specialized workers using 10 specialized machines might be able to produced Stuffed Amigos at an average cost of 50 cents each.

Decreased Resource Prices

Another advantage of expanding the scale of production is lower resource prices. A bigger activity might, for example, receive volume discounts from suppliers. These suppliers might be able to provide discounts because they are more efficiently using their fixed inputs in the short run.

The best example of this is electricity. Expanding the production of Wacky Willy Stuffed Amigos from a small one room shop with one person operating one sewing machine eight hours a day to a 100,000 square foot factory with 5,000 sewing machines being operated by three shifts of workers 24 hours a day, also uses more electricity. The local electric company is likely to charge The Wacky Willy Company a lower price per kilowatt hour of electricity for the larger operation. It can do this because the average cost of using the fixed capital of its generator and distribution system is less with additional production and sales.

Increased Bi-product Use

Most production activities generate bi-products. In many cases these are waste residuals tossed out with the trash. Some of these bi-products, however, can be valuable if the quantity is large enough. Larger scale production often generates sufficient quantities of bi-products to make them worth marketing and selling.

For example, the one-worker, one-machine production of Wacky Willy Stuffed Amigos generates waste fabric. The amount, however, is so small that it is not worth the effort to do anything but toss it in the trash. However, producing Stuffed Amigos in a 100,000 square foot factory with 5,000 sewing machines being operated by three shifts of workers 24 hours a day, the volume of waste fabric is enormous. This fabric can be shredded, mixed with a latex adhesive, and used by Natural Ned's Garden Emporium to mold lawn ornaments. While Natural Ned has little use for a handful of fabric scraps, a truckload is a different story. By selling these bi-products, The Wacky Willy Company effectively reduces the cost of producing Stuffed Amigos.

Increased Auxiliary Activities

Many production activities purchase inputs and intermediate goods from other businesses. The Wacky Willy Company, for example, does not make its own fabric from scratch but purchases it from a fabric supplier. With a small scale of Stuffed Amigos production (one-worker, one-machine), fabric sales to Wacky Willy is a very, very small fraction of the fabric supplier's overall business.

However, should Wacky Willy expand to a 100,000 square foot factory with 5,000 sewing machines being operated by three shifts of workers 24 hours a day operation, then it also buys substantially more fabric. It might buy so much fabric that the fabric supplier sets up a fabric production facility adjacent to the Wacky Willy factory. A sewing machine repair service might also set up nearby. A trade school that does nothing but train sewing machine operators to be hired by The Wacky Willy Company might even be established in close proximity. Having these support activities close to the Wacky Willy factory lowers the average cost of producing Stuffed Amigos by reducing the cost of these inputs.

Geometric Relation Between Volume and Area

An often overlooked geometric principle is extremely important to the increased scale of production. Surface area and volume do not increase proportionately. Take, for example, a cube that is one foot on each side. The volume inside this cube is one cubic foot. The surface area includes six sides, each of which is one square foot, for a total area of six square feet. This surface areas is important, because it is the amount of material needed to construct the cube. The volume is important, because it is the available work space inside the cube.

Now suppose the size of the cube is doubled. Of course, the key question is what it means to "double" the cube size. Does this double the volume to two cubic feet or doubling the surface area to 12 square feet? To make the calculations easier, consider a third meaning, doubling the length of each side from one foot to two feet, such that the cube that is two feet on each side.

This doubling of the dimensions results in a volume of eight cubic feet, clearly eight times the volume of the original cube. The surface area now consists of six sides, each of which is four square feet, for a total of twenty-four square feet. This is four times as much surface area as the six square feet of our original cube.

What has happened? By using four times as much material to build the second cube, there is eight times as much volume inside the cube. The average cost (in terms of the surface material) of producing work space (volume) is less for the larger cube than the smaller one.

In other words, the cost of building a 100,000 square foot Wacky Willy factory is less than twice the cost of constructing a 50,000 square foot factory. This reduces the average cost of larger scale Stuffed Amigos production.

Not the Short Run

In the long run, when all inputs under the control of the firm are variable, average cost declines, resulting in a negatively-sloped long-run average cost curve. In the short run, when at least one input is fixed and at least one input is variable, average total cost declines, resulting in a negatively-sloped short-run average total cost curve. The decrease of average total cost in the short run exists for different reasons than the decrease of average cost in the long run.
  • The Short Run: Because short-run average total cost is the combination of average fixed cost and average variable cost, the source of short-run decreases in average total cost is two-fold. First, total fixed cost is spread over larger quantities, meaning average fixed cost declines with greater production. Second, increasing marginal returns in the early stages of production causes a decrease in average variable cost. The resulting decrease in average total cost only occurs in the short run.

  • The Long Run: In the long run, there are no fixed inputs. As such, because there is no fixed cost and no average fixed cost, there can be no decline in average fixed cost. Moreover, marginal returns do not guide production in the long run, so increasing marginal returns is not relevant. Instead decreasing long-run average cost results from resource specialization, resource prices, bi-product use, auxiliary activities, and the relation between volume and area.


Recommended Citation:

ECONOMIES OF SCALE, AmosWEB Encyclonomic WEB*pedia,, AmosWEB LLC, 2000-2017. [Accessed: June 23, 2017].

Check Out These Related Terms...

     | diseconomies of scale | long-run total cost | long-run average cost | long-run marginal cost | minimum efficient scale | planning horizon |

Or For A Little Background...

     | returns to scale | increasing returns to scale | long-run production analysis | long-run, microeconomics | average cost | opportunity cost | fixed input | variable input | marginal returns | marginal analysis | microeconomics |

And For Further Study...

     | long-run average cost curve, derivation | long-run, macroeconomics | average total cost curve | law of diminishing marginal returns | short-run production analysis | U-shaped cost curves | opportunity cost, production possibilities |

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