Economic of Scale Essay

Submitted By VODORODOV
Words: 529
Pages: 3

At its most basic, an economy of scale (ES) means that by making (or buying) more of something each unit you make is less expensive. For example, let's say it costs ACME widget company $20 to make 10 widgets, so the average cost per widget is $2 (20/10 = 2). If ACME can make 20 widgets but still only spend $20, then the average cost per widget goes down to $1 (20/20 = 1). That's economy of scale in a nutshell - the cost for each item goes down when more items are produced.

It's the same principle that makes warehouse stores like Costco popular: if a 2kg bag of sugar costs $2 at a local grocer, but Costco sells a 5kg bag for $4, then shopping at Costco will save you money on a per kilo basis ($1 per kilo at the grocer, $0.80 per kilo at Costco).

Here's a more detailed example of how this works:

Let's say you decide to open a lawn care business. Your only product is one service - cutting grass.

In general, ES is about the relationship between 2 things: inputs and outputs. An input is anything that goes into making your product (or, as in this case, providing your service). This includes physical things (parts and/or tools) as well as labor (effort). Inputs can also be thought of as costs (you have to buy the parts from somewhere and pay people for their labor). An output is the product or service you provide.

To keep things simple, we'll assume that you only need 2 inputs to provide your service - a lawnmower and 1 hour of time to mow each lawn. If you paid $100 for the lawnmower and your time is worth $20/hour, then the cost to mow 1 lawn is $120. For you to avoid losing money, your only customer must be willing to pay at least $120 for your single hour of work. Seems a little steep, right?

Now let's say you find a second customer. Your overall costs will be $140 to mow 2 lawns ($100 + $20 for each lawn). Your cost per lawn is down to $70 ($140/2) because you only needed to buy 1 lawnmower, so its $100 cost is spread across 2 lawns. $70 still seems a bit expensive…