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What Are Economies of Scale? - Definition & Impact on Fixed Costs

What Are Economies of Scale? - Definition & Impact on Fixed Costs
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  • 0:02 Why Companies Have…
  • 1:09 Importance of Marginal Costs
  • 3:06 Blunders
  • 5:22 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

People talk often about the importance of 'economies of scale,' but what does that even mean? This lesson explains that concept, as well as the impact that economies of scale have on both fixed costs and marginal costs.

Why Companies Have Many Factories

Across the United States, there are all sorts of factories. Among these factories, there are many car plants, including some that you may not immediately associate with the United States. From Toyota to BMW, Honda to Subaru, a surprising number of car companies have built plants throughout the U.S. But why? For many companies, it is in order to achieve what is called economy of scale, or making sure that the scale of production is in line with the most profitable possible outcomes over the long term.

Before I go on, notice that I said long term - some significant short-term expenses may be necessary to achieve long-term profitability. By trying to achieve economy of scale, companies of all sizes can work to realize larger profits with smaller investments. By ignoring it, companies can quickly lose money, and often become material for the jokes of future economics students.

Importance of Marginal Costs

At their core, economies of scale are dependent on the marginal cost of the next good produced. Over the long term, marginal cost declines, but as more and more of a good is produced, it rises again to account for new capital expenditures, such as factories and staff required to produce additional goods. These costs are often fixed, and smart companies usually try to reduce them. However, by focusing on marginal costs, real savings can result. Good managers can hope to achieve economy of scale by keeping marginal costs as low as possible.

For example, one way that many foreign car manufacturers have achieved economies of scale in the United States is through opening domestic factories. Already, plants in their home countries were producing at a rate that would have required extra capital investment in terms of land, machinery, and staff. However, the price of foreign cars sold in the United States is significantly higher than it has to be due to tariffs charged on imported cars. By moving some of their manufacturing to the United States, those car companies could access a large market, as well as the ability to expand their own operations.

Further, far from charging tariffs, many state and local governments offer tax breaks to large car manufacturers. Also, since the new factories had to be built anyway, there was little effect on the fixed costs of the project. In short, automakers were able to lower their marginal cost for the next few thousand cars by locating plants in the United States, helping to achieve economies of scale.

Blunders

Of course, as is so often true, too much of a good thing can be terrible for an economy. It is important to always focus on marginal cost rather than total cost when adjusting to achieve an economy of scale. Remember, the marginal cost is the cost to produce just one more unit of a good, whereas the total cost is the sum of all costs of production. Failure to do so can leave some pretty crazy side effects.

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