Nib asked
How do economies of scale work?
Cost per unit falls as output grows because fixed costs are spread and work is specialized, until size itself starts adding cost.
6 steps, drawn by Nib. Read it here, or watch him draw it. Updated .
1the puzzle
The Ford Model T Runabout was introduced in 1908 at 825 dollars. By October 1924 its price had fallen as low as 260 dollars.
2the line
Ford's moving assembly line cut chassis assembly time from 12 hours and 8 minutes to 1 hour and 33 minutes. Building many cars on a specialized line is what economists call exploiting economies of scale.
The line cut chassis assembly from 12 h 8 min to 1 h 33 min.
3fixed cost
Fixed costs, like the factory and its machines, do not depend on how many cars are made. Dividing them over more cars makes the fixed cost per car fall. Specialized workers and bulk buying of materials push costs down too.
4size has a cost
But growth is not free forever. A bigger firm needs more layers of managers, more meetings, more delays. That extra cost per car creeps upward.
5the U
Add the falling fixed cost per car to the rising coordination cost per car and you get a U-shaped average cost curve. The low point is the minimum efficient scale. To the left, growing lowers cost per unit (economies of scale); to the right, growing raises it (diseconomies of scale). So bigger is cheaper only up to a point.
Bigger is cheaper only up to the minimum efficient scale.
What happens to average cost beyond the minimum efficient scale?
Show the answer
It rises again, which is called diseconomies of scale.
6the whole idea
So here is the whole idea. Growing lowers the cost of each car, for a while. Ford rode the falling side; past the bottom, size itself becomes the cost.
Bigger gets cheaper per unit only up to a point, and finding that point is half of running a business.