Economies of scale the bigger the factory, the lower the cost

IN CONTEXT

FOCUS

Markets and firms

KEY THINKER

Alfred Marshall (1842–1924)

BEFORE

1776 Adam Smith explains how large firms can lower unit costs through labor division.

1848 John Stuart Mill suggests that only large firms can adapt successfully to certain business changes, and that this can lead to the creation of natural monopolies.

AFTER

1949 South African economist Petrus Johannes Verdoorn shows that increasing growth creates increasing productivity through economies of scale.

1977 Alfred Chandler publishes The Visible Hand: the Managerial Revolution in American Business, which describes the rise of giant corporations and mass production.

From the beginning of the Industrial Revolution, when manufacturing shifted from small-scale outfits to large factories, it became apparent that bigger firms could produce at a lower cost. As a firm grows and produces more, it uses more machinery, labor, and raw materials, so a bigger factory has higher total costs. But it can also produce more for a lower unit cost. This fall in average costs is known as economies of scale.

In 1890, British economist Alfred Marshall explored this effect in Principles of Economics. He pointed out that when firms increase their output, all they can do in the short run is alter the number of workers to increase production—nothing else.

As extra workers add less to output than the workers before them, costs per unit rise. Yet in the long run, if a firm is able to double the size of its factory, workforce, and machines, it will be able to take advantage of the specialization of labor, and costs will fall.

In the 1960s another British economist, Alfred Chandler (1918– 2007), showed how the growth of large corporations caused a new Industrial Revolution at the start of the 20th century. Large enterprises came to dominate industries, producing more goods at lower cost and driving competitors out of business. These large firms often enjoyed a natural monopoly.