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Economies of scale occur when a business’s long-run average cost per unit falls as it increases output. The business may spend more in total while producing more, but each unit costs less on average.
What economies of scale mean
The key measure is long-run average cost: the lowest average cost a firm can achieve at a given output level when it can adjust all its inputs, such as its facilities, equipment, and workforce. If that average cost falls as output rises, the firm is experiencing economies of scale.
This is different from asking whether the company’s total spending goes up. Total costs often rise when production expands. Scale economies describe what happens to cost per unit, not whether the firm spends less overall.
A simple textbook example
OpenStax illustrates the idea with a hypothetical alarm-clock factory. Its instructional example assigns these average costs to different factory sizes; the figures are not measured costs from a real producer.
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| Factory size | Output | Illustrated average cost per clock |
|---|---|---|
| Small | 1,000 clocks | $12 |
| Medium | 2,000 clocks | $8 |
| Large | 5,000 clocks | $4 |
In the illustration, producing more clocks lowers average cost. A real company’s results depend on its production methods, costs, and market conditions; the example shows the concept rather than predicting what any particular firm will achieve. See OpenStax, Principles of Microeconomics 3e, section 7.5.
Why the long run matters
Economies of scale are a long-run concept because the firm is free to change all inputs and select a production setup suited to its output. In the short run, at least one input—such as the size of a factory—may be fixed. A business producing more in that situation is not necessarily operating at a different long-run scale.
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Not the same as diminishing marginal returns
Diminishing marginal returns concern short-run production when one or more inputs remain fixed: adding more of a variable input may yield smaller additional increases in output. Economies of scale concern how long-run average cost changes when the firm can vary all inputs. Both can occur: a fixed plant may face diminishing returns as more workers are added, while a larger plant or different technology could lower average cost at a higher scale. OpenStax explains this distinction in section 7.5.
Internal and external economies of scale
Scale economies can originate inside a firm or in the industry around it. The distinction matters because a company may benefit from its own expansion, from changes in its business environment, or from both.
| Type | Where the source originates | What it describes |
|---|---|---|
| Internal economies of scale | Within the firm | Cost advantages associated with the firm’s own growth. |
| External economies of scale | In the wider industry | Cost advantages associated with industry growth that can affect firms in that industry. |
The OECD distinguishes external economies generated by industry growth from internal economies generated by firm growth, and describes scale economies as often technology-based and connected with lower long-term average unit costs. Its SME and Entrepreneurship Outlook 2019, Annex 3.A discusses these concepts.
How industry growth can also raise costs
External effects are not always cost-reducing. The Open University gives the example of rapid industry growth increasing demand for a limited pool of skilled workers. Firms may compete for those workers and bid up wages, raising costs even when the pressure comes from the industry’s expansion rather than one firm’s own size. See The Open University’s explanation of long-run costs and economies of scale.
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When growth stops lowering average cost
Expansion does not guarantee greater efficiency. As a firm becomes very large, managing and coordinating its operations can become harder. OpenStax notes that additional management layers can contribute to communication failures and work disruptions. Such problems may cause long-run average cost to rise: this is called diseconomies of scale.
A firm’s long-run average cost curve can slope downward as scale economies emerge, flatten where average cost changes little, and slope upward if diseconomies develop. It is a model of the production choices available to a firm, not a rule that every business follows the same curve or reaches one universal ideal size. The OECD also discusses risks such as growing transaction costs and corruption, and notes that smaller-scale technologies may adapt better to fluctuating demand. Those trade-offs mean a larger operation is not necessarily the best fit for every business.
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What the evidence says about scaling firms
An OECD report published in 2025, “Scalers as drivers of competitiveness,” estimates that without scalers, median multi-factor productivity across the 11 countries with available data would have been 6% lower in 2020, on average. This is a reported counterfactual for those countries—not an estimate for every country or proof that each firm benefits from expansion. The report also says scale economies are smaller in services than manufacturing in the context it examines; that finding should not be treated as a universal rule for every service business. See the OECD report’s discussion of scalers and competitiveness.
How to assess scale effects in a business
When considering whether growth could lower costs for a particular business, separate the potential source of savings from the pressures that could offset them:
- Identify the source: Is the potential advantage tied to the firm’s own expansion, or to growth in its industry?
- Compare unit costs over time: Look at long-run average cost as output changes, rather than total spending alone.
- Check the conditions: Consider the firm’s technology, access to skilled workers and other inputs, coordination burden, and how variable demand is.
- Look for rising costs as well as savings: Management complexity or scarce inputs can offset lower unit costs, and may eventually push average cost upward.
These checks help distinguish a real scale advantage from the assumption that a bigger operation must be more efficient.
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