Economy of scale

Overview

Economies of scale is a concept that may explain patterns in international trade or in the number of firms in a given market. The exploitation of economies of scale helps explain why companies grow large in some industries. It is also a justification for free trade policies, since some economies of scale may require a larger market than is possible within a particular country—for example, it would not be efficient for Liechtenstein to have its own carmaker if they only sold to their local market. A lone carmaker may be profitable, but even more so if they exported cars to global markets in addition to selling to the local market. Economies of scale also play a role in a "natural monopoly". There is a distinction between two types of economies of scale: internal and external. An industry that exhibits an internal economy of scale is one where the costs of production fall when the number of firms in the industry drops, but the remaining firms increase their production to match previous levels. Conversely, an industry exhibits an external economy of scale when costs drop due to the introduction of more firms, thus allowing for more efficient use of specialized services and machinery.