Economies of Scale and Scope

Revised, March 2018

Ultimately, managerial economics involves calculating value to determine how to best maximize profit. The economy-of-scale (economy-of-size) and economy-of-scope concepts are two ways to think about the most efficient use of  available resources (mostly fixed costs) to address need.  Solid business planning will consider both concepts; after all, getting “the most bang for your buck” is best way to get the most profit from the enterprise, as well as determine the most efficient and sustainable production levels.

The economy-of-scale concept is essentially spreading fixed costs over a large number of units of production. Because fixed costs remain the same regardless of the number of units produced.  Increase the number of produced-units; the per-unit fixed-cost and the total-cost-per-unit also decline. Examples of fixed costs include depreciation on machinery or a processing facility, administrative overhead, interest payments on real estate or capital assets, and other costs that remain constant regardless of production level. The savings across the number of units with a low-fixed cost business is significant. Of course, cost-reduction for a high-fixed cost (for example start-up cost) business will be considerably greater over time and units of production.

The economy-of-scope concept is the process of reducing the cost of resources and skills for an individual project or enterprise by spreading the use of these resources and skills over two or more projects or enterprises. This concept is about efficiently using available resources to address need. For example, fixed cost for an enterprise is now half if those available resources can be applied over two projects or enterprises rather than just one. If those same resources are further spread over three projects or enterprises, the cost per project or enterprise is reduced to a third, and so on.

For example, as a farmer, agronomic skills, or the education needed for farming and farm-business management, can be used in the production of multiple crops; being both a seed dealer and a farmer means that the knowledge gained in either area be used both as a salesperson and a farmer; farmers who sell crop insurance leverage their expertise as farmers. With respect to the fixed-cost associated with equipment, the cost of a tractor or combine can be spread over several crop enterprises because, the tractor serves many roles for many crop or livestock enterprises and the combine, with different grain heads can be employed with several crops, as well as for off-farm contract harvesting. Separate tractors or combines do not need to be purchased for each additional crop enterprise.

It is important to remember that economies of size and scope are not mutually exclusive. Economies of scope allow cost sharing across several enterprises; additionally, the size of the individual projects or enterprises should be increased to those “sweet spots” that achieve optimal economy of size.

It is, of course, important to realize that both the economy-of-scale and economy-of-scope will have limits, and one should know where those limits come into play, and become major cost issues, with respect to your project or enterprise. For example, there will be a point where there is optimal cost benefit, after that, cost-per-additional-unit will increase. This could due to extra energy or equipment demands, need for rented storage space, market saturation and overkill and perhaps a need to expand marketing, storage or transportation beyond what is at hand or economical.

For more in depth consideration of these concepts, consult any textbook on microeconomics and search the various resources available elsewhere on the Internet. For any particular agricultural enterprise, it is important to consider similar operations and how their growth from economy-of-scale or economy-of scope, or was eventually complicated or limited by them.