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The increase in output from Q to Q₂ causes a decrease in the average cost of each unit from C to C₁.

Economies of scale characterizes a production process in which an increase in the scale of the firm causes a decrease in the long run average cost of each unit.

Economies of scale can be enjoyed by any size firm expanding its scale of operation. The common ones are purchasing (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial instruments), and marketing (spreading the cost of advertising over a greater range of output in media markets). Each of these factors reduces the long run average costs (LRAC) of production by shifting the short-run average total cost (SRATC) curve down and to the right.

This should not be confused with increasing returns to scale which is represented by the SRATC where simply increasing output within current capacity reduces the short run cost per unit.

This is, of course, an extremely simplistic example and, in real life, there are countering forces of diseconomies of scale. As these forces balance, an optimum production volume can be found (referred to as constant returns to scale).

This principle can be equally applied to an organization resulting in firms within a particular industry tending to be similar sizes. Economists have studied this effect as the theory of the firm.

A natural monopoly is often defined as a firm which enjoys economies of scale for all reasonable firm sizes; because it is always more efficient for one firm to expand than for new firms to be established, the natural monopoly has no competition. However, standard economic theory also holds that on account of the unique shapes of the natural monopoly's LRAC and SRAC, it can never experience economic profit and thus requires subsidies or other government intervention to remain profitable.

In the short run at least one factor of production is fixed. Therefore the SRAC curve will fall and then rise as diminishing returns sets in. In the long run however all factors of production vary and therefore the LRAC curve will fall and then rise according to economies and diseconomies of scale.

There are two typical ways to achieve economies of scale:

1. High fixed cost and constant marginal cost
2. Low or no fixed cost and declining marginal cost

Economies of Scale - If a firm increases its inputs twofold, its outputs increase more than twofold.
Diseconomies of Scale - If a firm increases its inputs twofold, its outputs increase less than twofold.
Constant Returns to Scale - If a firm increases its inputs twofold, its outputs increase exactly twofold.

• Diseconomies of scale
• Ideal firm size
• Economies of scope
• The Long Tail

• Economies of Scale Definition by The Linux Information Project (LINFO)