Economies of scale – benefits that come from high production volumes – can make it hard for new companies to enter an industry. Incumbent firms with high production volumes gain benefits from their scale – companies entering the market at a small scale face a competitive disadvantage.
This article unpacks how economies of scale can act as a barrier to new firms entering a market – potentially deterring the entrance of new companies, or causing those companies that do enter to face a disadvantage relative to incumbent firms.
Overview of economies of scale
Economies of scale arise from savings that are achieved as the volume of production increases – the more you make of a product, the lower the cost per item. Common sales economies include:
- Purchasing materials at a better rate: There may be volume discounts in the raw materials, arising from better bargaining power, savings on delivery, or other cost savings relative to small or one-off purchases.
- Fixed costs are spread over a larger number of products: There are likely fixed costs in operating, inured irrespective of the number of products produced. These may include the rent on a facility, the cost of machinery, or the cost of developing the product. When you manufacture a larger volume of products, these costs are spread over a much larger number of products, in turn pulling the fixed cost allocated to each product lower.
- Labor cost per unit declines: Beyond costs that are entirely fixed, there are certain variable costs that may decline the greater volume that you produce. Greater volumes may allow more efficient routines to be implemented, potentially reducing the labor component of each product produced
How are new entrants disadvantages by economies of scale?
Small entrants face a competitive disadvantage
One of the primary ways that economies of scale act as a barrier for new firm entry is that the new companies will face a cost disadvantage relative to much larger existing companies. New companies may for example not have the scale to purchase material at a better rate or spread fixed costs over a large number of products.
New firms don't have the brand recognition to overcome economies of scale
The challenge of not having the scale to operate as efficiently as incumbent firms is compounded by the fact that new entrants may not have the established brand in order to grow the company to overcome sale disadvantages. Rather than the economy of scale barriers being a temporary disadvantage, new firms may have a permanent challenge – lacking the brand to build up production volumes, and facing a competitive disadvantage that further compounds their challenge to grow.
The market may not support a large new entrant
Another challenge that can block entrance is that the market may not support another large firm. It may simply not be possible for another firm to achieve the economies of scale necessary to be efficient, because there isn’t a large untapped population that can be sold to. Especially in stagnant or declining markets, the only way of achieving economies of scale would be to acquire customers from incumbent firms (which would potentially result in intense competition, as firms look to maintain their customer base to sustain their economies of scale).