Question

How do economies of scale work?

Answer 1

it's about the effect of the initial investment and it works in 2 ways .. Production Capabilities, and MPC vs MPS

First: Production Capabilities:
Consider one product type
given 10 producers, each with one owner, each with $100,000
and One Producer (10 owners) that has $1,000,000

This One Producer can buy that $200,000 machine, hire the experienced labor (even attract them from smaller producers for higher wages), bargain for raw material deals to reduce cost. and can even expand through research and development.

With production capabilities increased in productivity and limited in cost, Scale Producer can provide better quality, produce more units, at lower prices that are still profitable.

Small producers will not be able to cope with the big producer, they will be highly sensitive to market turbulence, and the gap will continue to escalate exponentially.

If Small producers scored 10% rate of return, Scale producer would definitely score 15%, but even if he scored the same (10%), it means he will amount for $100,000 which is nearly the size of a small producer. This leads to Second.

Second: Marginal Propensity to Consume vs Marginal Propensity to Save/Invest:

given that generated rate of return for Scale producer will be higher than Small producers because of better quality, productivity, and reduced cost.
so each Small producer got $10,000 profits. they will tend to distribute dividends of $5,000, and Save/Invest the other $5,000 to scale up to $105,000 business. (5% growth)

While the Scale producer will yield (say) 15%, amounting to $150,000. because the profit level is higher, MPC will decline in favor of MPS, Partners would receive better dividends of $5,500 each (still better welfare) of total $55,000, and reinvest $95,000 to scale up to $1,095,000 business. (9.5% growth)

Scale Producer's Growth rate increases at a rate faster than that of Small Producers'. Gap increases exponentially, inevitably forcing them to exit market.