Mental Model: Economies of Scale

I have been building a list of mental models to help myself better understand the world. I will occasionally do a write-up to explain one of them and how it applies to the real world. If you want to view my full list of mental models or read my previous posts on mental models then you can go to this link: https://www.mikegorlon.com/mental-models.

Economies of scale are the cost advantages that companies experience when their production becomes larger and more efficient.

The larger size and better efficiency allow the company to spread their costs over a larger amount of goods.

To get a better idea of this in more simpler terms, think about when you go to buy water at your local grocery store.​

One bottle of water there may cost around $1 or $1.25, but when you buy a 12 pack or a 24 pack you may pay around $5-$6 for a 12 pack or $9-$10 for the 24 pack.​

The bigger the pack that you buy, the lower it cost for each bottle of water.​

1 bottle = $1.25

$6/12 pack = $0.50 per bottle

$10/24 pack = $.42 per bottle

These lower unit costs accrue to business owners as well when their business gets larger allowing them to place bigger orders for a higher volume of goods resulting in a lower unit cost.​

As the company gets bigger, they also get more efficient in running their production.

If done correctly, this can result in the competitive advantage known as economies of scale.​

Companies can take these extra savings and spend them on other benefits for their company like advertising.​

Companies like Pepsi and Coke buy huge quantities of corn syrup, water, aluminum, cardboard and other raw materials for their soda resulting in a much lower unit cost per soda than other soda companies such as RC Cola.

In other words, it may only cost Pepsi and Coke 40 cents to ​produce one bottle of soda that they are going to sell for at least $1.

Pepsi and Coke then use the excess savings from their scale for their huge marketing budgets.

This is why you’re so much more likely to see TV commercials, especially those very expensive Super Bowl commercials, for Pepsi and Coke products but you never see any from RC Cola.