Understanding Economies of Scale

Man Selling

I saw something on the news about Amazon’s deal with the United States Postal Service recently. I’m not sure I understand everything that’s going on with it, but I have to say that I find it kind of fishy that Amazon can afford to deliver stuff to me so cheaply. My parents have Amazon Prime, and they use it to ship things to their house or to me at my dorm all the time. The two-day shipping is free, so Amazon is paying for it, but all the stuff on Amazon is still so cheap. How can this be? Is Amazon ripping off the United States Postal Service, like some people are saying?

We don’t get political here at Ask the Experts, so we’ll have to let you make up your own mind about how fair or unfair Amazon’s business practices and deal with the United States Postal Service are. However, we can give you the background you’ll need to analyze everything.

Amazon is not without its critics, as we suggested above. Some people claim that their deal with USPS is unfair. Many experts support a more common criticism, which is that Amazon skimps on costs at the expense of their workforce. We’ll examine those claims in a moment. However, we should first look at the single largest factor in Amazon’s low prices and cheap shipping: economies of scale.

An economy of scale is something that saves money by taking advantage of high volume or some other factor that makes the scale we’re dealing with large. Let’s use a hypothetical to understand how it works.

Let’s say you want to sell widgets. You sell three widgets on three different days to three different customers, so you drive three times to the post office and send three different boxes. You charge a price that makes you a small profit.

What if one customer buys all three widgets? You still have some set costs: the widgets themselves, for instance. However, now you only have to take one trip to the post office. Maybe you can save on shipping, too, by putting them all together. You can charge less for the widgets, and make the same profit.

This is an economy of scale! Savings like this are the reason that buying wholesale is cheaper. And the benefits mount as you grow larger and larger. When you bought your WidgetMaker 3000 (which makes widgets, of course), it cost you a certain amount. The price was set, regardless of how many widgets you were making. However, if you make more widgets with it, you’ll get more bang for your buck, of course. You’ll pay for electricity and employees, but each widget will effectively cost less to make, because the fixed costs like that of the WidgetMaker 3000 are spreading across a larger and larger number of sellable items. This is why buying wholesale is so cheap.

Amazon is a great example of how scale works in business. Amazon sells a ton of items, so it can make huge profits overall, even while making small profits on each item. It can get good deals on shipping by offering a big chunk of business to one carrier; in this case, USPS. Amazon certainly has plenty of costs that rise as it ships more items. However, in many cases, it is able to get more efficient the more stuff it sells!

That’s not the whole story, of course. Amazon employees may be overworked. Some politicians feel that Amazon’s deal with the USPS is unfair (though many experts disagree). Some experts are concerned about large-scale competition in general, fearing it hurts local business. You’ll have to develop your own opinions!

“Education is the best economic policy there is.” - Tony Blair

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