Economies of Scale and the Rise of Mega Factories: The Case of Tesla’s Gigafactories

A fundamental economic concept is economies of scale. This shows how large firms can produce more efficiently than small ones (up to a certain point at least), with lower short-run average costs the more they produce. As a result, we have begun to see a rise in mega-factories, as market-leading firms have continually tried to produce as much as they can at the least cost possible. Elon Musk’s Tesla has put this into practice with the development of a chain of what it calls gigafactories, from California to Shanghai.  

Economies (and Diseconomies) of Scale

Economists often talk about the benefits of economies of scale. As the following graph shows, the average costs (AC) of a firm change depending on the timeframe and scale of production. As firms expand, they can gain cost savings, which results in lower average costs than for smaller production levels.

For example, a firm may begin producing a product using a single production line in one factory. Its fixed costs, at that point, solely relate to operating that factory. If it has the confidence to add an extra production line or factory, the additional costs are likely to be smaller, leading to lower average costs overall.

In the following graph, we can see a series of short-run average cost curves that relate to a series of potential output ranges. Each new short-run curve represents the firm adding additional capacity. At all production levels up to point Q, each successive short-run curve results in economies of scale.

In many industries you can reach a level of output when average costs stop reducing, however. Here, a firm may begin to have issues from being “too” large. These are called diseconomies.

The Rise of Gigafactories

One way that firms have tried to increase their production capacity is by building bigger and bigger factories – mega factories. The term megafactory was first coined by Benchmark Minerals, a specialist information provider for the lithium-ion battery to electric vehicle (EV) supply chain, in its Lithium-ion Battery Megafactories Assessment that tracks the global build-out of cell capacity worldwide.

Although the name originated in the EV industry, mega factories can operate in any industry of a large enough scale.

Ironically, however, there is now a new name for even larger factories, and it also originated in the EV industry. These are gigafactories. Elon Musk originated the term in a Tesla investor’s call in 2013 when talking about the need to massively increase battery production capacity.

Since then, Musk’s proposition has become a reality, and there are now about 200 gigafactories worldwide.  Tesla currently operates five gigafactories (in Nevada, New York, Texas, Shanghai, and Berlin), with a further five gigafactories in development and negotiation.

How Tesla’s Gigafactories Drive Economies of Scale

As their names suggest, Tesla’s gigafactories enable the production of electric vehicles and their components on a massive scale.

Tesla recognizes the benefits of vertical integration by customizing each gigafactory to specialize in the different components needed for electric vehicles. For example, the factory in Nevada is one of the world’s largest battery manufacturing plants. It focuses on producing electric motors, energy storage products (Powerwall), batteries, and drivetrains. The New York gigafactory specializes in building solar roofs, solar panels, and electric components. The Shanghai plant focuses more on the finished product, in particular, the Model 3 and Model Y cars.

One of the reasons that Tesla has distributed its gigafactories around the world is to minimize the transport of complete vehicles as much as possible. They have aimed to build their cars near the consumers who will ultimately buy them. Why there are costs of transporting parts around the world, these are less than the costs of transporting their cars from a central location.

The Tesla gigafactories produce on a massive scale and take advantage of advanced automation and artificial intelligence. The factories are built using a modular design, making it easy to expand them if there is high demand.

The combination of vertical integration, automation and optimizing their supply chains, has significantly reduced Tesla’s production costs, moving them to a much lower short-run average cost curve than earlier. This has resulted in Tesla being able to reduce their prices over time, making them more competitive against traditional petrol cars. Tesla doesn’t appear to be suffering any obvious diseconomies yet, meaning they can still benefit from opening further gigafactories.

What Diseconomies Could Tesla Face if It Gets Too Big?

So far, Tesla doesn’t appear to have faced diseconomies. It is continuing to expand and has more gigafactories in the pipeline. But what issues could it face as its production levels increase?

The larger the Tesla empire grows; the more difficult communications and logistics and communications could become. This could be heightened by Tesla’s focus on vertical integration – if they don’t get all parts of the production chain perfectly coordinated, there could be waste and unused capacity caused by shortages at various stages of production.

There are two main types of diseconomies of scale:

1. Internal diseconomies of scale – an increase in the Long Run Average Cost (LRAC) due to what’s happening in the firm, e.g. poor communications, logistics, or worker alienation at being in such a large firm.
2. External diseconomies of scale – an increase in LRAC due to a growth in the industry, e.g. a shortage of skilled workers at Tesla’s gigafactories, if the EV industry grew more quickly than businesses can train workers, or an increase in component prices, including tariffs on imported components. While EV usage is considered carbon-free, scientists believe that large-scale production of EV batteries is causing environmental pollution. They observe that the precious metals used are hazardous to human health.

While Tesla can do little about external diseconomies, it will have to work on perfecting its systems to minimize the chances of internal diseconomies as it grows.