A firm’s minimum efficient scale (MES) of production is the smallest output volume for which unit costs reach a minimum. If a firm wishes to minimize its production costs, it must enter and operate within its industry at the MES.
Knowing the MES helps a firm to determine the scale of operations at which costs will be lowest. This is a key determinant of profitability and the amount of capital investment that a firm may need to enter an industry. Certain industries may thus be attractive to new entrants because of their small-scale economies, while others are less attractive because they require large-scale economies.
What one really wants to know, however, is the ratio of MES to the overall size of the market.This ratio helps a firm understand what market share is required to permit a low-cost entry into a market and achieve cost parity with existing producers. If a firm cannot readily acquire the market share needed to support the MES, it will operate with a higher cost structure than industry incumbents.
For example, assume an industry where a 15 percent market share is required to achieve cost parity with incumbents. A new entrant to this industry should therefore target its market share at 15 percent or above to have unit costs as low as those of incumbents.In addition, the new entrant should expect prices to decrease since its entry will increase the industry supply, driving prices down. The exception to this situation would be where a new entrant drives an incumbent from the industry and replaces their capacity.
For incumbents, a large MES may represent a barrier to entry for their industry. If all else remains equal, a large MES relative to the market can create a disincentive for entry, due to the difference between pre- and post-entry pricing. Equally importantly, long-term survival at a scale less than MES requires that a firm achieve some valuable differentiation which allows it to charge a price premium. Product or service differentiation thus becomes critical for firms operating at a scale below MES.