Economies and Diseconomies of scale

Economies of Scale
Goods can be produced at a lower cost per good as the quantity produced increases as a result of efficient specialization of machinery and labor for large-scale factory operations. Average fixed costs will decline as costs such as advertising can be spread across more and more units.

Reasons:

• Mass production
• specialization of factors of production
• Learning by doing

Diseconomies of Scale
Occur when per unit costs go up as output is increased as a result of bureaucratic inefficiencies – more attention may be given to administrative rules as opposed to innovation. Worker motivation is also more difficult as the number of employees increases.

Reasons:

• Coordination inefficiencies
• Increasing difficulties in communications
• Increased principal-agent problems

When economies of scale occur, the long-run average total cost (LRAC) curve will be declining; with diseconomies of scale, the LRAC curve will be rising.

Law of diminishing marginal returns to a Factor of Production

At low level of output, increasing inputs may cause production to go up at an increasing rate, i.e. increasing mariginal return. Think two workers may be more efficient than one worker.

But after certain point, production will increase at diminishing rate as cost rise at an increasing rate. Think the working field may not support well for too many workers.

Curves of costs

Short-run marginal cost (MC) curve

• At first decline and then go up at some point, and intersect the average total cost and average variable cost curves at their minimum points.

Average variable cost (AVC) curve

• Go down (but will not be as steep as the marginal cost), and then go up. This will not go up as fast as the marginal cost curve.

Average fixed cost (AFC) curve

• Decline as additional units are produced, and continue to decline.

Average total cost (ATC) curve

• Initially decline as fixed costs are spread over a larger number of units, but go up as marginal costs increase due to the law of diminishing returns.

The marginal revenue curve

• Horizontal and equal to price for price takers (pure competition), and downward sloping and below demand curve for a price searcher (monopolistic competition, oligopoly, or monopoly).

Factors that Cause Cost Curves to Shift

• Increase in prices of resources => shift upwards.
• Increase in Taxes => shift updwards
• Tax on variable input shifts MC, AVC, & ATC. Fixed tax shifts AFC & ATC.
• Cost-reducing technological improvements => shift downwards.
• Which curves to be shifted depend on whether the technology affects fixed or variable costs.

Type of costs

Total fixed cost (Sunk cost) (TFC)

• Already incurred due to past decisions
• Cannot be changed in short run.
• Related to passage of time but not level of production
  

Total variable cost (TVC)

• Incurred in producing goods eg labour and raw materials
• Can change in short run
• Related to level of production but not passage of time
  

Average fixed cost (AFC)

• Averaged fixed cost decreases as output increase
  AFC = ATC / total output
  

Average variable cost (AVC)
AVC= TVC / Total output

Average total cost (ATC)

• Total cost per unit of output
  ATC= (TFC + TFC) / Total output
  

Marginal cost

• Additional costs of producing one more unit
  MC = DTC/Dq
  TC = TFC + TVC

Opportunity costs

• The return available from alternative investments

Decision time frames

Short run
In long run, firm can Increase output by changing variable factors such as labour. But, some production factors including size of the plant, the size/number of plants, the technology used, equipment and the management organization cannot be changed

Long run
In the long run, firm has sufficient time to adjust any and all production factors, e.g. expanding/shrinking/demolishing/building factories or leaving/entering an industry.

My tips:

• Differences in short run and long run are critical to the concept of economic profit.