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Chapter 6
The Theory of the Firm I:
Production, Costs, Revenues
and Profit
6.4 Returns to Scale
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Learning Objectives
 Distinguish between increasing returns to scale, decreasing
returns to scale and constant returns to scale.
 Describe how economies of scale and diseconomies of scale can
affect a firm/industry at the scale of production changes.
 Describe determinants of economics of scale and diseconomies of
scale.
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Costs In The Short And In Long Run
 Some costs are fixed in the short run, but all are variable
in the long run.
 For example, in the long run a firm could choose the size
of its factory.
 Once a factory is chosen, the firm must deal with the
short-run costs associated with that plant size.
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Returns to Scale
 Constant returns to scale the property whereby long-run
average total cost stays the same as the quantity of
output change.
 Economies of scale (increasing returns to scale) the
property whereby long-run average total cost falls as the
quantity of output increases.
 Diseconomies of scale (decreasing returns to scale) the
property whereby long-run average total cost rises as the
quantity of output increases.
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Constant, Increasing and Decreasing Returns to Scale
Factory
(1st input)
Labour
(2nd input)
Output with
Output with
Output wit
constant
increasing
decreasing
returns to scale returns to scale returns to scale
100 units of
100 units of
100 units of
output
output
output
1 plant
5 workers
€10 000
2 plants
€500
10 workers
€105
200 units of
output
€105
250 units of
output
€105
250 units of
output
€10 000
€1000
€105
€84
€140
Definition of Economies of Scale (long run)
 Economies of scale refers to when a firm enables to
produce a large scale of output level more efficiently at
lower cost.
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Economies of Scale
Costs
LRATC
Economies
of scale
0
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Output
Determinants of Economies of Scale
There are several main determinants of economies of scale:
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Determinants of Economies of Scale
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Increasing Specialisation of Labour
 When a firm expands, it reaches a certain scale of
production at which it becomes worthwhile to take
advantage of division of labour.
 Firms can afford to employ specialist staff in key posts.
 Workers begin to specialise in certain stages of the
production process, thus productivity increases.
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Increasing Specialisation of Labour
Each worker specialises in performing tasks that make
use of skills, interests and talents. This leads to:
 increasing the firm’s efficiency
 reducing cost of production
 raising demand and revenue
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Technology (Efficiency of Capital Equipment)
The larger the output of a firm, the more viable it
becomes to use large technologically advanced
machinery.
Large technologically advanced equipment is likely to be
more efficient, producing output at a lower average costs
than smaller machines.
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Technology (Efficiency of Capital Equipment)
However, a small firm with a small volume of output
cannot make effective use of large machines, and is
forced to use small, less efficient ones.
Examples:
 A large power generator is more efficient than a small
one.
 Agriculture machinery is designed for large plantations
but cannot be used in small fields.
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Overhead Expenditures
 Certain costs of activities such as marketing and
advertising, design, research and development have
lower average costs if they can be spread over large
volumes of output.
Examples: having built a factory, the cost of that factory
is the same regardless of the amount of output that is
produced. Other costs including local taxes, most
administrative costs, data processing, company pension
schemes, etc …
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Specialisation of Management
Large scales of production allow for more managers to be
employed, each of whom can be specialised in a
particular area (such as production, sales, finance, and so
on).
This leads to greater efficiency and lower average cost.
Certain number of managers (lower, middle and upper
management) are required to oversee the production
process.
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Finance and Procurement
 Large firms with a strong reputation may be able to
negotiate more favourable borrowing rates or can secure
lower supply costs because they are buying in larger
quantities and can agree discounts from suppliers.
 Banks tend to be more willing to lend large firms.
Thus, reducing average costs as output increases.
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External Economies of Scale
External economies arising from locating where there is a
specialist pool of labour or the infrastructure is better.
 If the firm is in an industry that is itself expanding, there
may also be external economies of scale.
Example: computer industry has expanded rapidly
 a pool of skilled labour is built up that all the firms can
draw upon
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External Economies of Scale
 encourage people to acquire the skills needed to
enter such sector
 colleges may begin to find it viable to provide
courses (e.g. computer engineering).
Each individual firm benefits in this way from the overall
expansion of the sector.
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Research and Development
A large firm that have a research and development
department can reduce average costs.
A firm that invests on research and development can
reduce costs and develop more efficient methods of
production will raise total revenue.
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Risk Bearing
Large firms usually produce a range of products. This
enables them to spread the risk of trading.
If the profitability of one of the products it produces
falls, it can shift its resources to the production of more
profitable products.
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Group Activity
Decide the type of economies of scale each of the following
may be an example of:
a).
A book publisher buying a large quantity of paper.
b).
A pharmaceuticals company setting up a laboratory to
develop anti-AIDS drugs.
c).
A supermarket chain employing an expert in chocolate
to place its orders with suppliers.
d).
A car manufacturer issuing new shares.
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Activity
Read Real World Focus, p. 154.
Complete All Questions.
*Note: To draw a diagram, look at figure 6.6, p. 154.
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Diseconomies of Scale
Diseconomies arise because organisation begins to get
so large and complex that management finds it more
difficult to manage due to coordination and
communication problems.
Therefore, the average costs or costs per unit of
production begin to rise as output increases.
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Economies & Diseconomies of Scale
Costs
LRATC
Diseconomies
of scale
Economies
of scale
0
Output
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Causes of Diseconomies of Scale
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Co-ordination & Monitoring Difficulties
As a firm expands and the number of employees
increase, there may come to a point where its
management runs into difficulties of co-ordination,
organisation, co-operation and monitoring.
This can lead to growing inefficiencies causing average
costs to increase.
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Communication Difficulties
A large firm size may lead to difficulties in
communication between various component parts of
the firm.
Again resulting in inefficiencies and higher average
costs.
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Poor Worker Motivation
When the staff increase, workers may begin to lose their
motivation, to feel bored and to care little about their
work, they become less efficient, with the result that
costs per unit of output start to increase.
When the staff increase, worker motivation begin to
decrease, there may be a lack of personal involvement
and engagement by management, factory workers and
office staff may feel alienated, thus leading to
inefficiency and average costs start to rise.
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Returns to Scale
 Firms generally eager to take advantage of economies of
scale, and try to avoid diseconomies of scale.
Empirical studies agree that firms can achieve economies
of scale by increasing their size.
Some studies suggest that after exhausting economies of
scale, many firms exhibit constant returns to scale, and
do not run into diseconomies of scale even as size
becomes very large.
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Summary
 In particular, many costs are fixed in the short run but variable in
the long run.
 Economies of scale are falling long run average costs resulting
from the growth of a firm.
 Diseconomies of scale are rising long run average costs resulting
from a frim growing too large.
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Activity
Test your understanding 6.5, p.155.
Complete Questions 3, 4, 5 and 6.
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