A2 Economics
PowerPoint Briefings 2007
Economies of Scale
Long Run Production
and Costs
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In the Long Run
• In the long-run
• “But this long run is a misleading guide to current
affairs. In the long run we are all dead. Economists
set themselves too easy, too useless a task if in
tempestuous seasons they can only tell us that
when the storm is long past the ocean is flat again.”
• John Maynard Keynes, 1936
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Long Run Costs
• Economies of scale are not relevant in the short run
production function
• Economies of scale are the cost advantages that a
business can exploit by expanding their scale of
production in the long run. The effect of economies
of scale is to reduce the long run average costs of
production over a range of output.
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Long Run Returns to Scale
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Long Run Output
(Units)
Total Costs (£s)
Long Run Average
Cost (£ per unit)
1000
12000
12
2000
20000
10
5000
45000
9
10000
80000
8
20000
144000
7.2
50000
330000
6.6
100000
640000
6.4
500000
3000000
6
Returns to Scale – Work out the total cost for
each scale of production
Factor Inputs
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Production
Costs
(K)
(La)
(L)
(Q)
(TC)
(TC/Q)
Capital
Land
Labour
Output
Total
Cost
Average
Cost
Scale A
5
3
4
100
Scale B
10
6
8
300
Scale C
15
9
12
500
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200
Now calculate average cost for each scale
Factor Inputs
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Production
Costs
(K)
(La)
(L)
(Q)
(TC)
(TC/Q)
Capital
Land
Labour
Output
Total
Cost
Average
Cost
Scale A
5
3
4
100
3256
Scale B
10
6
8
300
6512
Scale C
15
9
12
500
9768
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200
Measuring the Returns to Scale
Factor Inputs
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Production
Costs
(K)
(La)
(L)
(Q)
(TC)
(TC/Q)
Capital
Land
Labour
Output
Total
Cost
Average
Cost
Scale A
5
3
4
100
3256
32.6
Scale B
10
6
8
300
6512
21.7
Scale C
15
9
12
500
9768
19.5
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200
The Long Run Average Cost Curve
• The LRAC curve or ‘envelope curve’ is drawn on
the assumption of their being an infinite number of
plant sizes – hence its smooth appearance
• If LRAC is falling when output is increasing then the
firm is experiencing economies of scale
• When LRAC rises, the firm experiences
diseconomies of scale
• If LRAC is constant, then the firm is experiencing
constant returns to scale
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Drawing the Long Run Average Cost Curve
Cost
per
unit
AC1
AC2
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AC3
Output
Drawing the Long Run Average Cost Curve
Cost
per
unit
AC1
AC2
AC3
LRAC
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Output
Drawing the Long Run Average Cost Curve
Cost
per
unit
AC1
AC2
AC3
LRAC
Q1
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Q2
Q3
Output
The LRAC as a cost boundary
Cost
per
unit
Attainable
costs per
unit
LRAC
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Output
Cost advantages of economies of scale
AC1
AC2
140
AC3
120
C os ts (£)
100
80
60
40
20
0
0
1
2
3
4
5
O u tp u t
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6
7
8
9
10
Scale economies – higher output
MC1
AC1
AC2
140
AC3
120
Costs (£)
100
80
60
40
20
0
0
1
2
3
4
5
Output
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6
7
8
9
10
Scale economies – higher output
MC1
AC1
AC2
140
AC3
120
MC3
Costs (£)
100
80
60
40
20
0
0
1
2
3
4
5
Output
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6
7
8
9
10
Scale economies – higher output
MC1
AC1
AC2
140
AC3
120
MC3
Costs (£)
100
80
60
40
AR
20
0
0
1
2
3
4
5
Output
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6
7
MR
8
9
10
Scale economies – higher output
MC1
AC1
AC2
140
AC3
120
MC3
Costs (£)
100
80
60
40
AR
20
0
0
1
2
3
4
5
Output
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6
7
MR
8
9
10
Scale economies – higher output
MC1
AC1
AC2
140
AC3
120
MC3
Costs (£)
100
80
60
40
AR
20
0
0
1
2
3
4
5
Output
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6
7
MR
8
9
10
Scale economies – higher profit
MC1
AC1
AC2
140
AC3
120
MC3
Costs (£)
100
80
60
40
AR
20
0
0
1
2
3
4
5
Output
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6
7
MR
8
9
10
Internal Economies of Scale
• Internal economies of scale arise from the internal
growth of a business as it expands the scale of its
operations
• External economies of scale result from the
expansion of the industry as a whole of which the
business is a member
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Technical Economies of Scale
• Expensive capital inputs: Large-scale businesses
can afford to invest in expensive and specialist
capital machinery
• Specialisation of the workforce: Within larger firms
there is the possibility of splitting complex
production processes into separate tasks to boost
factor productivity
• The law of increased dimensions or the “container
principle
• Learning by doing: The unit (average) costs of
production typically decline in real terms as a result
of production experience
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Exploiting Size and Scale
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The container principle
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Scale economies in printing
• Advances in printing
technology and the
use of huge printing
presses have driven
down the costs of
publishing
• Print on demand
increases the
elasticity of supply
for many publishing
businesses
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Marketing Economies of Scale
• A large firm can spread its advertising and
marketing budget over a much larger output
• It can purchase its factor inputs in bulk at
negotiated discounted prices if it has monopsony
(buying) power in the market
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Managerial Economies of Scale
• This is a form of division of labour
• For example, large-scale manufacturers employ
specialists to supervise production systems
• Increased investment in human resources and the
use of specialist equipment, such as networked
computers can improve communication
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Financial Economies of Scale
• Larger firms are usually rated by the financial
markets to be more ‘credit worthy’ and have access
to credit facilities, with favourable rates of
borrowing
• Businesses quoted on the stock market can
normally raise fresh money (extra financial capital)
more cheaply through the sale (issue) of equities to
the capital market
• Larger companies are also likely to pay a lower rate
of interest on new company bonds because of a
better credit rating.
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Learning economies
• Learning reduces unit cost (LRAC) through the
benefits of industry experience
• Businesses learn through experience the most
productive processes
– Workers may become more adapt at their job and
their speed increases.
– Managers learn to schedule the production process
more effectively.
– Engineers improve design tolerances and learn to
develop better and more specialised tools and plant
organisation.
– Suppliers learn how to process materials required
more effectively
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Learning Economies
Cost
(per unit
of output)
Economies of Scale
B
LRAC1
Output
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Learning Economies
Cost
(per unit
of output)
Economies of Scale
A
B
Learning
C
economies
LRAC1
LRAC2
Output
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Network Economies of Scale
• Some networks and services have huge potential
for economies of scale
• As they are more widely used (or adopted), they
become more valuable to the business that
provides them
• The classic examples are the expansion of a
common language, a common currency, online
auctions and air transport networks
• The marginal cost of adding one more user to the
network is close to zero, but the resulting financial
benefits may be huge
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Network economies in aviation
• Consider a long haul flight from Sydney to London
or Amsterdam
• Virtually every city in Europe is just a short
connecting flight away
• Networks allow consumers to move quickly
between many different centres of population
• Network economies also important for producers –
their production and distribution systems need to be
in easy reach of both their suppliers and their
customers
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Single routes
5 Aircraft
A
B
C
D
E
F
G
H
I
J
5 Routes
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5 Aircraft – 55 connections
5 Aircraft
A
B
J
C
I
D
H
E
G
F
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55 Connections
2 Networks and an Alliance
2 Networks / Alliances
A
B
A
B
J
C
I
D
H
E
G
C
I
D
H
E
F
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J
G
F
= 210 Connections
The Minimum Efficient Scale
• The minimum efficient scale (MES) is the long run
output where a business fully exploits the available
internal economies of scale
• It corresponds to the minimum point of the long run
average total cost curve
• This is also the output where a business achieves
productive efficiency
• The minimum efficient scale will vary from industry
to industry
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External Economies of Scale
• When the long-term expansion of an industry leads to the
development of ancillary services which benefit all or the
majority of suppliers in the industry
– A labour force skilled in the crafts of the industry
– Components suppliers re-locate close to production
centres – reducing transportation costs
– Concentration of the food processing industry around
ports
– Trade magazines in which all firms can advertise
cheaply and disseminate information
– Development research capabilities in local universities
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• External economies partially explain the tendency for firms
to cluster geographically
Economies of Scope
• Economies of scope occur where it is cheaper to
produce a range of products rather than specialize
in just a handful of products.
• A company’s management structure, administration
systems and marketing departments are capable of
carrying out these functions for more than one
product
• Expanding the product range to exploit the value of
existing brands is a good way of exploiting
economies of scope.
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Different shaped LRAC curves
AC
U-Shaped LAC: average costs decline
over low levels of output, but increase
at higher levels of output
LRAC2
LRAC1
L-Shaped LAC: Average costs declining
over all levels of output.
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Output
Causes of Diseconomies
• Control – costs and limitations of monitoring
productivity and the quality of output from
thousands of employees in big corporations –
possible stakeholder conflicts
• Co-ordination - difficult to co-ordinate complicated
production processes across several plants in
different locations and countries
• Co-operation - workers in large firms may feel a
sense of alienation and subsequent loss of morale.
Possible failures of human resource management
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