SECTION 1.5A THEORY OF THE FIRM
AND MARKET STRUCTURES (HL ONLY)
PRODUCTION AND COSTS
1. Distinguish between the short run and long run
in the context of production.
Short run is a period of time when at least one of the
factors of production is fixed. Usually labor is the easiest
factor to change. Thus in short run a firm can increase
production only by employing more labor because no
more land or capital is available. Thus, labor is the
variable factor in the short run.
The planning period over which a firm can consider all
factors of production as variable is called the long run.
In the long run, firm may contemplate alternatives such
as modifying the building or building a new facility.
2. Define total product, average product and marginal
product, and construct diagrams to show their relationship.
Marginal product (MP) is the change in total output
when one more input is employed.
MP = Change in total product / Change in number of inputs
Average product (AP) is the total product divided by
the number of inputs producing it.
AP = Total product / Number of workers
Total product (TP) is the total quantity of output
produced by a firm for a given quantity of inputs.
TP = Total Output
2. Define total product, average product and marginal
product, and construct diagrams to show their relationship.
Production function
It is the equation that expresses
the relationship between the
quantities of productive factors
(such as labor and capital)
used and the amount of
product obtained.
It states the amount of product
that can be obtained from
every combination of factors,
assuming that the most efficient
available methods of
production are used.
2. Define total product, average product and marginal
product, and construct diagrams to show their relationship.
A production function shows the relationship between
the quantity of inputs used to produce a good, and
the quantity of output of that good.
It can be represented by a table, equation, or graph.
Example:
 Farmer
Jack grows wheat.
 He has 5 acres of land.
 He can hire as many workers as he wants.
Example: Farmer Jack’s Production Function
Q
(no. of (bushels
workers) of wheat)
3,000
Quantity of output
L
2,500
0
0
1
1000
2
1800
3
2400
500
4
2800
0
5
3000
2,000
1,500
1,000
0
1
2
3
4
No. of workers
5
2. Define total product, average product and marginal product,
and construct diagrams to show their relationship.
The marginal product of any input is the increase in
output arising from an additional unit of that input,
holding all other inputs constant.
 Example: if Farmer Jack hires one more worker,
his output rises by the marginal product of labor.
 Notation:
∆ (delta) = “change in…”
Examples:
∆Q = change in output, ∆L = change in labor
∆Q
 Marginal product of labor (MPL) =
∆L
EXAMPLE : Total & Marginal Product
L
Q
(no. of (bushels
workers) of wheat)
∆L = 1
0
1
∆L = 1
∆L = 1
∆L = 1
∆L = 1
2
3
4
5
0
MPL
∆Q = 1000
1000
∆Q = 800
800
∆Q = 600
600
∆Q = 400
400
∆Q = 200
200
1000
1800
2400
2800
3000
EXAMPLE: MPL = Slope of The Total Product Curve
Q
(no. of (bushels MPL
workers) of wheat)
0
0
1000
1
1000
800
2
1800
600
3
4
5
2400
2800
3000
400
200
MPL
3,000
Quantity of output
L
equals the
slope of the
2,500
production function.
2,000
Notice that
MPL diminishes
1,500
as L increases.
1,000
This explains why
500 production
the
function
gets flatter
0
as L0 increases.
1
2
3
4
No. of workers
5
Why MPL Is Important?
Recall one of the Ten Principles:
Rational people think at the margin.
 When Farmer Jack hires an extra worker,
 his costs rise by the wage he pays the worker
 his output rises by MPL
 Comparing them helps Jack decide whether he
would benefit from hiring the worker.

2. Define total product, average product and marginal
product, and construct diagrams to show their relationship.
Product curves
It can be observed that,
at first, the marginal
product curve increases
and then decreases. The
marginal product curve
cuts the average product
curve when average
product are at their
peak.
2. Define total product, average product and marginal
product, and construct diagrams to show their relationship.
2. Define total product, average product and marginal
product, and construct diagrams to show their relationship.
How is this pattern explained?
 With a small number of workers, output is low and a
division of labor cannot be employed, and workers
cannot specialize or develop new skills.
 However, marginal returns increase quickly as
specialization occurs and efficiency increases. This
creates the opportunity for labor to develop skills and
become more productive.
 Eventually, marginal returns diminish as the effects of
specialization and new skills wear off. This pattern has a
considerable impact on the firm’s short-run cost curves.
3. Explain the law of diminishing returns.
Law of increasing returns:
 This states that as more units of variable factor are
added to a fixed factor, output will first rise more
than proportionately. Thus, the firm experiences
increasing returns. (Usually due to specialization)
Law of diminishing returns:
 The law states that as more units of a variable factor
are added to a fixed factor, there will come a point
when output will rise less than proportionately. The
firm experiences diminishing returns. (Usually due to
sharing the fixed resources)
3. Explain the law of diminishing returns.
This graph shows firm's total
product curve with the ranges
of increasing marginal
returns, diminishing
marginal returns, and
negative marginal returns
marked. This firm experiences
increasing marginal returns
between 0 and 3 units of
labor per day, diminishing
marginal returns between 3
and 7 units of labor per day,
and negative marginal
returns beyond the 7th unit of
labor.
3. Explain the law of diminishing returns.
Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal)
Example: Farmer Jack’s output rises by a smaller and
smaller amount for each additional worker. Why?
 If Jack increases workers (variable input) but not land,
(fixed input) the average worker has less land to work
with, so will be less productive.
 In general, MPL diminishes as variable inputs rises
whether the fixed input is land or capital (equipment,
machines, etc.).
4. Calculate total, average and marginal
product from a set of data and/or diagrams.
HOW TO:
Total product is the output of workers as the
number of workers increases.
Average product is the “output per worker” =
Total Product/ number of workers
Marginal product is the “output of the last
worker” = Change in total product / change in
the number of workers.
4. Calculate total, average and marginal
product from a set of data and/or diagrams.
Consider the following example:
Returns to labor
Assuming one factor is fixed, the addition of extra workers will result in increasing returns
followed eventually by diminishing returns.
WORKERS
1
2
3
4
5
6
7
8
9
TOTAL PRODUCT
6
16
28
42
56
66
69
70
69
AVERAGE PRODUCT
MARGINAL PRODUCT
5. Explain the meaning of economic costs as the opportunity cost of
all resources employed by the firm (including entrepreneurship).
Accounting costs are the costs most often associated
with the costs of producing. Economic costs are not only
the costs of producing a good, it also includes the
opportunities forgone by producing this product.
Example: If a firm is producing Computers then the
accounting costs are the costs incurred for producing the
computers. Economic costs include the cost of producing
the computers as well as opportunity cost. Suppose, If
this firm could lease its office and the plant for say
$100,000 then that is the opportunity cost.
6. Distinguish between explicit costs and implicit
costs as the two components of economic costs.
Explicit costs – require an outlay of money,
e.g. paying wages to workers
 Implicit costs – do not require a cash
outlay, e.g. the opportunity cost of the
owner’s time

 Depreciation
is considered a explicit cost.
Depreciation is the decrease in value due to
wear and tear, decay, decline in price, etc.
6. Distinguish between explicit costs and implicit costs
as the two components of economic costs.
Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business.
The interest rate is 5%.
 Case 1: borrow $100,000


explicit cost = $5000 interest on loan
Case 2: use $40,000 of your savings,
borrow the other $60,000
explicit cost = $3000 (5%) interest on the loan
 implicit cost = $2000 (5%) foregone interest you could have
earned on your $40,000.

In both cases, total (exp + imp) costs are $5000.
6. Distinguish between explicit costs and implicit costs as
the two components of economic costs.



Accounting profit
= total revenue minus total explicit costs
Economic profit
= total revenue minus total costs (including explicit
and implicit costs)
Accounting profit ignores implicit costs,
so it’s higher than economic profit.
6. Distinguish between explicit costs and implicit
costs as the two components of economic costs. Economic
Profit versus Accounting Profit


When total revenue exceeds both explicit and implicit costs,
the firm earns economic profit.
Economic profit is smaller than accounting profit. Sometimes
referred to as:





Super Normal Profit
Monopoly Profit
Producer Surplus
Above Normal profit
Abnormal profit
Normal Profit is when total revenue just equals explicit
and implicit cost. (Break even or Zero Economic
Profit)
Figure 1 Economic versus Accountants
How an Economist
Views a Firm
How an Accountant
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
Explicit
costs
CHAPTER 13 THE COSTS
OF PRODUCTION
Copyright © 2004 South-Western
7. Explain the distinction between the short run and the long run,
with reference to fixed factors and variable factors.
In the short run, because at least one factor of production
is fixed, output can be increased only by adding more
variable factors. Hence we consider both fixed and variable
costs.
Fixed costs
 Fixed costs are business expenses that do not vary
directly with the level of output i.e. they are treated as
independent of the level of production.
 Examples of fixed costs include the rental costs of
buildings; the costs of leasing or purchasing capital
equipment such as plant and machinery.
7. Explain the distinction between the short run and the long run,
with reference to fixed factors and variable factors.
Variable Costs
 Variable costs are costs that vary directly with output.
Examples of variable costs include the costs of
intermediate raw materials and other components, the
wages of part-time staff or employees paid by the hour,
the costs of electricity and gas and the depreciation of
capital inputs due to wear and tear.
 The planning period over which a firm can consider
all factors of production as variable is called the long run.
 In the long run, firm may contemplate alternatives such as
modifying the building or building a new facility.
8. Distinguish between total costs, marginal
costs and average costs.
Total cost
 It is composed of all the fixed cost and variable cost put
together.
TC= VC+FC
Marginal Cost
 It is the cost of production for adding one extra unit of output.
Marginal costs are variable costs consisting of labor and
material costs, plus an estimated portion of fixed costs (such
as administration overheads and selling expenses).
Change in total cost / Change in output
Average Cost
 It is the Total cost of production divided by total output.
AC=TC/output
8. Distinguish between total costs, marginal costs
and average costs.
Total fixed costs
 Given that total fixed costs (TFC) are
constant as output increases, the
curve is a horizontal line on the cost
graph.
Total variable costs
 The total variable cost (TVC) curve
slopes up at an accelerating rate,
reflecting the law of diminishing
marginal returns.
Total costs
 The total cost (TC) curve is found by
adding total fixed and total variable
costs. Its position reflects the amount
of fixed costs, and its gradient
reflects variable costs.
9. Draw diagrams illustrating the relationship between marginal costs
and average costs, and explain the connection with production in the
short run.
Average fixed costs
 Average fixed costs are
found by dividing total
fixed costs by output. As
fixed cost is divided by an
increasing output, average
fixed costs will continue to
fall.
 The average fixed cost
(AFC) curve will slope down
continuously, from left to
right.
9. Draw diagrams illustrating the relationship between marginal costs and
average costs, and explain the connection with production in the short run.
Average variable costs



Average variable costs are found by
dividing total fixed variable costs by
output.
The average variable cost (AVC) curve will
at first slope down from left to right, then
reach a minimum point, and rise again.
AVC is ‘U’ shaped because of the
principle of variable Proportions, which
explains the three phases of the curve:
 Increasing returns to the variable
factors, which cause average costs to
fall, followed by:
 Constant returns, followed by:
 Diminishing returns, which cause costs to
rise.
9. Draw diagrams illustrating the relationship between marginal costs and
average costs, and explain the connection with production in the short run.
Average total cost
 Average total cost (ATC) is also
called average cost or unit cost.
Average total costs are a key cost in
the theory of the firm because they
indicate how efficiently scarce
resources are being used. Average
variable costs are found by dividing
total fixed variable costs by output.
 Average total cost (ATC) can be
found by adding average fixed costs
(AFC) and average variable costs
(AVC). The ATC curve is also ‘U’
shaped because it takes its shape
from the AVC curve, with the upturn
reflecting the onset of diminishing
returns to the variable factor
9. Draw diagrams illustrating the relationship between marginal costs and
average costs, and explain the connection with production in the short run.
Areas for total costs:
Total Fixed costs and Total
Variable costs are the
respective areas under the
Average Fixed and
Average Variable cost
curves.
TC = ATC x Q
VC = AVC x Q
FC = (ATC – AVC) x Q
9. Draw diagrams illustrating the relationship between marginal costs and
average costs, and explain the connection with production in the short run.
Marginal costs
 Marginal cost is the cost of
producing one extra unit of
output. It can be found by
calculating the change in total cost
when output is increased by one
unit.
 It is important to note that marginal
cost is derived solely from variable
costs, and not fixed costs.
 The marginal cost curve falls
briefly at first, then rises. Marginal
costs are derived from variable
costs and are subject to the principle
of variable proportions.
9. Draw diagrams illustrating the relationship between marginal costs and
average costs, and explain the connection with production in the short run.
The significance of marginal cost
The marginal cost curve is significant in the theory of the firm for two reasons:
 It is the leading cost curve, because changes in total and average costs are
derived from changes in marginal cost.
 The lowest price a firm is prepared to supply at is the price that just covers
marginal cost.
ATC and MC
Average total cost and marginal cost are connected because they are derived from
the same basic numerical cost data. The general rules governing the relationship
are:
 Marginal cost will always cut average total cost from below.
 When marginal cost is below average total cost, average total cost will be falling,
and when marginal cost is above average total cost, average total cost will be
rising.
 A firm is most productively efficient at the lowest average total cost, which is also
where average total cost (ATC) = marginal cost (MC).
EXAMPLE 2: Why ATC Is Usually U-Shaped
$200
As Q rises:
Eventually,
rising AVC
pulls ATC up.
$150
Costs
Initially,
falling AFC
pulls ATC down.
$175
$125
$100
$75
$50
$25
$0
0
1
2
3
4
Q
5
6
7
EXAMPLE 2: ATC and MC
ATC
MC
$200
Average Marginal
Rule:
$175
When MC < ATC,
$125
Costs
ATC is falling.
$150
$100
When MC > ATC,
$75
ATC is rising.
$50
The MC curve
crosses the
ATC curve at
the ATC curve’s
minimum.
$25
$0
0
1
2
3
4
Q
5
6
7
Efficient Scale


The bottom of the U-shaped ATC curve occurs at
the quantity that minimizes average total cost. This
quantity is sometimes called the efficient scale of the
firm.
Efficient scale , MC = ATC
Efficient scale is the quantity that minimizes
average total cost.
EXAMPLE 2: The Various Cost Curves Together
$200
$175
ATC
AVC
AFC
MC
Costs
$150
$125
$100
$75
$50
$25
$0
0
1
2
3
4
Q
5
6
7
9. Draw diagrams illustrating the relationship between marginal costs and
average costs, and explain the connection with production in the short run.
Total costs and marginal costs

Marginal costs are derived exclusively
from variable costs, and are
unaffected by changes in fixed costs.
The MC curve is the gradient of the TC
curve, and the positive gradient of the
total cost curve only exists because of
a positive variable cost.
Sunk costs


Sunk costs are those that cannot be
recovered if a firm goes out of
business. Examples of sunk costs include
spending on advertising and marketing,
specialist machines that have no scrap
value, and stocks which cannot be sold
off.
Sunk costs are a considerable barrier
to entry and exit.
10. Explain the relationship between the product curves (average product and
marginal product) and the cost curves (average variable cost and marginal cost),
with reference to the law of diminishing returns.
The check-shape of the marginal cost curve is closely related to the humpshape of the marginal product curve.
Because variable cost is largely associated with the cost of employing a
variable input in the short run, it is possible to identify a connection between
the marginal cost curve and the marginal product curve.
The quantity of output in which marginal cost is at a minimum is the same
quantity of output produced by the variable input when the marginal product
of the variable input is at a maximum.
Over the range of production in which marginal product increases and the
variable input experiences increasing marginal returns, the marginal cost
curve declines. (Due to specialization)
Over the range of production in which marginal product increases and the
variable input experiences decreasing marginal returns brought on by the law
of diminishing marginal returns, the marginal cost curve is rising. (Due to
over use of fixed inputs) `
10. Explain the relationship between the product curves (average product and marginal
product) and the cost curves (average variable cost and marginal cost), with reference to
the law of diminishing returns.
11. Calculate total fixed costs, total variable costs, total costs, average
fixed costs, average variable costs, average total costs and marginal costs
from a set of data and/or diagrams.
HOW TO:
 TFC is constant as output increases. It is the firm’s
total cost when output = 0.
 TVC increases as output increase, at first at a
decreasing rate (due to increasing returns), and
then at an increasing rate (due to diminishing
marginal returns).
 TC = TVC + TFC. If you know the firm’s fixed
costs and its variable costs, TC can easily be
calculated.
EXAMPLE 2: Costs
Q
FC
VC
TC
$800
FC
$700
VC
$0 $100
$600
1
100
70
170
$500
2
100 120
220
3
100 160
260
4
100 210
310
5
100 280
380
6
100 380
480
7
100 520
620
Costs
0 $100
TC
$400
$300
$200
$100
$0
0
1
2
3
4
Q
5
6
7
11. Calculate total fixed costs, total variable costs, total costs, average
fixed costs, average variable costs, average total costs and marginal costs
from a set of data and/or diagrams.



AFC = TFC / Q of output. AFC falls as output
increases as the firm “spreads its overhead”.
Graphically, it is the distance between AVC and ATC.
AVC = TVC / Quantity of output. AVC falls at first
due to increasing returns and then increases due to
diminishing returns. MC and AVC should intersect at the
lowest point of AVC
ATC = AFC + AVC, or TC / Quantity of output. ATC
lies ABOVE the AVC curve (since it includes the
average fixed costs), and will intersect MC at its
lowest point.
11. Calculate total fixed costs, total variable costs, total costs,
average fixed costs, average variable costs, average total costs and
marginal costs from a set of data and/or diagrams.
OUTPUT
TOTAL FIXED COST
1
2
3
4
5
6
7
8
100
100
100
100
100
100
100
100
AVERAGE FIXED COST
100
50
33.3
25
20
16.6
14.3
12.5
EXAMPLE 2: Average Fixed Cost
FC
0 $100
1
2
100
100
AFC
n.a.
$100
50
3
100 33.33
4
100
25
5
100
20
6
100 16.67
7
100 14.29
$200
Average
fixed cost (AFC)
is$175
fixed cost divided by the
quantity
of output:
$150
Costs
Q
AFC
$125
= FC/Q
$100
Notice
$75 that AFC falls as Q rises:
The firm is spreading its fixed
$50
costs over a larger and larger
$25
number
of units.
$0
0
1
2
3
4
Q
5
6
7
11. Calculate total fixed costs, total variable costs, total costs, average
fixed costs, average variable costs, average total costs and marginal costs
from a set of data and/or diagrams.
OUTPUT
TOTAL VARIABLE COST
1
2
3
4
5
6
7
8
50
80
100
110
150
220
350
640
AVERAGE VARIABLE COST
50
40
33.3
27.5
30
36.7
50
80
EXAMPLE 2: Average Variable Cost
VC
AVC
0
$0
n.a.
1
70
$70
2
120
60
3
160
53.33
4
210
52.50
5
280
56.00
6
380
63.33
7
520
74.29
$200
Average
variable cost (AVC)
is$175
variable cost divided by the
quantity of output:
$150
Costs
Q
AVC
$125
= VC/Q
$100
As$75
Q rises, AVC may fall initially.
In most cases, AVC will
$50
eventually rise as output rises.
$25
$0
0
1
2
3
4
Q
5
6
7
11. Calculate total fixed costs, total variable costs, total costs, average
fixed costs, average variable costs, average total costs and marginal costs
from a set of data and/or diagrams.
OUTPUT
1
2
3
4
5
6
7
8
AVERAGE FIXED COST
100
50
33.3
25
20
16.6
14.3
12.5
AVERAGE VARIABLE COST
50
40
33.3
27.5
30
36.7
50
80
AVERAGE TOTAL COSTS
150
90
67
52.5
50
53.3
64.3
92.5
EXAMPLE 2: Average Total Cost
Q
TC
0 $100
1
170
ATC
$200
Usually,
as in this example,
$175
the ATC curve is U-shaped.
n.a.
$150
$170
2
220
3
260 86.67
4
310 77.50
5
380
76
$25
6
480
80
$0
7
620 88.57
Costs
110
$125
$100
$75
$50
0
1
2
3
4
Q
5
6
7
11. Calculate total fixed costs, total variable costs, total costs, average
fixed costs, average variable costs, average total costs and marginal costs
from a set of data and/or diagrams.
MC = the change in TC / the change in output.
It is the cost of the last unit produced. MC sloped down
when a firm’s workers experience increasing returns and
upwards once the firm experiences diminishing marginal
returns.
11. Calculate total fixed costs, total variable costs, total costs, average
fixed costs, average variable costs, average total costs and marginal costs
from a set of data and/or diagrams.
OUTPUT
1
2
3
4
5
6
7
8
TOTAL COST
150
180
200
210
250
320
450
740
MARGINAL COST
30
20
10
40
70
130
290
EXAMPLE 1: The Marginal Cost Curve
0
TC
MC
$1,000
$2.00
1000
$3,000
$2.50
1800
$5,000
$3.33
2400
$7,000
2800
$9,000
3000 $11,000
$10
Marginal Cost ($)
Q
(bushels
of wheat)
$12
$8
MC usually rises
as Q rises,
as in this example.
$6
$4
$2
$5.00
$10.00
$0
0
1,000
2,000
Q
3,000
12. Costs in the Short Run & Long Run
Short run:
Some inputs are fixed (e.g., factories, land).
The costs of these inputs are FC.
Long run:
All inputs are variable
(e.g., firms can build more factories,
or sell existing ones)
 In the long run, ATC at any Q is cost per unit using
the most efficient mix of inputs for that Q (e.g., the
factory size with the lowest ATC).
12. Distinguish between increasing returns to scale,
decreasing returns to scale and constant returns to scale.



Increasing return to scale: A given proportional
change in all resources in the long run results in a
proportional greater change in production.
Decreasing returns to scale: A given proportionate
increase in all resources in the long run results in a
proportionately smaller increase in production.
Constant returns to scale: The property whereby
long-run average total cost stays the same as the
quantity of output changes.
13. Explain the relationship between short-run
average costs and long-run average costs.
Long run costs
The firm’s long run average
cost shows what is
happening to average cost
when the firm expands, and
is at a tangent to the series
of short run average cost
curves. Each short run
average cost curve relates
to a separate stage or
phase of expansion.
14. Explain, using a diagram, the reason for the
shape of the long-run average total cost curve.


The long run cost curve
for most firms is assumed
to be ‘U’ shaped,
because of the impact of
internal economies and
diseconomies of scale.
However, economic
theory suggests that
average costs will
eventually rise because
of diseconomies of scale.
EXAMPLE 3: LRATC with 3 factory Sizes
Firm can choose
from 3 factory
sizes: S, M, L.
Each size has its
own SRATC curve.
The firm can
change to a
different factory
size in the long
run, but not in the
short run.
Avg
Total
Cost
ATCS
ATCM
ATCL
Q
EXAMPLE 3: LRATC with 3 factory Sizes
To produce less
than QA, firm will
choose size S in
the long run.
To produce
between QA and
QB, firm will choose
size M
in the long run.
To produce more
than QB, firm will
choose size L
in the long run.
Avg
Total
Cost
ATCS
ATCM
ATCL
LRATC
QA
QB
Q
A Typical LRATC Curve
ATC
In the real world,
factories come in
many sizes,
each with its own
SRATC curve.
So a typical
LRATC curve
looks like this:
LRATC
Q
How ATC Changes As the Scale of Production Changes
Economies of
scale: ATC falls
as Q increases.
ATC
LRATC
Constant returns
to scale: ATC
stays the same
as Q increases.
Diseconomies of
scale: ATC rises
as Q increases.
Q
Long Run Average Cost Curve
The long run average cost curve shows the least-cost
method of production of any given level of output.
 It is often drawn U-shaped (though in practice will
vary) to show that initially there may be economies
of scale which reduce the cost per unit.
 Subsequently there may be constant returns to
scale where the cost per unit remains the same and
eventually the cost per unit may begin to rise as
diseconomies of scale set in.
Long Run Average Cost Curve
Long Run Average Total Cost (LRATC)




LRATC of producing a given level of output when
all input can vary.
LRATC curve is constructed as the least cost of all
possible short run cost curves.
(NOTE) No AFC in the long-run. In the long run all
inputs are variable, so no fixed costs.
LRATC is equal to long run AVC (since all costs are
variable).
15. Explain factors giving rise to economies of scale, including
specialization, efficiency, marketing and indivisibilities.
Economies of scale are any decrease in long-run average
costs that come about when a firm alters all of its factors of
production in order to increase its scale of output. More
common when Quantity is low.
Examples:
 Specialization
 Division
of labor
 Bulk buying
 Financial economies
 Transportation economies
 Large machines
 Promotional economies
15. Explain factors giving rise to economies of scale, including
specialization, efficiency, marketing and indivisibilities.
Types of economy of scale:
 Technical economies are the cost savings a firm makes as it grows


larger, and arise from the increased use of large scale mechanical
processes and machinery. For example, a mass producer of motor
vehicles can benefit from technical economies because it can employ
mass production techniques and benefit from specialization and a
division of labor.
Purchasing economies are gained when larger firms buy in bulk and
achieve purchasing discounts. For example, a large supermarket
chain can buy its fresh fruit in much greater quantities than a small fruit
and vegetable supplier.
Administrative savings can arise when large firms spread their
administrative and management costs across all their plants,
departments, divisions, or subsidiaries. For example, a large multinational can employ one set of financial accountants for all its separate
businesses.
15. Explain factors giving rise to economies of scale, including
specialization, efficiency, marketing and indivisibilities.
Types of economy of scale:


Large firms can gain financial savings because they can
usually borrow money more cheaply than small firms. This
is because they usually have more valuable assets which
can be used as security (collateral), and are seen to be a
lower risk, especially in comparison with new businesses
Risk bearing economies are often derived by large firms
who can bear business risks more effectively than smaller
firms. For example, a large record company can more
easily bear the risk of a ‘flop’ than a smaller record
label.
16. Explain factors giving rise to diseconomies of scale,
including problems of coordination and communication.
Diseconomies of scale are any increase in long-run average costs
that comes about when a firm alters all of its factors of production in
order to increase its scale of output. More common when Quantity is
high.
Dis-economies of scale can occur for the following reasons:
 Poor communication in a large firm
 Alienation: Working in a highly specialized assembly line
can be very boring, if workers become de motivated. In a
large firm there is an increased gap between top and
bottom e.g. call centers
 Lack of control: when there is a large number of workers it
is easier to escape with not working very hard because it is
more difficult for managers to notice shirking.
16. Explain factors giving rise to diseconomies of scale,
including problems of coordination and communication.
Economic theory also predicts that a single firm may become less efficient if it
becomes too large. The additional costs of becoming too large are called
diseconomies of scale.
Examples of diseconomies include:


Larger firms often suffer poor communication because they find it difficult to
maintain an effective flow of information between departments, divisions or
between head office and subsidiaries. Time lags in the flow of information can
also create problems in terms of the speed of response to changing market
conditions. For example, a large supermarket chain may be less responsive to
changing tastes and fashions than a much smaller, ‘local’ retailer.
Co-ordination problems also affect large firms with many departments and
divisions, and may find it much harder to co-ordinate its operations than a smaller
firm. For example, a small manufacturer can more easily co-ordinate the activities
of its small number of staff than a large manufacturer employing tens of
thousands.
16. Explain factors giving rise to diseconomies of scale,
including problems of coordination and communication.
Internal diseconomies of scale



‘X’ inefficiency is the loss of management efficiency that occurs when firms become
large and operate in uncompetitive markets. Such loses of efficiency include over
paying for resources, such as paying managers salaries higher than needed to
secure their services, and excessive waste of resources.
‘X’ inefficiency
means that average costs are higher than would be experienced by firms in
more competitive markets.
Low motivation of workers in large firms is a potential diseconomy of scale that
results in lower productivity, as measured by output per worker.
Large firms may experience inefficiencies related to the principal-agent problem.
This problem is caused because the size and complexity of most large firms means
that their owners often have to delegate decision making to appointed managers,
which can lead to inefficiencies. For example, the owners of a large chain of
clothes retailers will have to employ managers for each store, and delegate some
of the jobs to managers but they may not necessarily make decisions in the best
interest of the owners
Diminishing Returns versus Economies of Scale:
The shape of short-run costs (MC, ATC and AVC) are determined by the law of
diminishing returns.
Since short-run costs are determined by the productivity of the variable resource
in the short-run (labor), diminishing returns assures that at first, since a firm can
expect to get MORE output for additional units of labor (as fixed capital is used
more efficiently) ATC declines as output increases.
But beyond a certain point, diminishing returns sets in and the additional output
attributable to more units of the variable resource declines.
Inevitably, a firm will experience higher and higher average costs as its output
continues to grow, since it's only able to vary the amount of labor used, not
capital.
The shape of long run ATC is determined by economies of scale (and
diseconomies of scale). All resources are variable in the long-run, but lower costs
cannot be guaranteed the larger a firm gets.
At first, efficiency is improved as the firm grows, but at some point it becomes ‘too
big for its own good’ and costs start to rise as productivity of resources (land,
labor and capital) is inhibited due to the firm's massive size.
What is the difference between Diminishing
Returns and Diseconomies of Scale?
Diseconomies of scale and diminishing returns show how a
company can suffer losses in terms of production output/higher
cost when inputs are increased.
Despite their similarities, the two concepts are quite different to
one another.
Diminishing returns to scale looks at how production output
decreases as one input is increased, while other inputs are left
constant (fixed).
Diseconomies of scale occurs when the per unit cost rises as
output is increased.
Another major difference between diminishing returns and
diseconomies of scale is that diminishing returns to scale occur in
the short run, whereas diseconomies of scale is a problem that
a company can be faced with over the long run.
Diminishing Returns vs Diseconomies of Scale
• Diseconomies of scale and diminishing returns are both concepts that
represent how the company can end up making losses as inputs are
increased in the production process.
• Diminishing returns to scale looks at how production output decreases
as one input is increased, while other inputs are left constant.
• Diseconomies of scale refers to a point at which the company no longer
enjoys economies of scale, and at which the cost per unit rises as more
units are produced.
• A major difference between diminishing returns and diseconomies of
scale is that diminishing returns to scale occur in the short run, whereas a
company faces diseconomies of scale over a longer period of time.