The long run total cost curve takes on a U shape:
The first half of the curve is due to economies of scale.It is now clear that this refers to a situation where the firm expands the inputs of both its fixed and variable factors in order to increase production. Economies of scale thus correspond to a situation where long-run average costs falls as output increases. There may be several reasons why this is the case. Some may arise from factors that are internal to the firm, whereas others may be external – beyond the firm’s control – arising when the whole industry expands.
Internal economies of scale
These arise as a firm expands its production. For example, there may be indivisibilities in production, whereby some inputs can only be used in certain quanities. A train would be a very inefficient way of transporting a single passenger, and only becomes cost-effective when transporting many passengers.
There may also be fixed costs in the production process that must be incurred before any production takes place at all. As the volume of production expands, these fixed costs are spread out over more units of output, lowering average costs. Many pharmaceutical companies invest large sums of money in research and development (R&D) in order to expand their product range (and to match the R&D spending of their rivals. These expenditures are necessary in order to stay in business in the market, but do not vary with levels of output, so average costs fall as the R&D is spread across more units of output.
Specialisation may be another source of economies of scale – as I have discussed before. Large scale production enables the process to be broken into a series of parts, and this allows workers to become adept at their part of the process, again reducing costs.
There may also be managerial economies of scale, by which a larger firm can have specialist departments dealing with procurement or human resources.
A large firm may lso be able to obtain better deals on its purchases of inputs, or on its borrowing. All these things may reduce the average cost for the larger firm.
External economies of scale
External economies of scale arise as an industry expands. For example, when a new industry first sets up in an economy it may be difficult to recruit workers with the skills required for the new activity, and firms may need to provide their own training. As the industry expands, there will be more workers that have acquired the necessary skills. It may even be that local colleges find it worthwhile to set up courses that provide training for these skills. Firms thus find they need to spend less on providing training, and this element of costs falls. One example of this is the computer industry – computer science is now an established degree course whose cost is external to the company but benefit internal.
Constant returns to scale is found when long-run average costs remain constant with an increase in ouput – it is the DMZ between economies and diseconomies of scale.
Diseconomies of scale
A common source of diseconomies of scale is in management. As firms continue to grow, additional layers of management may be needed to cope with the increasingly complex operations – especially if the firm is spread out between many physical locations. As the firm becomes more cumbersome in its organisation, the average cost of running and monitoring activity within the firm tends to rise. The rapid developments in technology in recent years may have enabled some of these problems to be overcome, as it becomes easier to use technology to assist in the administration of the firm. This may help to explain the appearance of some giant firms.
It is also possible that there could be external diseconomies of scale – for example, if the industry grows so rapidly that the supply of workers is much less than the demand. They helps to explain why average costs may start to rise at some level of output. This point may come at different outputs in different industries.
It is important not to confuse the notion of returns to scale with the idea introduced earlier of diminishing marginal returns to a factor. The two concepts arise in different circumstances. The law of diminishing returns to a factor applies in the short run, when a firm increases its inputs of one factor of production while facing fixed amounts of other factors. It is thus solely a short-run phenomenon. Diseconomies of scale, sometimes referred to as decreasing returns to scale, can occur in the long run, and refers to how output changes as firms vary the auantitis of all factors.
The point at which long-run average costs stops falling is known as the minimum efficient scale. This is the smallest level of output that a firm can produce at the minimum level of long run average cost.
If a firm is running at its lowest level of long run average costs it is in a position of productive efficiency. Remember that the long run average cost curve (LAC) is drawn as a U shape because of the assumptions that were made of the technology of production. The underlying assumption here is that the firm faces economies of scale at relatively low levels of output, so the LAC slopes downwards, but at some point decreasing returns to scale set in and LAC begins to slope upwards. This turns out to be a convenient representation, but in practice the LAC can take a variety of shapes, depending on when and for how long economies, diseconomies, and constant returns to scale set in. The value of fixed costs could dominate the variable costs of production, leading to limited economies of scale.