Costs of Production and Economies and Diseconomies of Scale
A firm's costs of production are split into fixed costs, which do not change with output in the short run, and variable costs, which change directly with output; these sum to give total cost.
Before you start
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Method
- Define and distinguish short-run costs: fixed cost, does not vary with output, e.g. rent or insurance; variable cost, varies directly with output, e.g. raw materials or piece-rate wages; total cost, fixed plus variable; average total cost, total cost divided by output; and marginal cost, the change in total cost from producing one more unit.
- Explain why short-run average and marginal cost curves are typically U-shaped: initially spreading fixed costs over more output lowers average cost, but the law of diminishing marginal returns eventually causes marginal, then average, cost to rise.
- Distinguish the short-run cost curves from the long-run average cost (LRAC) curve, which shows the lowest possible average cost of producing each output level once all factors, including the scale of the plant, can be varied.
- Learn the named internal economies of scale: purchasing/bulk-buying (discounts from buying inputs in bulk), technical (large-scale, more efficient machinery), managerial (specialist managers for each function), financial (larger firms can borrow more cheaply) and risk-bearing (large diversified firms can spread risk across products or markets).
- Learn external economies of scale, benefits available to all firms in an industry as the whole industry grows in a location, e.g. a specialised local skilled labour force, or a cluster of specialist suppliers.
- Learn the main causes of diseconomies of scale as a firm grows too large: coordination problems between departments, communication difficulties as information passes through layers of management, and reduced worker motivation in a very large, impersonal organisation.
- Draw and interpret the LRAC 'envelope' curve: falling while economies of scale dominate, reaching a minimum efficient scale (MES, the lowest output at which LRAC is minimised), then rising if diseconomies of scale dominate; a flat range shows constant returns to scale.
Worked example
A firm's total cost of producing 1,000 units is 8,000 pounds, made up of 3,000 pounds of fixed costs and 5,000 pounds of variable costs. When it produces 2,000 units, total cost rises to 13,000 pounds, with fixed costs unchanged. Calculate the average total cost at each output level and state whether the firm is experiencing economies of scale between these two output levels.
- Average total cost at 1,000 units = total cost / output = 8,000 / 1,000 = 8 pounds per unit.
- Average total cost at 2,000 units = 13,000 / 2,000 = 6.50 pounds per unit.
- Compare: average total cost has fallen from 8 pounds to 6.50 pounds per unit as output doubled.
- Check variable cost per unit: 5,000/1,000 = 5 pounds at 1,000 units, and (13,000-3,000)/2,000 = 5 pounds at 2,000 units, so variable cost per unit is unchanged and the fall in average cost comes from fixed costs being spread over more output.
- Since average total cost has fallen as output has risen, the firm is experiencing economies of scale between these two output levels.
Practice questions
Try each question, then tap to reveal the answer.
Q1What is a fixed cost? Give an example.Show answer
Answer: A cost that does not change with the level of output in the short run, e.g. rent on a factory or insurance.
Q2What is a variable cost? Give an example.Show answer
Answer: A cost that changes directly with the level of output, e.g. raw materials or piece-rate wages.
Q3Define marginal cost.Show answer
Answer: The extra cost of producing one more unit of output.
Q4Name two internal economies of scale.Show answer
Answer: Any two of: purchasing/bulk-buying economies, technical economies, managerial economies, financial economies, or risk-bearing economies.
Q5Give one example of an external economy of scale.Show answer
Answer: A specialised local pool of skilled labour, or a cluster of specialist local suppliers, that develops as a whole industry grows in an area.
Q6What is the minimum efficient scale (MES)?Show answer
Answer: The lowest level of output at which a firm's long-run average cost is minimised.
Q7State one likely cause of diseconomies of scale.Show answer
Answer: Coordination or communication problems as a firm grows very large, e.g. information becoming distorted as it passes through many layers of management.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
A firm's average total cost falls as it increases output from 5,000 to 20,000 units per month. Explain two internal economies of scale that could account for this fall.
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Evaluate whether growing to a larger scale of production will always reduce a firm's long-run average costs.
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See real A Level Economics past-paper questions, with official mark schemes →
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