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Constant, Increasing and Decreasing Cost Industries

Constant, Increasing and Decreasing Cost Industries

Author: Kate Eskra
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This lesson will explain Constant, Increasing and Decreasing Cost Industries
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Tutorial

CONSTANT, INCREASING AND DECREASING COST INDUSTRIES

Source: Image of Economies and Diseconomies of Scale graph created by Kate Eskra, Image of Long Run Average Cost Curve created by Kate Eskra, Image of Economies of Scale graph created by Kate Eskra, Image of Diseconomies of Scale graph created by Kate Eskra

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Hi. Welcome to Economics. This is Kate. This tutorial is on "Constant, Increasing and Decreasing Cost Industries." As always, my key terms are in red, and my examples are in green. In this tutorial, you'll recognize where the firm experiences economies and diseconomies of scale. And I'll show you this on a long-run average cost curve. We'll talk about how different industries and firms have different cost structures, and that's what results in economies of scale in some industries and diseconomies of scale in others.

So economies of scale is generally a long run concept. Remember, in the long run, that's where all inputs and costs become variable. That constraint of one input, at least one input or cost being fixed, is no longer a constraint. And so here, the firm really can alter its factory size or scale of operation. And one example of this is just that a local business might decide instead of just having one store to open up many more locations across the region. There, they're impacting their scale of operation.

In the long run their average cost curve is U-shaped, as it is in the short run. In the long run, we see that average costs, up to a certain point, will fall as the business gets bigger and produces more. When that's the case, they are said to experience economies of scale. Once those average costs start rising, they're said to experience diseconomies of scale. So this is where they're not lowering their costs anymore from getting bigger. Because of that, it will be U-shaped. And here you can see that.

So up to point Q, right here, the firm experiences economies of scale because average costs are falling as they're getting larger, as they're producing more. And so this is where they're achieving a lot of benefits from increasing their sales production or operation. Beyond that point, on my graph here, this is where the firm is experiencing diseconomies of scale or increasing costs. And here, there are diminishing benefits from increasing the scale of production. On my graph, it's for a very short amount of time, but where the long run average cost curve might be flat-- like right in here-- would represent what we call constant returns to scale. There would be really no change in average costs in this small region right here from increasing their scale of production.

So the economies of scale, as one of your key terms, is defined as an increase of operational facilities that create a decrease in marginal cost. Sometimes you'll see this as average cost. Whereas diseconomies of scale is an increase of operational facilities that create an increase in marginal or average costs.

So if we have our long run average cost curve here comprised of all of our various short run-- that's Short Run Average Cost, that's what SRAC stands for. It's comprised of all these different short run scenarios. The goal in the long run is to find which of these scenarios will minimize our average costs in the long run. The firm in the long run can adjust to changing market conditions and can make the best decision. And here, that would be on Short Run Average Cost Curve Four. So going back to our economies and diseconomies, the firm would experience economies of scale up to this point and diseconomies of scale beyond that point.

So how is it that the long run average cost curve is related to market structure? Well, every firm does not have the same shape long run average cost curve. It really varies among industries, and even in the same industry, it's going to vary between companies. The idea is that it all has to do with differences in costs of production.

So first of all, we know that we have fixed costs, and fixed costs are necessary for the production process to begin. So sometimes these are sunk costs. They're upfront costs. They're sometimes called overhead, but they're not related to production levels. They stay the same no matter how much the company produces. So the higher the production level, the company is able to spread out those fixed costs and achieve a lower average fixed cost per unit. Keep in mind that the total fixed cost stays the same across all units produced, but what they can do as they get bigger and bigger and bigger is spread out those fixed costs.

It's the variable costs that are in fact related to production levels. And so as the firm increases production, they're going to experience an increase in their variable costs, and these are going to really form the basis of defining whether the firm is seeing economies, constant, or diseconomies of scale.

So here is an example of economies of scale as a barrier to entry. Notice how on this long run average cost curve, I drew it so that it never experiences diseconomies of scale. Average cost is constantly falling. And utility companies provide a really good example of economies of scale like this because they have enormous upfront fixed costs.

Depending on the utility company that we're talking about, most of them have a significant network that they have to put in place. But once that network is in place and they've already spent the money to do that, as long as it's in the area that they're servicing, having an additional home or servicing an additional home is going to be relatively inexpensive because that network is already in place. And so as they grow and grow and grow, their average cost structure just continues to kind of fall because the variable cost is not increasing that much at all. And they're able to spread out that initial upfront fixed cost. So it makes sense for companies with really large upfront costs to produce a lot.

Once the company is established-- so if we go back to our utility company example-- it's going to become really difficult to enter the market and compete because of the cost advantage that that existing firm already has from the economies of scale. And even if a firm would try to enter, the competition might drive the price too low for either of them to even see any kind of profit situation.

And so this is why many utility companies are what we consider natural monopolies where it just makes sense for them to be the only company offering a utility in that area. And so the size of the existing firm really becomes a huge barrier to entry. And remember barriers to entry are what create less competitive market structures like monopoly or oligopolies.

But in more competitive industries, diseconomies of scale are certainly possible. It is possible for a firm to actually get too large, and there are some inefficiencies that can certainly result. Once a company gets too large, we often see that if they have too many departments or divisions of their company, very often there's poor communication and coordination problems between all of these different employees and departments.

And unfortunately, sometimes the larger the company gets employees-- like managers even-- start feeling less connected to the firm. They might not even know the owners, and so we find that sometimes employees make decisions that really are not in the best interests of the owners or for the company in general. And so those can lead to these inefficiencies that raise the average cost as a company gets larger and larger.

And so notice here that I drew longer average cost curve where they actually begin to experience diseconomies of scale at a pretty low level of output. And when that happens, this is the opposite of what I showed you a couple slides ago. And here there is an opportunity for new firms to enter pretty easily. OK? Remember, when new firms can enter easily that's where we see more competitive industries.

So in this tutorial, we talked about how a firm's long run average cost curve is made up of short run average cost curves, each representing a different scale of production. And you were able to see that where average costs fall as the scale increases, the firm experiences economies of scale. Where those average costs begin to rise as the company gets bigger, that's where the firm's experiencing diseconomies of scale. And finally, we talked about how not all industries and firms are the same. Different ones have different cost structures and that results in different long run average cost curves.

Thank you so much for listening. Have a great day.

Notes on "Constant, Increasing and Decreasing Cost Industries"

Terms to Know

Economies of Scale

An increase of operational facilities that create a decrease in marginal cost.

Diseconomies of Scale

An increase of operational facilities that create an increase in marginal cost.