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Economies, Constant and Diseconomies of Scale

Economies, Constant and Diseconomies of Scale

Author: Kate Eskra
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This lesson will explain Economies, Constant and Diseconomies of Scale
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Tutorial

ECONOMIES, CONSTANT AND DISECONOMIES OF SCALE

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

Video Transcription

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Hi. Welcome to economics. This is Kate. This tutorial is called Economies-- Constant and Diseconomies of Scale. As always, my key terms are in red and my examples are in green. In this tutorial, we'll be talking about how a firm's long run average cost curve is derived from its short run average cost curves.

You'll be able to recognize where the firm experiences economies and diseconomies of scale. And I will give you some examples of each of those. So we'll have to talk about the difference between the long run and short run for a minute here. It's fixed and variable costs that actually define the difference between the two. So in the short run, there's one fixed input or cost, at least.

So you can't immediately expand your factory or get out of your current lease. In the long run, everything becomes variable. So you can renegotiate your lease and make major changes to the firm. Since we're talking about average cost curves, I figured I'd show you a chart with some of the average costs.

This one has average total cost in it. And we just get average total cost by taking our total cost column and divide by quantity. Notice that when we see the numbers here, average total cost will fall at first. And then it will eventually rise. And this is just one short run scenario. I want you to keep that in mind when we see that on the graph.

So in the short run, like I said, the firm's operating on a fixed scale. And so they can certainly vary some things, like they can vary how many workers they hire or how many machines they purchase. But like we said, at least something is fixed, like the size of their factory. So in the short run, their average cost curve is u shaped, because as you saw, their average costs fall at first because of specialization and somewhat economies of scale.

And then eventually, their average costs rise due to the law of diminishing marginal returns. So once you hire another worker, for example, that next worker certainly will add to total production. But that worker won't add as much as the worker before, because there's just they are operating on a fixed scale.

There's not as much for everybody to do, because there is something , an input that is in fact fixed. And so diminishing marginal returns sets in at that point. And what the firm is going to do in the short run is maximize their profit or minimize loss. They're really trying to just do the best they can with the constraints that it's facing.

But then the long run, which is the subject again of this tutorial, everything becomes variable in the long run. And so here, they can alter the factory size. They can really affect what we call the scale of operation or how big they actually get. And so an example would be a local business deciding to open up more locations across the region. Instead of just having one retail outlet, they operate region-wide.

So the long run average cost curve is also going to be u shaped. And economies of scale are going to be where average costs are falling as the company decides to grow in size. And diseconomies of scale will be seen when average costs begin to rise as the company gets bigger. So here is what the long run average cost curve looks like.

The long run average cost curve is made up of each of these SRACs. And SRAC just stands for Short Run Average Cost Curve. And there's one, two, three, four, five, six, seven. Each one of these represents a different short run scenario, how big they are.

So short run average cost curve one would be the smallest scale of operation. And seven would be the largest scale of operation on this graph. And so what we do is we take the lowest points of each of these short average cost curves and we derive our long run average cost curve from that.

So how we would use this is if a firm wanted to produce at this quantity right here, quantity three, they would see which short run situation or which short run scale would be the ideal one for them. You can see that scale two, the average cost would be much higher than if we went to scale three.

So scale two would be too small of a scale. We wouldn't want to stay there. We would want to expand to the short run scenario three. And scale four, it would be too big. We wouldn't justify our production levels yet to expand that much.

So again, the long run average cost curve will always equal to our line below the short run average cost curves because you will never produce at a higher average cost in the long run than in the short run, because there are no constraints to minimizing cost in the long run. So I wanted to take away those short run average cost curves so we can just focus on the long run average cost for a minute here.

Up to point q right here, notice how the long run average cost curve is falling. That is where the firm is experiencing what we call increasing returns to scale. Or this is where they're seeing benefits from increasing their scale of production. That is economies of scale. This is a decreasing cost area.

And so they're getting a lot out of expanding or growing in size, as we can see on the x-axis. But beyond that, now average costs begin to rise. So this would be an increase in cost region. Really, there would be decreasing returns to scale, meaning they're not getting a lot out of growing in size.

It's not economical. So it's diseconomies of scale. So there are diminishing benefits here from increasing their scale of production. Where the long run average cost curve might be flat on my graph, it's a very small region right in here, would represent what we call constant returns to scale. There's no change really in average costs from increasing your size of business.

So in this small region here, it would make no difference whether you were here or here. It would be constant returns. So economies of scale as your key term is defined as an increase of operational facilities that create a decrease in marginal cost. Or sometimes you'll see this is average costs.

Whereas diseconomies of scale is you increase the size of your operation and you are going to experience an increase in marginal or average cost. So ultimately, the goal of all of this is to find which scale of operation will minimize average cost in the long run. And that's the wonderful thing about the long run is that there aren't constraints. They can adjust to changing market conditions in the long run.

And so here, according to how this graph is drawn, this quantity and this a scale of operation would minimize their average cost in the long run. So again, the firm experiences economies of scale up to short run average curve four and diseconomies of scale beyond that point.

So here's an economies of scale example for you. Notice that I drew it so that average costs are actually never increasing here. And you'll see this as an example with sometimes utility companies. If you think about it, utility companies have huge upfront costs that they have to cover.

They have to put in an entire network in place depending on what kind of utility company they are. And that cost is extreme. But once that network's in place, the additional cost of servicing another home is pretty low as long as the network's in that area. Because of that, as they service more and more and more homes, their average costs just fall, because they can spread out those large upfront costs.

And that's why many utility companies are referred to as natural monopolies, meaning it's just normal and natural for them to grow in size because of the cost advantage that they get here. Diseconomies of scale-- it is actually possible for a firm to get too large. And it can be really inefficient once a company grows too big.

And some of the things that we can see is with overly grown companies, sometimes there can be really poor communication problems and coordination problems when there's too many departments and divisions of the company and they're just not communicating efficiently anymore. Once a company gets really big, sometimes employees are detached. They don't feel as connected to the company and to the owners.

And so sometimes we find that employees in managerial positions, for example, begin making decisions that really aren't in the best interests of the company or of the owners. And so it can become inefficient, and average costs begin to rise.

So in this tutorial, we talked about how a firm's long run average cost curve is derived from those short run average cost curves, where each represent a different size or a different scale of operation. Where average costs are falling as the scale is growing, the firm experiences economies of scale. Where average costs begin to rise again as they grow in size, the firm experiences diseconomies of scale.

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

Notes on "Economies, Constant and Diseconomies of Scale"

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.