Economies and Diseconomies of Scale

Why does long-run average total cost have a U-shape, falling to q and rising thereafter. The answer involves two new concepts, economies and diseconomies of scale.

Economies of scale: The relation between long-run average total cost and plant size that suggests that as plant size increases the average cost of production decreases.

Diseconomies of scale: The relation between long-run average total cost and plant size that suggests that as plant size increases, the long-run average total cost curve increases.

The fact that the LRATC curve rises after q is due to diseconomies of scale. In this range of outputs, the firm has become too large for its owner to control effectively. Managers do not have the monitoring technology to hold costs down in a very large firm, and bureaucratic inefficiencies creep in. If such bureaucratic problems did not exist, firms would be much larger. Indeed, a single firm could produce all worlds’ output of a particular good or service. However, diseconomies may be hard to observe in the real world because it is m the firm's self-interest to correct its operations to keep costs down. Large firms will reorganize, spin off component parts, hire new managers, and in general seek ways to avoid diseconomies of scale.

Not all LRATC curves areU-shaped.

Other Shapes of the Long-Run Average Total Cost Curve

The LRATC curve in Figure 5 shows a unique ideal plant size at q. There is only one minimum point on this U-shaped curve. This means that there is a small range of plant sizes that are efficient in a particular industry, and plant sizes in the industry will tend to cluster at the level of q. The fact that most discount department stores are approximately the same size illustrates this point.

Figure 6 shows two other possible shapes the LRATC curve can take. Figure 6a illustrates constant returns to scale. In certain industries an initial range of economies of scale prevails up to a minimum efficient size of q₁. Beyond q₁ a wide variation in firm size is possible without a discernible difference in unit cost. Small firms and large firms can operate with the same unit costs over this range of outputs. This flat portion of the LRATC curve shows constant returns, or the same unit costs, for a range of output levels from q₁ to q₂. Beyond q₂ diseconomies of scale begin. This is apparently a very common LRATC curve in the real world because we observe both small and large firms prospering and surviving side by side in many industries, such as publishing and textiles.

Figure 6b shows an LRATC curve that exhibits economies of scale over its whole range, this is called increasing returns to scale. In such cases, the larger the firm, the lower is its costs. This type of LRATC curve is representative of such industries as utilities and telephone service.

Figure 6. Alternative LRATC Curves

(a) Constant returns to scale. The lowest possible production costs per unit exist within a large range between output levels q₁ and q₂. Both small and large firms can have the same long-run unit costs between q₁ and q₂.

(b) Increasing returns to scale. The more output the firm produces, the lower its long-run average total cost.

Constant returns to scale: The relation that suggests that as plant size changes, the long-run average total cost does not change.

Increasing returns to scale: The relation that suggests that the larger a firm becomes, the lower its long-run average total costs are.

Shifts in Cost Curves

Our analysis of cost curves has been based on the familiar ceteris paribus, or other things constant, assumption. In other words we held certain factors constant in the discussion of short-run and long run costs. What factors did we hold constant, and how do they affect cost curves.

Resource prices have been held constant it resource prices rise or fall, the firm's cost curves will rise or fall by a corresponding amount. If the price of gasoline falls, the cost curves of a trucking firm fall; this is illustrated by the fall from ATC₁ and MC₁ to ATC₂ and MC₂ in Figure 7.

Figure 7.The Effect of a Decrease in Resource Prices on Costs

As resource prices decrease, the cost curves the firm fall from ATC₁ and MC₁ to ATC₂ and MC₂. If resource prices increased the cost curves of the firm would rise.

 

Taxes and government regulation have been held constant. If government increases the excise tax on gasoline, the trucking firm's cost curves will rise. In fact, the average and marginal costs of the trucking firm will rise by the amount of the tax. Similarly, if government imposes more stringent highway weight limits for trucks, the costs of trucking firms will increase.

Technological change has been held constant. Advances in technology make it possible to produce goods and services at lower costs. The invention of the diesel engine, which is more durable and less expensive to operate than the conventional gasoline engine, shifted the cost curves of trucking firms downward. Trucking services can now be produced with fewer resources because of this technological improvement.