Economies and Diseconomies of Scale

Overview

This lecture explains the concepts of economies of scale, diseconomies of scale, and constant returns to scale by analyzing the long run average total cost (LRATC) curve in production.

Long Run Average Total Cost Curve (LRATC)

• The LRATC curve connects the minimum points of various short run average total cost curves for different fixed costs.
• In the long run, firms can change all inputs, including fixed costs, to optimize production for different output levels.
• The curve shows how average total cost changes as a firm increases production scale.

Economies of Scale

• Economies of scale occur when increasing production reduces the LRATC.
• Causes include specialization of labor, machine specialization, bulk purchasing, and supply chain efficiencies.
• Firms become more efficient as production scale increases up to a certain point.

Diseconomies of Scale

• Diseconomies of scale occur when increasing production increases the LRATC.
• Common causes are coordination issues and increased complexity within larger organizations.
• Additional costs can arise from exhausting cheaper inputs, needing to pay higher wages, or sourcing more expensive materials.

Constant Returns to Scale

• Constant returns to scale occur when increasing production does not affect the LRATC, keeping costs stable.
• This section of the LRATC curve is flat, meaning cost per unit remains unchanged as scale increases.
• Also referred to as efficient scale.

Key Terms & Definitions

• Long Run Average Total Cost (LRATC) — average cost per unit when all inputs are variable in the long run.
• Economies of Scale — reduction in average cost per unit as production increases.
• Diseconomies of Scale — increase in average cost per unit as production increases.
• Constant Returns to Scale — situation where average cost per unit remains unchanged as production scale increases.

Action Items / Next Steps

• Review the shapes and sections of LRATC curves for different production scales.
• Study examples of economies and diseconomies of scale in real-world businesses.