Economies of scale arise when the cost per unit falls as ...



Economies of scale arise when the cost per unit falls as output increases. Economies of scale are the main advantage of increasing the scale of production and becoming ‘big’.

Why are economies of scale important?

- Firstly, because a large business can pass on lower costs to customers through lower prices and increase its share of a market. This poses a threat to smaller businesses that can be “undercut” by the competition

- Secondly, a business could choose to maintain its current price for its product and accept higher profit margins. For example, a furniture-maker which could produce 1,000 cabinets at £250 each might expand and be able to produce 2,000 cabinets at £200 each. The total production cost will have risen to £400,000 from £250,000, but the cost per unit has fallen from £250 to £200. Assuming the business sells the cabinets for £350 each, the profit margin per cabinet rises from £100 to £150.

There are two main types of economies of scale: internal and external. Internal economies of scale have a greater potential impact on the costs and profitability of a business.

Internal economies of scale

Internal economies of scale relate to the lower unit costs a single firm can obtain by growing in size itself. There are five main types of internal economies of scale.

Bulk-buying economies

As businesses grow they need to order larger quantities of production inputs. For example, they will order more raw materials. As the order value increases, a business obtains more bargaining power with suppliers. It may be able to obtain discounts and lower prices for the raw materials.

Technical economies

Businesses with large-scale production can use more advanced machinery (or use existing machinery more efficiently). This may include using mass production techniques, which are a more efficient form of production. A larger firm can also afford to invest more in research and development.

Financial economies

Many small businesses find it hard to obtain finance and when they do obtain it, the cost of the finance is often quite high. This is because small businesses are perceived as being riskier than larger businesses that have developed a good track record. Larger firms therefore find it easier to find potential lenders and to raise money at lower interest rates.

Marketing economies

Every part of marketing has a cost – particularly promotional methods such as advertising and running a sales force. Many of these marketing costs are fixed costs and so as a business gets larger, it is able to spread the cost of marketing over a wider range of products and sales – cutting the average marketing cost per unit.

Managerial economies

As a firm grows, there is greater potential for managers to specialise in particular tasks (e.g. marketing, human resource management, finance). Specialist managers are likely to be more efficient as they possess a high level of expertise, experience and qualifications compared to one person in a smaller firm trying to perform all of these roles.

External economies of scale

External economies of scale occur when a firm benefits from lower unit costs as a result of the whole industry growing in size. The main types are:

Transport and communication links improve

As an industry establishes itself and grows in a particular region, it is likely that the government will provide better transport and communication links to improve accessibility to the region. This will lower transport costs for firms in the area as journey times are reduced and also attract more potential customers. For example, an area of Scotland known as Silicon Glen has attracted many high-tech firms and as a result improved air and road links have been built in the region.

Training and education becomes more focused on the industry

Universities and colleges will offer more courses suitable for a career in the industry which has become dominant in a region or nationally. For example, there are many more IT courses at being offered at colleges as the whole IT industry in the UK has developed recently. This means firms can benefit from having a larger pool of appropriately skilled workers to recruit from.

Other industries grow to support this industry

A network of suppliers or support industries may grow in size and/or locate close to the main industry. This means a firm has a greater chance of finding a high quality yet affordable supplier close to their site.

There are many types of business costs involved in starting or running a business. This article looks in detail different types of business costs.

Economic Cost:  Also known as the "opportunity cost" is a payment made to obtain the services of a resource which is at least equal to what that resource can earn elsewhere. 

Opportunity cost: It is the net return that could be realized if a resource were put to its next best use. It is "what we give up" from "the road not taken." 

Implicit costs:  The monetary income that a firm gives up when it uses a resource that it owns rather than buying it from the market.  In other words implicit costs are opportunity costs of owner owned resources including the services of the entrepreneur-costs that are not paid but must be taken into account to estimate the total cost 

Explicit costs:  The monetary payment a firm must make to an outsider to obtain a resource. 

Total costs:  The costs of all resources paid (explicit) and not paid (implicit)  

Accounting profit:  Is the difference between total cost explicit costs 

Normal profit: Is the opportunity cost of the entrepreneur (owner) - the minimum income that the entrepreneur must receive to perform the entrepreneurial functions for the firm. 

Economic profit:  The total revenue of a firm less all its economic costs; also called "pure profit" and "above normal profit." 

Short run:  A period of time so short that quantity of all inputs cannot be changed and at least one input (usually the plant) remains fixed or unchanged. New firms do not enter the industry, and existing firms do not exit. 

Long run:  A period of time long enough in which the quantity of all inputs can be changed-increased or decreases. New firms can enter and exit the market place 

Fixed costs:  Costs of inputs that do not change in a given period known as the short run. 

Variable costs: Cost of inputs that can change even in the short run. 

Relevant costs: These are costs that are relevant with respect to a particular decision. A relevant cost for a particular decision is one that changes if an alternative course of action is taken. Relevant costs are also called differential costs. Relevant costs are decision specific, meaning that a relevant cost may be important in one situation but irrelevant in another. They are also called incremental costs by accountants. 

Sunk costs: These are costs that were incurred in the past. Sunk costs are irrelevant for decisions, because they cannot be changed. Sunk costs are unrecoverable past expenditures. These should not normally be taken into account when determining whether to continue a project or abandon it, because they cannot be recovered either way.

A summary of costs, revenues, and profits

        Total costs = Rents + Wages + Interest + Normal profit

                        = Explicit costs + Implicit costs

                        = Fixed costs + Variable costs

Accounting profit = Total revenue (income) - Explicit costs

  Economic profit = Accounting profit - Implicit costs

                        = Total revenue - (Explicit costs +

                           Implicit costs)

                        = Total revenue - Total costs

  Variable Costs and Fixed Costs

All the costs faced by companies can be broken into two main categories: fixed costs and variable costs.

Fixed costs are costs that are independent of output. These remain constant throughout the relevant range and are usually considered sunk for the relevant range (not relevant to output decisions). Fixed costs often include rent, buildings, machinery, etc.

Variable costs are costs that vary with output. Generally variable costs increase at a constant rate relative to labor and capital. Variable costs may include wages, utilities, materials used in production, etc.

In accounting they also often refer to mixed costs. These are simply costs that are part fixed and part variable. An example could be electricity--electricity usage may increase with production but if nothing is produced a factory still may require a certain amount of power just to maintain itself.

Below is an example of a firm's cost schedule and a graph of the fixed and variable costs. Noticed that the fixed cost curve is flat and the variable cost curve has a constant upward slope.

[pic]

Short Run in Managerial Economics

Short-Run refers to that time period in which supply of a commodity can be increased only up to its existing production capacity. If demand has increased, there is not enough time for a firm to install new machines nor for the new firms to enter the industry. The main features of short-run are:-

(1) In the short-run there are two types of factors of production

• Fixed Factors

• Variable Factors

(2) In the short-run supply can be changed only by varying variable factors.

(3) The fixed factors cannot be changed.

(4) In short-run demand plays greater role than supply in the determination of price.

(5) The price that is determined in the short period is called Sub-normal price.

(6) There are two types of cost in the short-run:

• Fixed Cost: The costs of fixed inputs are called fixed costs. Fixed costs are costs which do not change with changes in the quantity of output.

• Variable Cost: Variable costs are those costs which are incurred on the use of variable factors of production.

Example of Short Run

Supposing you have a carpet manufacturing factory. If you run your factory for full 24 hours, you can produce 10 carpets at the most. Supposing demand for carpets increases to 20 carpets per day for two days only. You will be unable to meet this additional demand. Your maximum production capacity is limited to 10 carpets only. You do not have time to install new looms to increase your production.

Long Run in Managerial Economics

Long-Run refers to that time period in which supply of a commodity can be increased or decreased according to the changed conditions of demand. The increased demand can be met with increasing the supply by installing machines. Or new firms can enter the industry. On the contrary, if demand has gone down, some firms will discontinue their production. Price, in the long-run is therefore, more influence by supply than demand. Price that comes to prevail in the long-run is called Normal Price. The main features of long-run are:

(1) In the long-run all factors are variable.

(2) In the long-run supply can be changed by varying all factors of production.

(3) In long-run demand and supply both plays equal role in the determination of price.

(4) The price that is determined in the long period is called Normal Price.

(5) In the long-run supply can be increased or decreased according to the demand.

(6) In the long-run new firms can enter the industry and old firms can leave

Cost curve

In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of production, where they make the most profits. There are various types of cost curves, all related to each other. The two basic categories of cost curves are total and per unit or average cost curves.

Short-run average variable cost curve (SRAVC)

Average variable cost (which is a short-run concept) is the variable cost (typically labor cost) per unit of output: SRAVC = wL / Q where w is the wage rate, L is the quantity of labor used, and Q is the quantity of output produced. The SRAVC curve plots the short-run average variable cost against the level of output, and is typically U-shaped.

Short-run average total cost curve (SRATC or SRAC)

Typical short run average cost curve

The average total cost curve is constructed to capture the relation between cost per unit of output and the level of output, ceteris paribus. A perfectly competitive and productively efficient firm organizes its factors of production in such a way that the average cost of production is at the lowest point. In the short run, when at least one factor of production is fixed, this occurs at the output level where it has enjoyed all possible average cost gains from increasing production. This is at the minimum point in the diagram on the right.

Short-run total cost is given by STC = PKK+PLL,

where PK is the unit price of using physical capital per unit time, PL is the unit price of labor per unit time (the wage rate), K is the quantity of physical capital used, and L is the quantity of labor used. From this we obtain short-run average cost, denoted either SATC or SAC, as STC / Q:

SRATC or SRAC = PKK/Q + PLL/Q = PK / APK + PL / APL,

where APK = Q/K is the average product of capital and APL = Q/L is the average product of labor. Short run average cost equals average fixed costs plus average variable costs. Average fixed cost continuously falls as production increases in the short run, because K is fixed in the short run. The shape of the average variable cost curve is directly determined by increasing and then diminishing marginal returns to the variable input (conventionally labor).

Long-run average cost curve (LRAC)

Typical long run average cost curve

The long-run average cost curve depicts the cost per unit of output in the long run—that is, when all productive inputs' usage levels can be varied. All points on the line represent least-cost factor combinations; points above the line are attainable but unwise, points below unattainable given present factors of production. The behavioral assumption underlying the curve is that the producer will select the combination of inputs that will produce a given output at the lowest possible cost. Given that LRAC is an average quantity, one must not confuse it with the long-run marginal cost curve, which is the cost of one more unit. The LRAC curve is created as an envelope of an infinite number of short-run average total cost curves, each based on a particular fixed level of capital usage.

In a long-run perfectly competitive environment, the equilibrium level of output corresponds to the minimum efficient scale, marked as Q2 in the diagram. This is due to the zero-profit requirement of a perfectly competitive equilibrium. This result, which implies production is at a level corresponding to the lowest possible average cost,[3]:259 does not imply that production levels other than that at the minimum point are not efficient. All points along the LRAC are productively efficient, by definition, but not all are equilibrium points in a long-run perfectly competitive environment.

In some industries, the bottom of the LRAC curve is large in comparison to market size (that is to say, for all intents and purposes, it is always declining and economies of scale exist indefinitely). This means that the largest firm tends to have a cost advantage, and the industry tends naturally to become a monopoly, and hence is called a natural monopoly. Natural monopolies tend to exist in industries with high capital costs in relation to variable costs, such as water supply and electricity supply.[3]:312

Short-run marginal cost curve (SRMC)

Typical marginal cost curve

A short-run marginal cost curve graphically represents the relation between marginal (i.e., incremental) cost incurred by a firm in the short-run production of a good or service and the quantity of output produced. This curve is constructed to capture the relation between marginal cost and the level of output, holding other variables, like technology and resource prices, constant. The marginal cost curve is U-shaped. Marginal cost is relatively high at small quantities of output; then as production increases, marginal cost declines, reaches a minimum value, then rises. The marginal cost is shown in relation to marginal revenue, the incremental amount of sales revenue that an additional unit of the product or service will bring to the firm. This shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing marginal returns. Marginal cost equals w/MPL. For most production processes the marginal product of labor initially rises, reaches a maximum value and then continuously falls as production increases. Thus marginal cost initially falls, reaches a minimum value and then increasesThe marginal cost curve intersects both the average variable cost curve and (short-run) average total cost curve at their minimum points. When the marginal cost curve is above an average cost curve the average curve is rising. When the marginal costs curve is below an average curve the average curve is falling. This relation holds regardless of whether the marginal curve is rising or falling.

Long-run marginal cost curve (LRMC)

The long-run marginal cost curve shows for each unit of output the added total cost incurred in the long run, that is, the conceptual period when all factors of production are variable so as minimize long-run average total cost. Stated otherwise, LRMC is the minimum increase in total cost associated with an increase of one unit of output when all inputs are variable.[4]

The long-run marginal cost curve is shaped by economies and diseconomies of scale, a long-run concept, rather than the law of diminishing marginal returns, which is a short-run concept. The long-run marginal cost curve tends to be flatter than its short-run counterpart due to increased input flexibility as to cost minimization. The long-run marginal cost curve intersects the long-run average cost curve at the minimum point of the latter.[1]:208 When long-run marginal costs are below long-run average costs, long-run average costs are falling (as to additional units of output).[1]:207 When long-run marginal costs are above long run average costs, average costs are rising. Long-run marginal cost equals short run marginal-cost at the least-long-run-average-cost level of production. LRMC is the slope of the LR total-cost function.

Graphing cost curves together

Cost curves in perfect competition compared to marginal revenue

Cost curves can be combined to provide information about firms. In this diagram for example, firms are assumed to be in a perfectly competitive market. In a perfectly competitive market the price that firms are faced with would be the price at which the marginal cost curve cuts the average cost curve.

Cost curves and production functions

Assuming that factor prices are constant, the production function determines all cost functions.[2] The variable cost curve is the inverted short-run production function or total product curve and its behavior and properties are determined by the production function.[1]:209 [nb 1] Because the production function determines the variable cost function it necessarily determines the shape and properties of marginal cost curve and the average cost curves.[2]

If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all its inputs are unaffected by how much of the inputs the firm purchases, then it can be shown[5][6][7] that at a particular level of output, the firm has economies of scale (i.e., is operating in a downward sloping region of the long-run average cost curve) if and only if it has increasing returns to scale. Likewise, it has diseconomies of scale (is operating in an upward sloping region of the long-run average cost curve) if and only if it has decreasing returns to scale, and has neither economies nor diseconomies of scale if it has constant returns to scale. In this case, with perfect competition in the output market the long-run market equilibrium will involve all firms operating at the minimum point of their long-run average cost curves (i.e., at the borderline between economies and diseconomies of scale).

If, however, the firm is not a perfect competitor in the input markets, then the above conclusions are modified. For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range.

[edit] Examples of cost functions

• Total Cost = Fixed Costs (FC) + Variable Costs (VC):

FC = 420

VC = 60Q + Q2

C = 420 + 60Q + Q2

• Marginal Cost (MC) = ∂C/∂Q; MC equals the slope of the total cost function and of the variable cost function:

MC = 60 +2Q

• Average Total Cost (ATC) = Total Cost/Q:

ATC = (420 + 60Q + Q2)/Q

ATC = 420/Q + 60 + Q

• Average Fixed Cost (AFC) = FC/Q:

AFC = 420/Q

• Average Variable Cost = VC/Q:

AVC = (60Q + Q2)/Q

AVC = 60 + Q

ATC = AFC + AVC

AFC = ATC - AVC*

• The vertical distance between the ATC curve and AVC curve represents AFC.

• The MC curve is related to the shape of the ATC and AVC curves:[8]:212

At a level of Q at which the MC curve is above the average total cost or average variable cost curve, the latter curve is rising.[8]:212

If MC is below average total cost or average variable cost, then the latter curve is falling.[8]:212

If MC equals average total cost, then average total cost is at its minimum value.[8]:212

If MC equals average variable cost, then average variable cost is at its minimum value.[8]:212

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