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Economies of scale

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As quantity of production increases from Q to Q2, the average cost of each unit decreases from C to C1.

Economies of scale, in microeconomics, refers to the cost advantages that a business obtains due to
expansion. They are factors that cause a producer’s average cost per unit to fall as the scale of output
is increased. "Economies of scale" is a long run concept and refers to reductions in unit cost as the
size of a facility and the usage levels of other inputs increase.[1] Diseconomies of scale are the
opposite. The common sources of economies of scale are purchasing (bulk buying of materials
through long-term contracts), managerial (increasing the specialization of managers), financial
(obtaining lower-interest charges when borrowing from banks and having access to a greater range of
financial instruments), marketing (spreading the cost of advertising over a greater range of output
in media markets), and technological (taking advantage of returns to scale in the production function).
Each of these factors reduces the long run average costs(LRAC) of production by shifting the short-run
average total cost (SRATC) curve down and to the right. Economies of scale are also derived partially
from learning by doing.

Economies of scale is a practical concept that is important for explaining real world phenomena such
as patterns of international trade, the number of firms in a market, and how firms get "too big to fail".
The exploitation of economies of scale helps explain why companies grow large in some industries. It
is also a justification for free trade policies, since some economies of scale may require a larger
market than is possible within a particular country — for example, it would not be efficient
for Liechtenstein to have its own car maker, if they would only sell to their local market. A lone car
maker may be profitable, however, if they export cars to global markets in addition to selling to the
local market. Economies of scale also play a role in a "natural monopoly."

Contents
[hide]

• 1 Natural monopoly

• 2 Economies of scale and returns to scale

• 3 See also

• 4 Notes

• 5 References

• 6 External links

[edit]Natural monopoly
A natural monopoly is often defined as a firm which enjoys economies of scale for all reasonable firm
sizes; because it is always more efficient for one firm to expand than for new firms to be established,
the natural monopoly has no competition. Because it has no competition, it is likely the monopoly has
significant market power. Hence, some industries that have been claimed to be characterized by
natural monopoly have been regulated or publicly-owned.

[edit]Economies of scale and returns to scale


Economies of scale is related to and can easily be confused with the theoretical economic notion
of returns to scale. Where economies of scale refer to a firm's costs, returns to scale describe the
relationship between inputs and outputs in a long-run (all inputs variable) production function. A
production function has constant returns to scale if increasing all inputs by some proportion results in
output increasing by that same proportion. Returns are decreasing if, say, doubling inputs results in
less than double the output, and increasing if more than double the output. If a mathematical function
is used to represent the production function, and if that production function is homogeneous, returns to
scale are represented by the degree of homogeneity of the function. Homegeneous production
functions with constant returns to scale are first degree homogeneous, increasing returns to scale are
represented by degrees of homogeneity greater than one, and decreasing returns to scale by degrees
of homogeneity less than one.

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[2][3][4] that at a particular
level of output, the firm has economies of scale if and only if it has increasing returns to scale, has
diseconomies of scale 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 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]See also

 Diseconomy of scale — A region of increasing quantity and increasing long-run average cost.

 Internal economies of scale

 Economies of scope

 Ideal firm size

 Returns to scale

 The Long Tail

 Network effects

[edit]Notes

1. ^ Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper

Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 157. ISBN 0-13-063085-3.

2. ^ Gelles, Gregory M., and Mitchell, Douglas W., "Returns to scale and economies of

scale: Further observations," Journal of Economic Education 27, Summer 1996, 259-261.

3. ^ Frisch, R., Theory of Production, Drodrecht: D. Reidel, 1965.

4. ^ Ferguson, C. E., The Neoclassical Theory of Production and Distribution, London:

Cambridge Unive. Press, 1969.

[edit]References

 Joaquim Silvestre (1987). "Economies and diseconomies of scale," The New Palgrave: A
Dictionary of Economics, v. 2, pp. 80–84.

[edit]External links
 Economies of Scale Definition by The Linux Information Project (LINFO)

Categories: Economics of production

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