8.7: returns to scale

• Returns to scale refer to how the output of a firm changes when all inputs are increased proportionally. This is a long-run concept, as in the long run, all inputs can be varied.
• Constant Returns to Scale: Output increases by the same proportion as inputs. For example, if inputs double, output also doubles.
• Increasing Returns to Scale (Economies of Scale): Output increases by more than the proportion of the increase in inputs. For example, if inputs double, output more than doubles.
• • Decreasing Returns to Scale (Diseconomies of Scale): Output increases by less than the proportion of the increase in inputs. For example, if inputs double, output increases by less than double.
• There are three possible outcomes when a firm increases its inputs (like labor, capital, machinery) by the same proportion:

  • constant returns to scale
  • increasing returns to scale (economies of scale)
  • decreasing returns to scale (diseconomies of scale)
• The concept of returns to scale affects the firm’s long-run average cost (LAC):

  • Increasing returns to scale lead to economies of scale: as the firm increases production, average cost per unit decreases.
  • Constant returns to scale mean that the LAC remains constant as output increases.
  • Decreasing returns to scale lead to diseconomies of scale: as the firm increases production, average cost per unit increases.
• • Increasing Returns to Scale (Economies of Scale):
  • In this scenario, the LAC curve slopes downward. As the firm increases production, it benefits from economies of scale, reducing its average cost.
• Constant Returns to Scale:

  • Here, the LAC curve is flat, meaning that increasing output does not change the average cost. The firm operates at a constant cost per unit as output increases.
• Decreasing Returns to Scale (Diseconomies of Scale):

  • In this case, the LAC curve slopes upward. As the firm increases production, it faces inefficiencies that cause the average cost to rise. This situation arises when the firm grows too large, leading to management and coordination problems.
• Economies of scale arise due to several factors:

  • fixed costs and indivisibilities
  • specialisation of labour
  • better use of machinery
• Specialization of Labor: As a firm grows, it can assign workers to specific tasks, allowing them to specialize and become more efficient.
• Fixed Costs and Indivisibilities: Some fixed costs (like management, machinery, and overhead costs) do not vary with output. For example, a factory manager can manage 10 workers as easily as they can manage 5, meaning that increasing output spreads fixed costs over more units, reducing the average cost per unit.
• Better Use of Machinery: Larger firms can afford to invest in more advanced and efficient machinery that increases productivity, reducing the cost per unit.
• Diseconomies of scale occur when a firm becomes too large and starts to experience inefficiencies:

  • managerial diseconomies
  • geographical diseconomies
• Managerial Diseconomies: As the company grows, management becomes more complex, and coordination becomes more difficult. More layers of management can lead to bureaucratic delays, communication problems, and slower decision-making, increasing costs.
• 1. Geographical Diseconomies: When a firm expands geographically, transporting goods over long distances increases costs. Also, setting up a second factory in a less ideal location may result in higher costs compared to the first location.
• The digital economy, including industries like music, films, and software, shows vast economies of scale:

  • The fixed costs of producing digital content (like making a movie or software) are high, but the marginal cost of distributing that content (like selling one more copy of software or streaming a song) is nearly zero.
  • This allows companies to scale easily without significant additional costs, leading to enormous economies of scale.
• Diseconomies of Scale in Practice

  Beyond a certain output level, average costs start rising, which we refer to as diseconomies of scale. Some common reasons include:

  1. Managerial Complexity: Managing a large organization becomes difficult, leading to inefficiencies.
  2. Geographical Issues: Expanding to new locations that are less efficient increases costs.

  Thus, the U-shaped LAC curve reflects the balance between economies and diseconomies of scale.
• different industries have different returns to scale because :

  certain industries benefit more from expanding production due to technological and capital investments, while others do not.
• The minimum efficient scale (MES) is the level of output where a firm first achieves economies of scale. This is the output level at which the LAC curve stops falling
• the higher the MES it suggests that manufacturing firms produce on a larger scale to achieve efficiency due to high fixed costs.