Costs and economies of scale

• Fixed costs


  Costs which do not vary with output. For example, rents, advertising and capital goods are fixed costs. They are indirect.
• Variable costs


  Costs that change with output. They are direct costs. For example, the cost of raw materials increases as output increases.
• Total cost


  The cost to produce a given level of output, calculated as: Total costs = total variable costs + total fixed costs
• Average cost


  The cost per unit, calculated as: Average costs = total costs / quantity produced
• Marginal cost


  The cost of producing one extra unit
• Short run


  • At least one factor of production cannot change, so there are some fixed costs
• Long run


  • All factor inputs can change, so all costs are variable
• The measure of the short run varies with industry. There is no standard.
• Law of diminishing marginal productivity

  1. Adding more units of a variable input to a fixed input increases output at first

  2. After a certain number of inputs are added, the marginal increase of output becomes constant

  3. When there is an even greater input, the marginal increase in output starts to fall
• As more inputs are added

  Total costs start to increase
• Marginal costs rise with increasing diminishing returns
• The lowest points on the cost curves are where diminishing marginal productivity sets in
• Before the lowest points, average costs are falling. After, average costs are rising.
• The MC curve cuts through the lowest points on the ATC and AVC curves
• Marginal return


  The extra output derived per extra unit of the factor employed
• Average return


  The output per unit of input
• Total return


  The total output produced by a number of units of factors (e.g. labour) over a period of time
• Diminishing returns only occur in the short run
• The law of diminishing returns assumes firms have fixed factor resources in the short run and the state of technology remains constant
• Increasing returns to scale

  Output increases by a greater proportion to the increase in inputs
• Decreasing returns to scale

  A doubling of input leads to a 1.5 times increase in output, linked to diseconomies of scale
• Constant returns to scale

  Output increases by the same amount that input increases by
• Long-Run Average Cost (LRAC) curve


  • Initially average costs fall as firms can take advantage of economies of scale
  • After the optimum level of output, average costs rise due to diseconomies of scale
  • The point of lowest LRAC is the minimum efficient scale
• 1. shaped LRAC curve


  • Costs per unit fall as output increases due to economies of scale
  • Even if there are diseconomies of scale within the firm, they are offset by the economies of scale gained by technical or production factors
• Internal economies of scale

  • Risk-bearing
  • Financial
  • Managerial
  • Technological
  • Marketing
  • Purchasing
• Network economies of scale

  Gained from the expansion of ecommerce, where large online shops can add extra goods and customers at a very low cost
• External economies of scale

  Occur within the industry, e.g. improved local infrastructure or more training facilities
• Diseconomies of scale


  • Control issues
  • Coordination problems
  • Communication challenges
• Increasing returns to scale

  Occurs where there are economies of scale and factor inputs become more productive
• Decreasing returns to scale

  Linked to diseconomies of scale, as it occurs when factor inputs become less productive