A larger firm becomes more productive and lowers average costs in the long-run through economies of scale. Economies of scale makes a firm’s short-run cost curve shift down in the long-run.
Remember the short-run is that period of time in which at least one factor of production is fixed. All factors of production are variable in the long-run.
Long-Run Average Cost A firm experiences (internal) economies of scale if long-run average costs (LRAC) fall as output rises.
A firm remains on the SRAC curve in the short-run because at least one factor of production is fixed. Let’s say the firm’s only fixed factor is its building. A firm can vary all the factors of production in the long-run, move to a larger building, become more efficient and move onto a lower SRAC curve. After some point though, the next building the firm moves to is now too large to use efficiently so it moves onto a higher SRAC curve. An infinite amount of SRAC curves can be drawn and combined to make the LRAC curve. The LRAC curve is the envelope of all the SRAC curves. LRAC shows the minimum cost in the long-run for each level of output.
EoS: LRAC falls as output rises, the firm is benefiting from economies of scale. A.k.a. increasing returns to scale, a doubling of inputs leads to a more than doubling of output.
MES: the LRAC has reached its minimum point, the minimum efficient scale (MES), the minimum scale to fully benefit from economies of scale.
CRS: LRAC is constant as output rises, the firm is experiencing constant returns to scale. A doubling of inputs leads to a doubling of output.
DEoS: LRAC rises as output rises, the firm is experiencing diseconomies of scale. A.k.a. decreasing returns to scale, a doubling of inputs leads to a less than doubling of output.
Examples of Economies of Scale A larger firm becomes more productive and lowers average costs for a number of reasons:
1) Technical Economies.
As a firm expands it can buy specialist machinery to use in its production process. Using specialist machinery to produce a larger quantity increases efficiency so average costs fall. Also, as a firm expands there is more scope for labour specialization. Workers can be given specific roles to stick to in the production process, become more efficient and thus reduce average costs. Moreover, the ‘Law of Increased Dimensions’ states that a doubling of height and width of a building leads to a more than proportionate increase in its cubic capacity. The Law of Increased Dimensions means that a firm can benefit from increasing returns to scale (this is particularly useful in the airline, shipping, transportation and storage industries).
2) Managerial Economies.
As a firm grows it can employ specialist staff to increase efficiency. Procurers (specialist buyers) can be employed to reduce the firm’s input costs. Managers can be employed to manage,motivate and/or supervise workers to increase labour productivity and lower unit labour cost. Accountants can be employed to minimize taxes and optimally deal with the firm’s profits and savings. Receptionists and IT staff can be employed to improve communication networks.
3) Financial Economies.
As a firm grows it becomes more profitable and successful so it becomes less risky, has a higher credit worthiness so it can obtain larger and quicker loans and at a lower interest rate.
4) Marketing Economies.
As a firm grows it can spread its advertising costs over its larger output. Additionally, the larger firm may gain some monopsony power to be able to bulk purchase and negotiate discounted prices for its inputs.
External Economies of Scale External economies of scale occurs when an industry grows and its LRAC falls.
All firms benefit from the growth in the industry, every firm experiences a downward shift in their LRAC curve. At each level of output, average costs are lower.
Examples of External Economies of Scale Many reasons cause external economies of scale:
1) Technological Improvement/Research and Development (R&D).
Maybe new and more efficient technology becomes available to the industry due to R&D, so productivity rises and unit costs fall.
The government could decrease taxes on the industry, so costs fall.
3) Labour Productivity (Education).
Maybe educational institutions train more students and train them better. Workers’ skills improve, so productivity rises and unit labour costs fall. Also, firms’ training costs fall.
Maybe the industry’s local infrastructure (roads and telecommunications) improves, so productivity rises and costs fall. Qatar Airways and Economies of Scale Let’s say the airline firm Qatar Airways is growing. Below is a brief summary of the types of economies of scale Qatar Airways may experience.
Anglo Pacific and Economies of Scale Let’s say the international shipping firm Anglo Pacific is growing. Below is a brief summary of the types of economies of scale Anglo Pacific may experience.