David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 7 Costs and supply
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Output
(o) Increasing returns to scale, or
economies of scale
Output
(b) Constant returns to scale
Output
(c) Decreasing returns to scale,
or diseconomies of scale
The three long-run overage cost LAC curves show the relationship between returns to scale and the shape of the LAC curve.
When LAC is declining, overage cost of production falls os output increases and there ore economies of scale. When LAC
is increasing, overage cost of production increases with higher output, and there ore decreasing returns to scale. The
intermediate case, where overage cost is constant, hos constant returns to scale.
Figure 7.10 Returns to scale and long-run average cost curve
We draw a cost curve for given input prices. Changes in average cost as we move along the LAC curve
cannot be explained by changes in factor prices. (Changes in factor prices shift cost curves.) The relationship
between average cost and the output LAC curve depends on the technical relation between physical
quantities of inputs and output> summarized in the production function.
Economies of scale (or
increasing returns to scale)
mean long-run average cost
falls as output rises.
Economies of scale
There are three reasons for economies of scale. The first is indivisibilities in the
production process, a minimum quantity of inputs required by the firm to be in
business at all whether or not output is produced. These are sometimes called fixed
costs> because they do not vary with the output level. To be in business a firm
requires a manager, a telephone, an accountant and a market research survey. The firm cannot have half a
manager and half a telephone merely because it wishes to operate at low output levels.
Beginning from small output levels> these costs do not initially increase with output. The manager can
organize three workers as easily as two. As yet there is no need for a second telephone. There are economies
of scale because these fixed costs can be spread over more units of output as output is increased, reducing
average cost per unit of output. However, as the firm expands further, it has to hire more managers and
telephones and these economies of scale die away. The average cost curve stops falling.
The second reason for economies of scale is specialization. A sole trader must undertake all the different
tasks of the business. As the firm expands and takes on more workers, each worker can concentrate on a
single task and handle it more efficiently.
The third reason for economies of scale is closely related. Large scale is often needed to take advantage of
better machinery. No matter how productive a robot assembly line is, it is pointless to install one to make
five cars a week. Average costs would be enormous. However, at high output levels the machinery cost can
be spread over a large number of units of output and this production technique may produce so many cars
that average costs are low.
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