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

7. 7 Returns to scale
Scale economies and the internet
Producing information products such as films, music and news programmes has a high fixed
cost, but distributing these products digitally has almost a zero marginal cost and no capacity
constraint. Scale economies are vast. Moreover, if marginal cost is close to zero, smart suppliers will price
their products so that marginal revenue is also tiny.
EMI, a legend of the music industry, was formed in 1931. Its Abbey Road studios in London hosted giants
such as the Beatles. Moving with the times, EMI has steadily withdrawn from the business of supplying
records and CDs, and now operates largely online. In April 2007, EMI announced it would begin releasing its
music as superior-quality tracks available exclusively on the iTunes Store. Costing £0.99, the tracks were to be
free of restrictions on access and distribution, and no longer utilized anti-copying software. Lower-quality
tracks with restrictions were to be sold for £0.79.
Diseconomies of scale
Beyond some output, the U-shaped average cost curve turns up again as diseconomies
of scale begin. Management is harder as the firm gets larger: there are
managerial diseconomies of scale. Large companies need many layers of management,
themselves needing to be managed. The company becomes bureaucratic,
co-ordination problems arise and average costs begin to rise.
Diseconomies of scale
(or decreasing returns to
scale) mean long-run average
cost rises as output rises.
Geography may also explain diseconomies of scale. If the first factory is located in the best site, to minimize
the cost of transporting goods to the market, the site of a second factory must be less advantageous. To take
a different example, in extracting coal from a mine, a firm will extract the easiest coal first. To increase
output, deeper coal seams have to be worked and these will be more expensive.
As output increases, the shape of the average cost curve thus depends on two things: how long economies
of scale persist and how quickly the diseconomies of scale set in. The balance of these two forces varies
from industry to industry and from firm to firm.
The long-run production function and the returns to scale
II
We defined the returns to scale in terms of the relationship between the long-run average cost
and the level of output. We can define the same concepts using the relationship between inputs
and output implied by a long-run production function.
We say that a production function displays increasing, constant or decreasing returns to scale if the following
definitions hold:
(a) Increasing returns to scale (or economies of scale): when all the inputs of production are increased by the
same factor and the output produced increases more than proportionally.
(b) Constant returns to scale: when all the inputs of production are
increased by the same factor and the output produced increases by the
same factor.
Constant returns to scale
mean long-run average costs
are constant as output rises.
(c) Decreasing returns to scale (or diseconomies of scale): when all the inputs of production are increased by
the same factor and the output produced increases less than proportionally.
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