1. As firms increase their scale of production in the long-run by investing in fixed factors like larger factories, they can experience increasing, constant, or decreasing returns to scale. 2. Increasing returns lead to lower average costs (economies of scale) while decreasing returns lead to higher average costs (diseconomies of scale). 3. The long-run average cost curve is often U-shaped, falling initially due to technical economies of scale then rising due to managerial diseconomies of scale at very high output levels.

1. Long-run production and cost theory

2. Changing the scale of operations
In the short-run, the level of production
1 small plant with can be changed within limits of the
60 workers can fixed factor/s of production (e.g.
produce 300 capital). To break these limits, firms
units per week. are able to increase the scale of their
operations in the long-run by investing
in fixed factors (e.g. building bigger
factories).
1 medium sized
plant with 80
workers can 1 large plant with
produce 600 100 workers can
units per week. produce 1000
units per week.
Note how the output per worker
increases as the plant size
increases. This effect is known
as increasing returns of scale.

3. Returns to scale

Increasing returns to scale is when an increase in the
scale of the factors of production leads to a more than
proportionate increase in output

Constant returns to scale is when an increase in the
scale of the factors of production leads to a proportionate
increase in output

Decreasing returns to scale is when an increase in the
scale of the factors of production leads to a less than
proportionate increase in output

4. A U-shaped long-run average
cost curve and its related short-
run average cost curves
Long-run costs
Costs The shape of the LRAC
curve
SRATC7
SRATC1 LRAC As firms increase the scale of
production and experience
SRATC2 SRATC6 increasing returns to scale,
so the average cost of
SRATC3 SRATC5 production falls. However,
Economies SRATC4 Dis-economies
when the scale reaches a
of scale of scale certain level there can be
C1 decreasing returns therefore
increasing average costs.
The long-run average cost
curve therefore is often
0 drawn as U-shaped.
Q1 Output
Economies and dis-economies
The falling LRAC is due to economies of scale and the rising LRAC at higher levels of
output are due to dis-economies of scale.
Short-run curves along the LRAC curve
At each point along the LRAC curve the short-run rules of production apply; costs fall due to the division of
labour and falling AFC, then rise as diminishing marginal returns kick in. As the scale of production increases
the long-run costs fall or increase, but the short-run curve still applies at each scale. It is important not to
confuse the short-run reasons for changing costs with the long-run reasons.

5. Economies and Dis-economies
Technical economies of scale Dis-economies of scale
Increasing returns to scale lead to economies of When the output of a firm increases it may
scale when the effect is translated into cost experience rising unit costs. This is often due to
theory. This reason for falling unit costs is known what are known as managerial dis-economies of
as technical economies of scale. There are other scale.
types of economies of scale apart from technical
economies. Managerial dis-economies occur as the firm gets
larger and it becomes more difficult to manage
The main types of technical economies are: the complexity of the firm. Often, levels of
hierarchy are introduced and different functional
Indivisibilities whereby there is a minimum parts of the firm are divided into departments.
efficient scale for a piece of equipment Communication problems may increasingly result,
both from the top to bottom of the hierarchy, and
Spreading of R&D costs over higher production between the departments.
levels
Volume economies which occur when the
increasing dimensions lead to proportionally
higher volume increases. For example, a factory
of twice the height, width and length will have four
times the volume.
Economies of massed resources e.g. fewer
spare parts need to be held if multiple identical
machines are run.

6. Other LRAC curves
Costs
Economies of small-scale production
LRAC curves are not always U-shaped. Some
firms experience the full economies of scale at
LRAC
quite a small scale. Personal services, such as
hairdressing for instance, are typical examples.
A wonky bowl-cut please
Hairdressers benefit from bulk buying
economies for things like shampoo at quite low
0 levels and experience managerial economies
Output with a limited number of salons, perhaps as
one manager oversees a few outlets. Chains
of hairdressers will experience dis-economies
early on as they need a 'head-office' to oversee
operations. If they wish to build a national
reputation they will also incur marketing costs
which a small, local hairdressers wouldn't incur.
It is for these reasons that hairdressers are
often small, local, independently-owned
businesses. The exception which proves the
rule is 'Tony and Guys' which can only sustain
its national operation by charging high prices as
an 'up-market' brand

7. Other LRAC curves
Costs
An L-shaped LRAC curve
In some industries, such as manufacturing, there
are significant economies of scale to be gained
but not dis-economies (at least not at the scale of
production required by the market).
LRAC Driving down costs
C1 Car manufacturing requires significant
Minimum Efficient Scale investment in equipment and set-up costs are
therefore very high. It is simply not cost-
0 Q1
Output
effective to spend all that money to only
produce a few cars. Large scale production is
achievable through the use of technology, such
as computer controlled robotics, and although
expensive, the average cost falls rapidly as
automation replaces labour and speeds up
production. Economies can also be gained as
firms source cheaper components
internationally, or set up their own plants in
countries where costs are low. Consumers
also want cars which have a recognisable
brand and large firms can benefit from mass-
market advertising which, if the market is large,
can be cost effective.

8. Minimum Efficient Scale
Minimum Efficient Scale (MES) is the term used to refer to the
Costs
quantity of output required to achieve the lowest average
production cost.
MES is often used to explain the reason for the number of firms in
a market. If the MES is at a high level of output then a very
large firm is required to produce at an efficient cost.
Therefore, the market will likely sustain one (monopoly) or a few
LRAC firms (oligopoly). Small firms attempting to enter the market will
C1 Minimum Efficient Scale experience very high production costs and be unable to compete
with the low unit costs, and therefore potentially low prices, of the
0 Q1 Output dominant, large firms in the market.
Outsourcing
It is not always cost effective for a firm to undertake all Why has outsourcing become more common?
aspects of a production process itself. Firms may
outsource (i.e. commission other firms to perform 1. Globalisation means firm can sell to, or buy
certain parts of production) as it may be cheaper to buy from, firms across the globe due to improved travel
from another firm because: and communication
- the other firm may be able to achieve better 2. The removal of trade barriers
economies of scale due to supplying a number of firms 3. Countries specialising in the production of
certain goods
- the firm may be 'specialists' who innovate and adopt
the latest practices and technology The UK has become so good at outsourcing that
some firms just design and brand a good and
- a national firm may take advantage of buying from a commission all the production to oversees firms.
foreign firm with lower production costs

9. 10 point summary
• In the short-run the level of production can be varied, and in the
long-run the scale of production changed
• As the scale of operations increases firms may experience
increasing, constant or decreasing returns to scale
• Increasing returns to scale are associated with decreasing
average costs, known as economies of scale
4. Decreasing returns to scale are associated with increasing
average cost, known as dis-economies of scale
5. The particular type of economies of scale associated with the
LRAC curve are technical economies

10. 10 point summary
6.The particular type of dis-economies of scale associated with the
LRAC curve is managerial dis-economies
7.The long-run average cost curve is often depicted as bowl-
shaped, with average costs falling due to economies, then
increasing due to dis-economies
8.The long-run average cost curve can also be drawn in different
ways to depict the conditions in specific industries e.g. L-shaped,
tick-shaped
9.The minimum efficient scale is the level of output at which the
minimum average cost of production is achieved in the long-run
10.It is not always most efficient for a firm to undertake every
stage of the production process; contracting out production is
known as outsourcing