ECON101: Principles of Microeconomics (2021.A.01)

Notice that the long-run average cost curve in Figure 8.9 "Relationship Between Short-Run and Long-Run Average Total Costs" first slopes downward and then slopes upward. The shape of this curve tells us what is happening to average cost as the firm changes its scale of operations. A firm is said to experience economies of scale when long-run average cost declines as the firm expands its output. A firm is said to experience diseconomies of scale when long-run average cost increases as the firm expands its output. Constant returns to scale occur when long-run average cost stays the same over an output range.

Why would a firm experience economies of scale? One source of economies of scale is gains from specialization. As the scale of a firm's operation expands, it is able to use its factors in more specialized ways, increasing their productivity. Another source of economies of scale lies in the economies that can be gained from mass production methods. As the scale of a firm's operation expands, the company can begin to utilize large-scale machines and production systems that can substantially reduce cost per unit.

Why would a firm experience diseconomies of scale? At first glance, it might seem that the answer lies in the law of diminishing marginal returns, but this is not the case. The law of diminishing marginal returns, after all, tells us how output changes as a single factor is increased, with all other factors of production held constant. In contrast, diseconomies of scale describe a situation of rising average cost even when the firm is free to vary any or all of its factors as it wishes. Diseconomies of scale are generally thought to be caused by management problems. As the scale of a firm's operations expands, it becomes harder and harder for management to coordinate and guide the activities of individual units of the firm. Eventually, the diseconomies of management overwhelm any gains the firm might be achieving by operating with a larger scale of plant, and long-run average costs begin rising. Firms experience constant returns to scale at output levels where there are neither economies nor diseconomies of scale. For the range of output over which the firm experiences constant returns to scale, the long-run average cost curve is horizontal.

Firms are likely to experience all three situations, as shown in Figure 8.10 "Economies and Diseconomies of Scale and Long-Run Average Cost". At very low levels of output, the firm is likely to experience economies of scale as it expands the scale of its operations. There may follow a range of output over which the firm experiences constant returns to scale – empirical studies suggest that the range over which firms experience constant returns to scale is often very large. And certainly there must be some range of output over which diseconomies of scale occur; this phenomenon is one factor that limits the size of firms. A firm operating on the upward-sloping part of its LRAC curve is likely to be undercut in the market by smaller firms operating with lower costs per unit of output.

Figure 8.10 Economies and Diseconomies of Scale and Long-Run Average Cost

The downward-sloping region of the firm's LRAC curve is associated with economies of scale. There may be a horizontal range associated with constant returns to scale. The upward-sloping range of the curve implies diseconomies of scale.