Internal and External Economies and Diseconomies of Scale

This section explores how the cost structure of a firm changes as its level of output varies. We will examine the concepts of economies of scale, diseconomies of scale, and their internal and external dimensions. Understanding these concepts is crucial for analyzing firm behavior and market structures.

Types of Cost

Costs are resources consumed in the production process. They are typically categorized into two main types: fixed costs and variable costs.

• Fixed Costs (FC): Costs that do not change with the level of output in the short run. Examples include rent, salaries of permanent staff, and insurance premiums.
• Variable Costs (VC): Costs that change with the level of output. Examples include raw materials, wages of temporary staff, and energy costs.
• Total Cost (TC): The sum of fixed costs and variable costs. $$TC = FC + VC$$
• Average Total Cost (ATC): Total cost divided by the quantity of output. $$ATC = \frac{TC}{Q}$$
• Average Variable Cost (AVC): Variable cost divided by the quantity of output. $$AVC = \frac{VC}{Q}$$

Types of Revenue

Revenue is the income a firm receives from selling its output. The primary type of revenue is total revenue.

• Total Revenue (TR): The total income from selling a certain quantity of output. $$TR = P \times Q$$ where P is the price per unit and Q is the quantity sold.
• Average Revenue (AR): Total revenue divided by the quantity of output. $$AR = \frac{TR}{Q} = P$$ (in perfect competition)

Profit

Profit is the difference between total revenue and total cost.

• Profit (π): $$π = TR - TC$$ or $$π = \text{AR} \times Q - TC$$
• Normal Profit: The minimum level of profit a firm needs to cover its opportunity cost. $$π = 0$$
• Economic Profit: Profit above and beyond normal profit. $$π > 0$$
• Economic Loss: Loss below normal profit. $$π < 0$$

Short-Run and Long-Run Production

In the short run, at least one factor of production is fixed. In the long run, all factors of production are variable.

Internal Economies of Scale

Internal economies of scale are cost advantages that a firm experiences as it increases its level of output. These arise from factors within the firm itself.

Economy of Scale	Description
Technical Economies	Specialisation of labour, use of large machinery, increased efficiency.
Managerial Economies	Specialist managers, better decision-making.
Purchasing Economies	Bulk buying discounts, better negotiating power.
Financial Economies	Access to cheaper loans, better credit terms.
Risk-Bearing Economies	Ability to spread risk over a larger output.
Marketing Economies	Lower per-unit marketing costs with higher output.

External Economies of Scale

External economies of scale are cost advantages that arise from factors outside the firm, typically due to the development of an industry or a geographical area.

• Development of a skilled labour force.
• Development of specialist suppliers.
• Infrastructure improvements (e.g., transport, communication).
• Knowledge spillovers between firms in the same industry.

Diseconomies of Scale

Diseconomies of scale are cost disadvantages that a firm experiences as it continues to increase its level of output. These arise from factors within the firm itself.

Diseconomy of Scale	Description
Management Diseconomies	Difficulties in coordinating large numbers of employees, slow decision-making.
Communication Problems	Increased communication costs, information overload.
Motivation Problems	Reduced employee motivation, increased absenteeism.
Bureaucracy	Excessive rules and regulations, slowing down operations.

The Long-Run Average Cost (LRAC) Curve

The LRAC curve shows the minimum average cost of producing different levels of output in the long run. It reflects the interplay between economies and diseconomies of scale.

The LRAC curve typically has a U-shape. Initially, as output increases, economies of scale prevail, and the LRAC curve slopes downwards. However, beyond a certain point, diseconomies of scale set in, and the LRAC curve slopes upwards. The minimum point of the LRAC curve represents the most efficient scale of production for the firm.