Economies and diseconomies of scale

What is the difference between the short run and the long run?

In the short run at least one input, such as the plant, equipment or technology, is fixed. In the long run every input is variable and firms can enter or exit. Firms operate in the short run and plan in the long run.

Each plant size has its own short-run cost curve, a short-run average total cost curve shaped like a smile. When the firm can choose its plant, it picks the size with the lowest cost for the output it wants. Tracing the lowest cost at every output gives the long-run average total cost (LRAC) curve: the envelope that hugs the bottom of all the short-run smiles.

How do you read the long-run cost curve?

Look at the slope. Here is a schedule for a solar-panel maker (cost per unit in USD).

Annual output (units)	2,000	3,000	4,000	5,000	6,000	7,000
LRAC (USD)	54	43	38	38	41	46

Long-run average total cost (LRAC)the lowest cost per unit at each output once plant size can change

• Falling LRAC: economies of scale Memorize output grows faster than inputs; grow
• Flat LRAC: constant returns to scale Use it starts at the minimum efficient scale
• Rising LRAC: diseconomies of scale Memorize output grows slower than inputs; shrink or restructure

• From 2,000 to 4,000 units the curve falls: economies of scale . Cost per unit drops as output grows.
• From 4,000 to 5,000 it is flat: constant returns to scale .
• Beyond 5,000 it rises: diseconomies of scale .
• The minimum efficient scale is the smallest output at the lowest LRAC: 4,000 units.

Under perfect competition the long-run price is driven down to the minimum LRAC, so a firm that is not at minimum efficient scale is at risk. A firm to the left should grow. A firm to the right should shrink or restructure.

Exam tip At minimum efficient scale a competitive firm survives. To the left, grow. To the right, shrink.

What are returns to scale?

Increasing returns to scale mean output grows by a larger percentage than inputs. Decreasing returns to scale mean it grows by a smaller percentage. With input prices unchanged, increasing returns lower cost per unit (economies) and decreasing returns raise it (diseconomies).

$$\frac{\%\Delta \text{output}}{\%\Delta \text{inputs}} \;\begin{cases} > 1 & \text{increasing (economies)} \\ = 1 & \text{constant} \\ < 1 & \text{decreasing (diseconomies)} \end{cases}$$

$$g_u = \frac{1 + g_{in}}{1 + g_{out}} - 1 \quad (\text{input prices unchanged})$$

Where do economies and diseconomies come from?

Sources of scale effects

• Economies of scale Memorize
  • Specialization of workers and managers
  • Better equipment and technology affordable only at high volume
  • Less waste and sellable by-products
  • Bulk-purchase discounts
  • Better use of market information
• Diseconomies of scale Memorize
  • Management strain communication breaks down
  • Duplicated functions overlapping product lines
  • Rising input prices huge purchases strain supply

Economies of scale	Diseconomies of scale
Output grows faster than inputs	Output grows slower than inputs
Specialization of workers and managers	Too big to manage well; communication breaks down
Affordable, more efficient equipment and technology	Duplicated functions and overlapping product lines
Less waste, sellable by-products	Input prices rise when buying huge quantities strains supply
Bulk-purchase discounts; better use of market information

Both can operate at once. The slope of the LRAC curve shows which one dominates at the current size.

Go deeper Diminishing returns are not diseconomies

Diminishing marginal returns belong to the short run: with the plant fixed, each extra worker adds less output than the one before, so marginal cost rises. Diseconomies of scale belong to the long run: every input, plant included, grows together and average cost still rises. The two share a shape but not a cause, and the exam likes to swap them.

Go deeper Why utilities grew regional and conglomerates broke up

A water or electricity network has large fixed costs for pipes or cables. Spreading them over more customers lowers the cost per customer for a long way, so utilities naturally grew regional. Sprawling conglomerates went the other way: past a point, the cost of coordinating unrelated businesses outweighed the savings, so many restructured. Analysts read scale as a source of cost advantage and pricing power (see business models in Corporate Issuers).