AQA 1.4: Production, Costs and Revenue 1.4.5 Economies and Diseconomies of Scale With the use of an AC curve explain the concept of economies and diseconomies of scale. Distinguish between internal and external economies of scale. AQA 1.4: Production, Costs and Revenue

1.4.5 What you need to know Recap from Y1 Economics The difference between internal and external economies of scale Reasons for diseconomies of scale The relationship between returns to scale and economies or diseconomies of scale The relationship between economies of scale, diseconomies of scale and the shape of the long-run average cost curve The L-shaped long-run average cost curve The concept of the minimum efficient scale of production Students should be able to categorise and give examples of both internal and external economies of scale Students should understand the significance of the minimum efficient scale for the structure of an industry and barriers to entry

Minimum efficient scale Productive efficiency occurs where no additional output can be produced from the factor inputs available at the lowest possible average or unit cost. In essence, this means that a firm operating at the lowest point on the LRAC curve cannot produce in a more efficient manner – if it decreases or increases the scale of production its average costs will increase. The minimum efficient scale (MES) is that scale of production where the long run average cost curve is at its lowest point If the MES occurs at low levels of output in relationship to the size of the market there is likely to be a large number of firms As the MES increases there will be fewer firms in the market as those firms operating on a larger scale will have much lower long run average costs This creates a barrier to entry for new firms wishing to enter the market as smaller businesses do not have the finance to increase their scale of production

Minimum efficient scale The Minimum Efficient Scale (MES) is that point where the LRAC curve is at its lowest point. The MES of a firm will have implications as to the degree of competition in the market. MES is low for firms in certain industries e.g. hairdressing. In other industries the MES can occur at high levels of output. Therefore, firms in some industries will operate on a large scale. Costs LRAC Increasing Returns to Scale Decreasing Returns to Scale Constant Returns to Scale Output

The relationship between returns to scale and economies or diseconomies of scale At first unit costs fall due to economies of scale. At this point economies outweigh diseconomies. The optimum output occurs when unit costs are at a minimum (productive efficiency). After this unit costs rise and diseconomies outweigh economies. This shows a relationship between economies of scale, diseconomies of scale and returns created by the scale of production. Costs LRAC Economies of scale outweigh diseconomies Diseconomies of scale outweigh economies Economies of scale equal diseconomies Output

Perfect competition In the long run, as firms leave or enter the industry, the firm will always operate at its minimum efficient scale, where the LRAC curve is at a minimum. If a firm is operating below its MES it will increase output as it is still experiencing economies of scale up to its MES. If a firm is operating above its MES it is experiencing diseconomies of scale and will reduce output. In perfect competition the MES occurs at very low levels of output as there are no barriers to entry for the firm. D = AR = MR Costs Output Q1 C1 MC LRAC We will look at the model of perfect competition in more depth in 1.5.3.

Monopolistic competition In conditions of monopolistic competition diseconomies of scale will often set in at low levels of output. A firm in this type of industry will often operate below its MES. It will normally have some spare capacity and is therefore underutilising its resources. Smaller firms will often have goals other than profit maximisation. As diseconomies of scale start to outweigh economies of scale at a low level of output firms are unlikely to increase the scale of production so few firms will operate above an output of Q1 where costs are at a minimum of C1. The MES is often low in this type of industry as fixed costs are low. Therefore, it is easy to enter the industry as there are no major costs acting as a barrier to entry. LRAC Costs C1 Q1 Output

Oligopoly/Monopoly In conditions of oligopoly and monopoly diseconomies of scale will set in at higher levels of output than that of monopolistic competition. A major reason for this is high fixed costs. As the scale of operations increases these high fixed costs are spread over a greater output, lowering average cost. This will give firms the incentive to increase the scale of production and act as a significant barrier to entry as smaller firms find it difficult to compete with larger competitors who will operate at a much lower LRAC. This leads to few firms in the industry. Costs LRAC C1 Q1 Output

L-shaped long-run average cost curve It is believed that in some industries the LRAC curve is L-shaped As the scale of production is increased from low levels of output average costs fall rapidly This is mainly because technical economies of scale continue to reduce average costs even at high levels of output, particularly as rapid technical progress leads to costs being continually reduced Diseconomies of scale at higher levels of output e.g. coordination and communication are not as prevalent because management theory has improved significantly to counter these problems The L-shaped LRAC curve can be compared to the U-shaped LRAC which has traditionally been used in microeconomics

Should natural monopolies be regulated? Natural monopoly In conditions of natural monopoly we see continual returns to scale. This leads to an L-shaped LRAC curve where average costs are always falling. This will give a firm the incentive to keep increasing the scale of production to reduce average costs further. This leads to highly significant barriers to entry. A natural monopoly is often highly regulated by the government as there is no competition. Consumer exploitation might occur if the industry was left to its own devices. Costs http://www.bbc.co.uk/news/business-23663406 LRAC Output Should natural monopolies be regulated?

10 quick questions in 10 minutes – are you ready? State 1 internal economy of scale. State 1 external economy of scale. State 1 diseconomy of scale. What does MES stand for? Where does MES occur on a LRAC curve? As MES increases will there be more or less firms in the market? Briefly explain why a high MES acts as a barrier to entry. In perfect competition does MES occur at a high or low level of output? What shape is a LRAC curve in a natural monopoly? What is a natural monopoly? End