Long Run Costs

Long- run and Economies of Scale In the long run, all factors of production are variable i.e. firms can increase their scale of production (get more of all factors of production) How the output of a business responds to a change in factor inputs is called returns to scale As firms and industries increase the scale of their operations there can be advantages which reduce the long-run average costs (LRACs) Economies of Scale refer to the ‘benefits’ of producing on a large scale

Handout Economies and Diseconomies of Scale Read and answer following questions

1.Explain the difference between internal and external economies of scale 2.List and briefly explain the different types of internal economies of scale 3.Using an appropriate diagram, illustrate the concept of economies and diseconomies of scale. (internal) 4.Distinguish clearly between diseconomies of scale and diminishing returns (to a factor). 5.Using examples illustrate external economies of scale. 6.Illustrate and explain the effect of external economies of scale on a firm’s LRAC (long run average cost curve)?

LRAC and Returns to Scale Costs Output LRAC Economies of Scale Diseconomies of Scale A Point A is the Minimum Efficient Scale of Production Range AB is the Optimum level of production- constant returns to scale B

Limits to Economies of Scale Limited total market demand for many products – Market demand may be insufficient for businesses to fully exploit the scale economies – “Niche markets” allow smaller-scale producers to supply at higher cost because consumers are willing to pay a higher price – In a recession - capital will be under-utilised leading to excess capacity and rising average total costs Occupational immobility of capital equipment – Some large units of fixed capital may not be transferable to other uses if there is a switch in consumer demand. Diseconomies of scale – A business may expand beyond the optimal size in the long run and experience diseconomies of scale

Do economies of scale always improve the welfare of consumers? Mass production might lead to a standardisation of products – limiting effective consumer choice in the market Market demand may be insufficient for economies of scale to be fully exploited. Some businesses may be left with a substantial amount of excess capacity if they over-invest in new capital Businesses may use economies of scale to build up monopoly power in their own industry and this might lead to a reduction in consumer welfare and higher prices in the long run – leading to a loss of allocative inefficiency Economies of scale might be used as a form of barrier to entry – whereby existing firms have sufficient spare capacity to force prices down in the short run if there is a threat of the entry of new suppliers

Conclusion S/r AC, MC and TCs are influenced by increasing and diminishing returns L/r AC, MC and TCs are influenced by economies and diseconomies of scale Economies of Scale provide benefits and disadvantages for firms and consumers