Nov 25 2009
From short to long: Economies of scale and the long-run average total cost curve
Published by Jason Welker at 4:56 pm under
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WikipediaLook closely at the two cost curves below:
The curve on the left is a firm’s short-run average total cost curve. The one on the right represents a firm’s long-run average total cost curve. See the difference?
I didn’t think so. The shape of a typical firm’s short-run and long-run ATC curves may in fact be identical. But there are some very important differences to understand about the short-run costs and long-run costs faced by firms.
The Short-Run: In microeconomics, we define the short-run as the period of time over which a firm’s plant size is fixed. The only variable resource is labor and raw materials, meaning that when demand increases for a firm’s product, the firm is able to increase employee work hours, hire more workers and use existing capital more intensively, but it does not have the time to acquire new capital or expand factory size. Likewise, when demand falls for a firm’s products, it can cut back on work hours, fire workers, but cannot downsize its plants or factories.
The Long-Run: The long-run is defined as the variable-plant period. A firm can adjust the number of all its inputs: land, labor and capital. One way of thinking about the difference between the short-run and the long-run is imagining the long-run as several different short-runs spread out over a larger range of output. The graph below will illustrate this concept for you.
When we examine the long-run ATC more closely, it becomes apparent that there are in fact lots of little short-run ATC curves along the length of the long-run curve. Each of the gray lines in the graph above represent a short-run period in which this firm opened a new factories. There are three distinct phases of this firm’s long-run ATC:
- Economies of scale: As this firm first begins to grow and open new factories, it becomes better and better at what it is producing, is able to get more output per unit of input, and thus experiences lower and lower average total costs as it grows larger. “Scale” is a synonym for size. The bigger the firm’s size, the lower its costs of production: this is called “economies of scale”. My favorite illustration of the concept of economies of scale is to think about two shoe companies: Nike and Luigi’s Fine Italian Shoes. Nike makes shoes in giant factories in Indonesia, ships them in giant containers to all corners of the world in shipments containing 100,000 shoes each. Luigi makes shoes in his basement in Milan, has two employees, and ships shoes one at a time to customers around Europe. Who will have a lower average total cost of producing shoes? Luigi or Nike? Clearly, Nike has economies of scale, Luigi does not. If Luigi were to grow his business, chances are his average total costs would decline.
- Constant Returns to Scale: For the firm above, economies of scale assure that the larger it becomes, the lower its average total costs get. Efficiency in production improves whether through the lower price of inputs achieved through bulk-ordering, its ability to attract and hire skilled managers, the lower per unit cost of shipping larger quantities of products, or other such benefits of being big. At a certain point, however, the benefits of getting larger begin to diminish. This firm’s tenth factory is its minimum efficient scale: The level of total output this firm must achieve to minimize its long-run average total cost. Beyond this level of production, as this firm continues to grow, it will see no further cost benefits; in other words, it will achieve constant returns to scale (size).
- Diseconomies of scale: Why did the Mongol, the British and the Soviet empires collapse? Some historians argue it was because they became too big for their own good. When an organization (whether it’s a country or a firm) becomes TOO big, it begins to experience inefficiencies. When a firm grows so large that it has factories in all corners of the world, a dozen levels of management, and countless opportunities for corruption and miscommunication, its efficiency decreases and its average total costs begin to increase. In the 1980′s General Motor Company began to lose lots of business to smaller Japanese rivals. The outcome was the gigantic corporation broke up into smaller divisions, which then began to operate as different firms. For a while, GM remained competitive, partially because as a smaller firm, it was more efficient and able to compete on cost with its foreign rivals.
Diminishing Returns versus Economies of Scale: A common area of confusion for economics students is the difference between these two seemingly similar concepts. The difference lies in the two curves above, the short-run ATC and the long-run ATC.
- The shape of short run costs (MC, ATC and AVC) are determined by the law of diminishing returns. Since short-run costs are determined by the productivity of the variable resource in the short-run (labor), diminishing returns assures that at first, since a firm can expect to get MORE output for additional units of labor (as fixed capital is used more efficiently) ATC declines as output increases. But beyond a certain point, diminishing returns sets in and the additional output attributable to more units of the variable resource declines. Inevitably, a firm will experience higher and higher average costs as its output continues to grow, since it’s only able to vary the amount of labor used, not capital.
- The shape of long run ATC is determined by economies of scale (and diseconomies of scale). All resources are variable in the long-run, but lower costs cannot be guaranteed the larger a firm gets. At first, efficiency is improved as the firm grows, but at some point it becomes “too big for its own good” and costs start to rise as productivity of resources (land, labor and capital) is inhibited due to the firm’s massive size.
Discussion Questions:
- What does it mean that a firm can become “too big for its own good”? Can you think of any other organizations (economic or otherwise) that have gotten so big that they’ve failed?
- Why does your hometown have only one electricity company? Why aren’t utility industries such as water, natural gas, and garbage collection more competitive? How does the concept of economies of scale lead to certain industries being “natural monopolies”?
- Why don’t more companies make jumbo jets?
About the author: Jason Welker is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. In addition to maintaining numerous online resources for economics student and educators, Jason developed the online version of the IB Economics course for Virtual High School and is currently authoring a textbook for IB Economics students for Pearson Baccalaureate which will be available in Spring of 2011. His economics student wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards". Related posts:
- China’s automobile market – an example of Economies of Scale
- Diminishing returns and the short-run costs of production – “Econ Concepts in 60 Seconds”
- Lesson Plan: Costs of Production Presentation for Y1 IB Economics
- American auto makers insult the intelligence of high school Econ students!
- Monopoly prices – to regulate or not to regulate, that is the question!
Do you like what you read on this blog? The author is currently working on an Economics textbook that will be available to order in Spring 2011. For more information, click above.
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Submit your Econ questions here. Replies will be posted to the blog
1. A company becomes “too big for its own good” when it reaches a point that it it grows so large it becomes inefficient. This can happen because of many reasons. After a certain point, when the company is so large, they have too many factories or resources to take control of. With factories or production plants all around the world, there would have to be many levels of management, which as the post says, could lead to corruption and miscommunication. Also, the major problem with a firm becoming to large, is that the costs would be massive. In order to run a firm that is so large, there are millions and millions of dollars of costs. Higher wages, capital, and land are all parts of being a mega firm. The Roman Empire was an example of this. It was so large that it became too hard to control and protect, and eventually fell apart.
3.Why don’t more companies make jumbo jets?
It can be very difficult to start a large company like a jumbo jet producer. At low production, costs are very high, because there is a massive fixed cost (factories, techniques,etc.) The only way that some jumbo jet companies can make a profit is by ‘spreading the overhead’. When the firm splits the cost of the expensive equipment and techniques required to build jumbo jets among many planes, the Average Total Cost is much lower, and if the company sells them at a price higher than the ATC, they can make a profit. However, it is very hard to start up a company like this, especially when others already are in it, and willing to sell at a lower price and higher quality than a start-up jumbo jet company can.
Whenever i talk to my father or brother i find it intriguing that there are so many workers in their respective banks who bring in no income. I ask myself how there are so many positions that deal solely with administrative duties such as managers, human resources, I.t. However through understanding, LR-ATC i understand that these positions are necessary for economies of scale to occur. In order for each additional ATC curve to be more efficient and lower than the previous effective managers must be put in place so that the workers who bring in income are more efficient and the cost of each additional product is lower than before. However, a firm can get “to big for its own good” and the costs of its administrative workers will outweigh the benefit of having additional workers bringing in money. During the international banking crisis, Starbucks was experiencing diseconomies of scale and only realized it once it revenues decreased. Starbucks had to close down stores or face failing.
2.Why does your hometown have only one electricity company? Why aren’t utility industries such as water, natural gas, and garbage collection more competitive? How does the concept of economies of scale lead to certain industries being “natural monopolies”?
My hometown only has one electricity company, because it takes time to built a big company like electricity. Also everybody uses the other firm it needs time to spread that a new company is built. For example windows and mac. Windows is spread worldwide and windows almost bought every game for the computer. So for different games you need windows. So companys like mac maybe produce good software and computers, but all the games and softwares on the market work with windows, because they bought them. Those industries are a monopoly, so it has barriers to enter this market. It’s not easy to enter the market.
1. When a firm is so big that it cannot allocate its resources properly, it is not efficient anymore. For example, it has too many branches but no longer the means to sustain its facilities the firm’s Total costs start to increase.
To save the firm, they would have to close down some branches until the firm returns to ‘Constant returns to scale’.
1.What does it mean that a firm can become “too big for its own good”? Can you think of any other organizations (economic or otherwise) that have gotten so big that they’ve failed?
When a firm becomes “too big for its own good”, this means that it is entering diseconomies of scale. At a certain point, a firm will not be able to manage effectively, and as the firm gets bigger and bigger, it gets more and more difficult to effectively manage it, hence be competitive. With additional plants and factories, the firm will not get more productive; on the contrary, as management of the whole firm goes down, the average cost will rise. A good non-economic example of this is the Roman Empire. As the empire got bigger and bigger and bigger, it was becoming impossible to manage from Rome, and eventually the Empire split into two, the Occidental and Oriental Roman Empires. However, this system did not last very long, and eventually the Roman Empire was crushed.
What does it mean that a firm can become “too big for its own good”? Can you think of any other organizations (economic or otherwise) that have gotten so big that they’ve failed?
When a firm becomes too big for its own good, it means that the firm is experiencing diseconomies of scale – ATC is rising and workers in the newly opened plant, for example, are becoming less efficient. One of the possible causes for this might be the company’s inability to manage the firm in its allocation of resources – for example labor not utilizing capital efficiently. A real-life example would be Wal-Mart. About 1 or 2 years ago, Wal-Mart was about to face a disceconomy of scale as they were opening up new outlets. However, as far as I know, the executives at Wal-Mart came to realize that fairly quickly and decided to focus on their existing retail outlets and slow down with their global expansion of outlets.
[...] WW Blog – Economies of scale and the long-run ATC (Read and respond to the discussion questions as a table group) [...]
3. Jumbo Jets are not a competitive market, this is due to the fact that is takes a lot of time, money and capital to create them. Therefore there are only a few companies that make jumbo jets as they have the ability to produce and ship them for a lower price as they are ordering materials and shipping in bulk quantities. It would be very hard to create a company that makes jumbo-jets over night as it would be too costly and not very likely for the company to gain a large profit in such a short period of time, this is why there are only a few companies that specialize in making jumbo jets.
A company is defined as being “too big for its own good” when is becomes so big it is inefficient. Efficiency decreases and its average total costs begin to increase. This is caused by having too many management teams across the globe which can lead to miscommunication and corruption. Average total costs can increase when the company is forced to increase land, labor, and capital in order to produce the product throughout the world.
3. Why don’t more companies make jumbo jets?
The jumbo jet market is not characterized as a perfectly competitive market. This is important because this means that there are significant obstales preventing ‘just any’ firm from entering and exiting the industry. The short run costs would, in most cases in a jumbo jet market, overcome the profits and the firm would be forced to discontinue. Jumbo jets specifically have an naturally high total resource cost, meaning that without underlying advantages such as materials deals, entering the market would be an unwise economic decision for most entrepeneurs.
1. Why don’t more companies make jumbo jets?
- There are so few companies that make jumbo jets because there are significant barriers for entry into the aircraft market. Jumbo jets are incredibly expensive to design build and run, the amount of fuel that they use for one flight is around 10,000 pounds per hour so to start the company you will have to have a lot of money. Also since plane travel is considered a risky venture there is a certain amount of brand loyalty that controls the market.