Economies of Scale
Earlier in this module we saw that in the short run when a firm increases its scale of
operation (or its level of output), its average cost of production can decrease or
increase. This is illustrated in Figure 1.
Figure 1. Short Run Average Costs. The normal shape for a short-run average cost curve is U-shaped with
decreasing average costs at low levels of output and increasing average costs at high levels of output.
What happens to a firm’s average costs when it increases its level of output in the long
run? Many industries experience economies of scale. Economies of scale refers to the
situation where, as the quantity of output goes up, the cost per unit goes down. This is
the idea behind “warehouse stores” like Costco or Walmart. In everyday language: a
larger factory can produce at a lower average cost than a smaller factory. Figure 2
illustrates the idea of economies of scale, showing the average cost of producing an
alarm clock falling as the quantity of output rises. For a small-sized factory like S, with
an output level of 1,000, the average cost of production is $12 per alarm clock. For a
medium-sized factory like M, with an output level of 2,000, the average cost of
production falls to $8 per alarm clock. For a large factory like L, with an output of 5,000,
the average cost of production declines still further to $4 per alarm clock.
Figure 2. Economies of Scale A small factory like S produces 1,000 alarm clocks at an average cost of $12
per clock. A medium factory like M produces 2,000 alarm clocks at a cost of $8 per clock. A large factory like L
produces 5,000 alarm clocks at a cost of $4 per clock. Economies of scale exist because the larger scale of
production leads to lower average costs.
The average cost curve in Figure 2 may appear similar to the average cost curve in
Figure 1, although it is downward-sloping rather than U-shaped. But there is one major
difference. The economies of scale curve is a long-run average cost curve, because it
allows all factors of production to change. Short-run average cost curves assume the
existence of fixed costs, and only variable costs were allowed to change. In sum,
economies of scale refers to a situation where long run average cost decreases as the
firm’s output increases.
One prominent example of economies of scale occurs in the chemical industry.
Chemical plants have a lot of pipes. The cost of the materials for producing a pipe is
related to the circumference of the pipe and its length. However, the volume of
chemicals that can flow through a pipe is determined by the cross-section area of the
pipe. The calculations in Table 1 show that a pipe which uses twice as much material to
make (as shown by the circumference of the pipe doubling) can actually carry four times
the volume of chemicals because the cross-section area of the pipe rises by a factor of
four (as shown in the Area column).
Table 1. Comparing Pipes: Economies of Scale in the Chemical
Industry
Circumference (2πr) Area (πr2)
4-inch pipe 12.5 inches 12.5 square inches
8-inch pipe 25.1 inches 50.2 square inches
Table 1. Comparing Pipes: Economies of Scale in the Chemical
Industry
Circumference (2πr) Area (πr2)
16-inch pipe 50.2 inches 201.1 square inches
A doubling of the cost of producing the pipe allows the chemical firm to process four
times as much material. This pattern is a major reason for economies of scale in
chemical production, which uses a large quantity of pipes. Of course, economies of
scale in a chemical plant are more complex than this simple calculation suggests. But
the chemical engineers who design these plants have long used what they call the “six-
tenths rule,” a rule of thumb which holds that increasing the quantity produced in a
chemical plant by a certain percentage will increase total cost by only six-tenths as
much.
Shapes of Long-Run Average Cost Curves
While in the short run firms are limited to operating on a single average cost curve
(corresponding to the level of fixed costs they have chosen), in the long run when all
costs are variable, they can choose to operate on any average cost curve. Thus,
the long-run average cost (LRAC) curve is actually based on a group of short-run
average cost (SRAC) curves, each of which represents one specific level of fixed
costs. More precisely, the long-run average cost curve will be the least expensive
average cost curve for any level of output. Figure 3 shows how the long-run average
cost curve is built from a group of short-run average cost curves.
Five short-run-average cost curves appear on the diagram. Each SRAC curve
represents a different level of fixed costs. For example, you can imagine SRAC 1 as a
small factory, SRAC2 as a medium factory, SRAC3 as a large factory, and SRAC4 and
SRAC5 as very large and ultra-large. Although this diagram shows only five SRAC
curves, presumably there are an infinite number of other SRAC curves between the
ones that we show. Think of this family of short-run average cost curves as representing
different choices for a firm that is planning its level of investment in fixed cost physical
capital—knowing that different choices about capital investment in the present will
cause it to end up with different short-run average cost curves in the future.
Figure 3. From Short-Run Average Cost Curves to Long-Run Average Cost Curves The five different
short-run average cost (SRAC) curves each represents a different level of fixed costs, from the low level of
fixed costs at SRAC1 to the high level of fixed costs at SRAC 5. Other SRAC curves, not shown in the diagram,
lie between the ones that are shown here. The long-run average cost (LRAC) curve shows the lowest cost for
producing each quantity of output when fixed costs can vary, and so it is formed by the bottom edge of the
family of SRAC curves. If a firm wished to produce quantity Q 3, it would choose the fixed costs associated with
SRAC3.
The long-run average cost curve shows the cost of producing each quantity in the long
run, when the firm can choose its level of fixed costs and thus choose which short-run
average costs it desires. If the firm plans to produce in the long run at an output of Q 3, it
should make the set of investments that will lead it to locate on SRAC 3, which allows
producing q3 at the lowest cost. A firm that intends to produce Q3 would be foolish to
choose the level of fixed costs at SRAC2 or SRAC4. At SRAC2 the level of fixed costs is
too low for producing Q3 at lowest possible cost, and producing q3 would require adding
a very high level of variable costs and make the average cost very high. At SRAC 4, the
level of fixed costs is too high for producing q 3 at lowest possible cost, and again
average costs would be very high as a result.
The shape of the long-run cost curve, in Figure 3, is fairly common for many industries.
The left-hand portion of the long-run average cost curve, where it is downward- sloping
from output levels Q1 to Q2 to Q3, illustrates the case of economies of scale. In this
portion of the long-run average cost curve, larger scale leads to lower average costs.
We illustrated this pattern earlier in Figure 2.
In the middle portion of the long-run average cost curve, the flat portion of the curve
around Q3, economies of scale have been exhausted. In this situation, allowing all
inputs to expand does not much change the average cost of production. We call
this constant returns to scale. In this LRAC curve range, the average cost of
production does not change much as scale rises or falls.
