Economies and Diseconomies of scale
In the Long Run like in Short Run average total cost (ATC) is U shaped, but why? We can’t explain this by law of diminishing returns, because only in short run plant’s capacity is fixed. In long run all resources are variable. Since prices of the resources are constant we can explain the form of the ATC in terms of economies and diseconomies of scale:
Economies of Scale or economies of production explain the down-sloping part of ATC curve. The following factors may lower ATC of production:
Large-scale production also means the better us and specialization of management. A manager that can supervise 50 people will be used inefficiently when the firm will employ only 20. Small plants won’t use managers to their best advantage, because they will have to divide time among more functions. Greater production means that manager will do his job full time so a higher efficiency will be achieved. This may result in lower product price.
Increased specialization of labor becomes more achievable when factor’s size is increased. Hiring more workers means that tasks can be divided and subdivided, so that each worker has its own function. In this case a worker will perform only one job instead of five. In a small firm some skilled machine operators won’t be used efficient since they will perform unskilled task, leading to higher production costs.
Workers by performing fewer tasks will become more proficient at them. Also greater labor specialization eliminates the time loss needed for them to switch their job.
Small businesses may not afford to buy the most efficient machineries. Some of these machineries are available only for mass-production, so a high efficiency is achieved only when there is used a big amount or resources. So a small firm is in dilemma between choosing to produce at inefficient equipment or at efficient one but with small amount of resources, but in both cases output is inefficient and too costly.
An example of factor that creates economies of scale is advertising. These costs for advertising are decreased as more units are sold. So if there is an increase in quantity of resources ex: 30% followed by a greater increase in quantity of output ex: 50% then this event declines ATC and may be a factor of economies of scale.
Diseconomies of Scale
While a firm is expanding, their ATC may increase, so the curve of it becomes up-sloping. The main factor of diseconomies of scale is the difficulty of controlling and operating a bigger firm. In small ones a single manager may make all decisions for plant’s operations.
But as the firm grows there is need for more managers. One person can’t digest and understand all the information needed for decision making. Expansion of management hierarchy leads to problems of communication and cooperation. So decision making may be slowed down so that they fail to respond immediately to change in consumer’s demand.
In massive production workers may feel free from their employers so that they care less about working efficiently. So if there is an increase in quantity of resources ex: 30% followed by a smaller increase in quantity of output ex: 20% then this event increases ATC and may be a factor of diseconomies of scale.
Constant Return Scale
In some industries a wider range of output may exist between the output at which economies of scale end and output at which diseconomies of scale begin. This range is called constant return scale and may exist over a wide part of long-run curve in which average total cost (ATC) doesn’t change. So if there is quantity Q input there will be also quantity Q output.