Production in the shortrun

If we assume that a firm only uses capital (which is fixed) and labour (which is variable), what will happen to output as we employ more and more workers? If a factory is designed for 1000 people its unlikely to have a high output if there is only one worker. As workers are added it is likely that the marginal output will increase as specialization occurs. There will come a point when output per worker will fall, e.g., if there are 5000 workers in a factory designed for 1000 they will get in each other's way. If the extra worker adds less to total output than the worker before him, we say diminishing marginal returns is occurring.

Production in the longrun

The law of diminishing marginal returns assumes the firm is operating in the shortrun (as capital is fixed). As we know in the longrun firms are able to vary all of their factors of production, what will happen to output as inputs are increased in the longrun?

Firms are able to grow in one of two ways:

• Internal growth: this occurs when a firm expands its own sales and output.  To do this firms must employ more factors of production (CELL).
• External growth: this occurs via mergers and takeovers

As firms grow we have found that their average cost of production per unit can fall, we call this economies of scale.

Internal economies of scale occur because of the increase in output by the firm:

• Technical economies - large firms are able to buy equipment that wouldn't be economical for small firms to purchase, as it would lie idle for a majority of the time.

e.g., Tesco are able to afford electrical point of sale (EPOS) equipment that wouldn’t be economical for a corner shop o buy.

• Managerial economies - Larger firms have greater scope for the specialisation of labour, employing specialist workers to perform a relatively narrow task.

e.g., large schools can employ specialist biology, chemistry and physics teachers, while a small school has to employ a general science teacher.

• Increasing dimensions - doubling the height and width of a building or ship etc. will lead the volume to increase by around threefold. This means the bigger the building or ship the lower the average cost will be.

• Marketing economies - as a firm grows the average cost of advertising per unit will fall, leading to lower average costs.

e.g., small firms are unable to afford large scale advertising campaigns, while their larger competitors are able to  finance television and radio campaigns.

• Purchasing economies - buying in bulk means that you will normally receive a discount from the supplier.

e.g., these are similar to when you go into a supermarket and are able to buy individual items cheaper in a multipack.

• Financial economies - larger firms are deemed to be more credit worthy, therefore they have a better chance of being lent money and they are given a lower rate of interest on loans

e.g., Sainsbury’s are more likely to be able to pay back a loan than a small cornershop so a bank will charge them a lower rate of interest to reflect this.  If the bank refuse Sainsbury’s the loan its more than likely they will take their business elsewhere, whilst the cornershop will have fewer banks willing to take on their risky business.

External economies of scale arise due to factors that the firm is unable to control:

• Growth of industry - if many firms are located in close proximity, better roads will be built that will reduce costs. Other firms will train workers that can be poached, thereby reducing expenditure.
• Lowering taxation - a decrease in national insurance contributions for example would lower a firm's costs.
• Technology - the introduction of a more efficient technology would lower the costs for the firm.

Some firms become too large and they reach a point where the average cost per unit begins to increase, which is called diseconomies of scale and occurs because of:

·        X-inefficiency - managing a large organisation with many workers spread over a large area can be very difficult, due to problems in control, co-ordination, motivation, communication and co-operation.

The point where costs of production are at their lowest is called the minimum efficient scale (MES), this is shown on the diagram. Also shown is the relationship between the SRAC and LRAC. The LRAC is known as an envelope for all of the SRAC.

It's possible for the MES to occur over a range of outputs for the firm, this is shown on the diagram below.