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