Updated Jun 26, 2020 In economic theory, production decisions are determined mainly by returns to scale and the development of per-unit costs. That means firms set the level of output based on how the profitability changes as they increase or decrease production. In that context, we can distinguish between (1) economies of scale, (2) diseconomies of scale, and (3) constant returns to scale. Economies of scale occur when the long-run average cost falls as the quantity of output increases. That means larger quantities can be produced at a lower average unit cost than smaller quantities. In that case, producers have an incentive to increase the level of production to improve profitability. Economies of scale often occur because higher levels of production enable specialization of workers and equipment, which increases productivity (see also internal economies of scale). In addition to that, several external economies of scale exist that can also boost a firm’s productivity as the level of output increases. To give an example, let’s compare two imaginary retail companies. One of them is a large corporation called Malwart, and the other one is a small local store called Bob’s Sporting Goods. Bob manages his inventory and distribution manually and by himself. Meanwhile, Malwart manages its distribution with a sophisticated software program developed specifically for them. Not surprisingly, Malwart’s inventory and distribution management is much more efficient and productive than Bob’s. However, it’s not feasible for Bob to invest in similar software, because his company is simply too small and he cannot afford to spend that much money. Diseconomies of scale occur when the long-run average cost falls as the quantity of output increases. That means smaller quantities can be produced at a lower average unit cost than larger quantities. In this case, producers are incentivized to reduce the level of production to become more profitable. Diseconomies of scale usually arise because of coordination issues, which become more significant as organizations grow. To illustrate this, let’s revisit Malwart and Bob’s Sporting Goods. Assume that Malwart decides to expand its operations beyond the US border and open several stores in Mexico. This adds a significant amount of logistic and regulatory complexity to their business because they need to print additional marketing material in Spanish, ship products across the border, hire additional lawyers to deal with Mexican regulations, etc. This added complexity results in extra costs, which in turn drive up the average unit cost. Meanwhile, Bob doesn’t have to worry about all these foreign laws and regulations because his company is too small to expand across the border. Constant returns to scale arise when the long-run average cost does not change as the output increases or decreases. That means the average unit cost doesn’t depend on the quantity produced. In that case, producers cannot increase their profitability by changing the production output. Constant returns to scale usually occur over a limited range of production, where production is already specialized but not quite large enough to suffer from coordination problems. For example, assume Malwart decides not to expand across the border, but to open up a few more stores within the United States instead. By doing so, they can profit from many of the specializations already in place (e.g., the custom inventory management software) but, at the same time, add some organizational complexity. If these positive and negative effects cancel each other out, the profitability doesn’t change as the company expands. In economic theory, production decisions are determined mainly by returns to scale and the development of per-unit costs. In that context, we can distinguish between (1) economies of scale, (2) diseconomies of scale, and (3) constant returns to scale. Economies of scale occur when the long-run average cost falls as the quantity of output increases. Diseconomies of scale occur when the long-run average cost decreases as the quantity of output increases. And finally, constant returns to scale arise when the long-run average cost does not change as the output changes.1. Economies of Scale
2. Diseconomies of Scale
3. Constant Returns to Scale
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Microeconomics