Chapter 17 ：

Types of cost, revenue and

profit, short-run and long-
run production
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Lesson Contents

Contents

Short-run production and

01 cost function

Long-run production
02 and cost function

03 Economies of scale and

average costs

04 Calculation of
revenue and profits
 3. Economies of scale and average costs

SmartStudy
Syllabus 06

7.5.5 relationship between economies of scale and decreasing average

cost

A.
B.
C.
7.5.6 internal and external economies of scale
7.5.7 internal and external diseconomies of scale
Economies of scale

The shape of the LRAC

is also used to explain
economies of scale. A firm
experiences economies of
scale if costs per unit of
output fall as the scale of
production increases.

This is shown by the

downward sloping
section of the LRAC curve.
Economies of scale

A firm gets increasing

returns (IRS) from using its
factors of production, then it
can produce more
goods with smaller quantities
of the factors of production.
This means
the firm is producing at a
lower average cost.

Specialisation and the

division of labour are an
obvious source of economies
of scale.
Diseconomies of scale

The shape of the LRAC slopes

upwards after the minimum
point(MES).

The reason for this is that

beyond a certain size, a firm’s
costs per unit of
output may increase as the
scale of output continues to
increase.

This situation is one of

diseconomies of scale.

The concept of decreasing

returns (DRS) to scale implies
the situation above.
(Internal)Economies of scale

• Recall the notion of the division of labour. When a firm expands, it reaches a certain
scale of production at which it becomes worthwhile to take advantage of division of labour.

Workers begin to specialise in certain stages of the production process, and their productivity increases ---- this is
when the economies of scale start to play a role.

• Internal economies of scale: economies of scale that arise from the (internal)expansion of a firm.

• Although the division of labour is one source of economies of scale, it is by no means the only
source, and there are several explanations of cost benefits from producing on a large scale.

• Some of these are industry-specific, and thus some sectors of the economy exhibit more
significant economies of scale than others – it is in these activities that the larger firms tend to be found.
For example, there are no hairdressing salons that come into the top ten largest firms, but there are plenty of oil
companies.
Reasons for (Internal)Economies of scale

Technical economies:
refer to the advantages gained directly in the production process through more efficient production methods.

• One source of technical economies of scale arises from the physical properties of the universe:
There is a physical relationship between the surface area of an object and the volume of material that it can
enclose.
e.g. a large ship can transport proportionally more than a small ship, and large storage tanks hold more liquid
relative to the surface area of the tank than small tanks.

• Furthermore, some capital equipment is designed for large-scale production, and would only be
viable for a firm operating at a high volume of production.
e.g. Agricultural machinery designed for large plantations cannot be used in small fields; a production line for
car production would not be viable for small levels of output.

• There are many economic activities in which there are high overhead expenditures. Such
components of a firm’s costs do not vary directly with the scale of production, the technical economies of
scale will be significant for such an industry with high overhead expenditures.
Reasons for (Internal)Economies of scale

Marketing economies:
Firms need to reach their intended customers, however, the average spend on marketing for
a large firm is likely to be less per unit sold than for a small firm.

• Large-scale firms are able to promote their products and pay lower rates for advertising on
television, in newspapers and on social media because they are able to purchase large amounts of air time and
space.

• This broad type of economies of scale includes

1. savings in logistics costs (the cost of moving goods from where they are produced to where they are finally
sold).
2. Transport and warehousing costs can be reduced where customers require these services on a large scale.

• large-scale firms can make savings through their IT systems:

1. search engines and corporate websites where customers can buy a wide range of items such as insurance,
hotel accommodation and airline tickets.
2. The cost savings through efficient IT systems also contributes to the success of huge on-line retailers such
as Alibaba and Amazon.
Reasons for (Internal)Economies of scale

Management economies:
In large-scale firms, managerial economies come about as a result of specialisation.

• As the firm expands, there is a range of volumes of output over which the management team
does not need to grow as rapidly as the overall volume of the firm, as a large firm can be managed more
efficiently.

• At some point, the organisation begins to get so large and complex that management finds
it more difficult to manage. At this point diseconomies of scale are likely to cut in – in other words, average
costs may begin to rise with an increase in output at some volume of production.

• As a firm expands, it may be able to employ specialist staff to handle these functions, and may
not need to expand those sections of the company proportionately with the growth of the business. Again, this
may lead to economies of scale.

• A firm operating on a small scale may need to buy in the expertise that it needs – for example, to
audit its accounts or advise on employment law.
Reasons for (Internal)Economies of scale

Finance economies:
Large-scale firms usually have better and cheaper access to borrowed funds than smaller firms. This is because
the perceived risk to the lender is lower.

• Also a large firm with a strong reputation may be able to raise finance for further expansion on
more favourable terms than a small firm.

• In other words, a large firm may be able to persuade a bank to advance the firm loans at lower
rates of interest than a small firm, where the risks may be seen to be greater.

• Moreover, such firms tend to have more valuable assets to offer as collateral.

• Banks often charge large borrowers less interests in order to attract them and because they
know that the administrative costs of operating and processing large loans are not significantly higher han the
costs of dealing with small loans.

• Large firms can also raise finance through selling shares, which is not available for sole traders
and partnerships. Public limited companies can sell to the general public.
Reasons for (Internal)Economies of scale

Purchasing economies:
As firms increase in scale, they increase their purchasing power with suppliers.

• Through bulk buying, they are able to purchase supplies more cheaply, so reducing average
costs. In particular, this relates to raw materials, energy and transport services. When buying in bulk in this
way, firms may be able to negotiate good deals with their suppliers, and thus again reduce average cost as
output increases.

One of the best examples of this is the US retail giant Walmart, which uses its huge purchasing power to buy
goods for its stores at the lowest prices. All major retailers behave in this
way.

• Purchasing economies can also be made where a retailer reduces the number of items it sells.
This allows the firm to concentrate on selling a more limited range of goods which can be bought in bulk at
discounted prices.

• It may even be the case that some of the firm’s suppliers will find it beneficial to locate in
proximity to the firm’s factory, which would reduce costs even more.
External Economies of scale

• If the firm is in an
industry that is itself
expanding, there may also be
external economies of
scale. Firms may benefit
from the fact that they
operate in an industry that is
expanding.

External economies of scale

may be one reason for the
trend towards the
concentration of rival firms
in the same geographical
area.

external economies of scale can reduce long_x0002_run average costs

for all firms in an industry.
 External Economies of scale

Reasons for external economies of scale:

1. Concentration:
• One example of an external economy of scale is where a firm is located close to other firms in
the same industry or related activities. Such geographical concentration can mean that transport and communication
links will be developed, so all firms will benefit.
• For example, if several mining companies set up in a region, the government could decide that it
is important to provide a railway link, which would then reduce transport costs for all of the companies.

2. Technology and skills:

• Some of the most successful firms of recent years have been in activities that require high levels of
technology and skills. As the sector expands, a pool of skilled labour is built up that all the firms can draw on. The
very success of the sector encourages people to acquire the skills needed to enter it, colleges may begin to find it
viable to provide courses, and so on.
• Each individual firm benefits in this way from the overall expansion of the sector. The greater
availability of skilled workers reduces the amount that individual firms need to spend on training.
Diseconomies of scale

occur for a firm when an increase in the scale of production leads to higher long-run average costs.

• Internal diseconomies of scale:

1. comminication: one issue that arises as a firm expands is that it becomes more difficult to
communicate across the organisation. This is especially the case if the firm has to operate across a range of
different locations.

This makes the organisation more difficult to manage, if the central managers cannot readily communicate their
needs and intentions to the workforce.

2. Coordination: Similarly, coordinating activity across a large firm becomes more costly and less
efficient. Coordinating in order to establish an efficient supply chain becomes more and more difficult as the firm
expands. Indeed, it is possible that some multinational corporations have divided their production activities across
a number of countries in order to take advantage of local conditions or resources in different locations.

for example, suppose that a manufacturing firm has separate factories producing components of a good, which
then need to be assembled somewhere else.
Diseconomies of scale

occur for a firm when an increase in the scale of production leads to higher long-run average costs.

• Internal diseconomies of scale:

3. Motivation: When a firm becomes large, it comes to rely on managers to oversee everyday production activities
and take day-to-day decisions. The firm’s owners may find it difficult to motivate these managers to run the firm
in the way that they want.

Also, workers may feel a lack of motivation due to the repetitive nature of the work they are carrying out. Workers
might also feel that they are just a small insignificant part of a big organisation where senior managers do not
appear to have a duty of care to employees. Although not particularly visible, these are underlying reasons for an
increase in costs as the firm expands its scale of operations.

• External diseconomies of scale:

1. Pollution: If several firms choose to locate in a region, the result may be an increase in pollution in the area.
Firms may then face higher pollution taxes or higher costs to reduce pollution levels.
Diseconomies of scale

occur for a firm when an increase in the scale of production leads to higher long-run average costs.

• External diseconomies of scale:

2. Infrastructure: If a number of firms choose to locate in an area, this can cause congestion on transport and
communication links, which can raise costs. For example, if there is growing pressure
on road and rail links that the government does not tackle, firms either face higher costs or find that they need to
invest in upgrading the transport network.

3. Over-extraction of minerals: In the case of mining companies that operate in a region, there may be pressure
arising from over-extraction of minerals. With many firms operating, it is likely that the costs of mining will rise
because the most accessible reserves are exhausted, and the difficulty of reaching the remaining stocks increases.

4. Input prices: The growth of firms in an area may put pressure on wages. Firms may find that in
order to recruit the workers that they need, they need to pay higher wages or offer non-pecuniary benefits or
assistance with housing costs.
Possible shapes of LARC curve

Typical U-shape of long run average cost curve that we have discussed in part A
Possible shapes of LARC curve

• LAC2 shows an
example of a situation in
which there are economies of
scale up to a point, after
which long_x0002_run
average cost levels out and
there is a long flat range over
which the firm faces constant
returns to scale, with costs
increasing at the same rate as
output.
Possible shapes of LARC curve

• LAC3 is a bit similar,

except that the constant
returns to scale (flat)
segment eventually runs out
and diseconomies of scale set
in.
Possible shapes of LARC curve

• In LAC4 the economies

of scale continue over the
whole range of output shown.
This could occur in a market
where the fixed costs are
substantial, dominating the
influence of variable costs.
Significance of economies of scale

• The extent of economies of scale in an industry and the level of output at which diseconomies
set in is significant because it affects the operation of markets.

• In particular, the existence of economies of scale affects the ability of a firm to compete with
other firms – and ultimately the extent of economies (or diseconomies) of scale has a major impact on the
structure of the market and the number of firms that will be viable.

• As we will see later, when diseconomies of scale set in at a low level of output relative to the
size of market demand, there is likely to be scope for firms to enter the market quite readily (ceteris
paribus).

• However, if there are substantial economies of scale, it becomes more likely that the market
will be dominated by a relatively small number of firms.
 4. Calculation of revenue and profits

SmartStudy
Syllabus 06

7.5.8 definition and calculation of revenue: total, average and marginal

revenue
(TR, AR, MR)

A.
B.
C.
D. 7.5.9 definition of normal, subnormal and supernormal profit
7.5.10 calculation of supernormal and subnormal profit
Firm’s revenue

• Revenue is the payment firms receive when they sell the goods and services that they have
produced.
• Revenue is sometimes referred to as sales.
• Revenue is usually expressed over a time period such as a month or year.

Three important concepts:

1. total revenue = price × quantity sold

2. average revenue = total revenue/quantity sold

3. marginal revenue = change in revenue/change in quantity sold

Competitive market

In analysing a firm’s revenue, it is important to

know the type of market in which the firm is
operating.
• In a fully competitive market the firm
has no control over the price of its goods. The
firm is a price taker, in a sense that the firm’s
demand curve will be horizontal and its revenue
will depend entirely on the amount of goods
sold.

• Demand curve is mathemetically a

function taking form as P(Q), in this market, it
is just a constant:
Competitive market

• The market demand curve however,

takes the usual form by summing up all the
individual firm’s demand curves.
Other types of markets

The firm will face a downward sloping demand curve. The firm is a price maker:

1. If the firm chooses to increase output, price will fall; if it decides to reduce output, price is
expected to increase. As output changes so does price and revenue.

2. The extent of the change in revenue will depend on the price elasticity of demand.

3. Proved already, The firm’s demand curve is its average revenue curve.

Marginal revenue will always be below average revenue since the firmcan only sell more goods by reducing
price: when average revenue (price) falls, marginal revenue also falls, as the revenue received on the last unit is
now lower. However, because all customers also
experience a fall in the price, marginal revenue must fall more rapidly than average revenue(2 times).

Mathematically,
Other types of markets

• This Figure reminds you of the

relationship between total revenue and the price
elasticity of demand (PED). The marginal
revenue (MR) curve has also been added to the
figure, and has a fixed relationship with the
average revenue (AR) curve.

• Recall that PED changes along the

demand curve, so continuing reducing price
will eventually lead to negative marginal
revenue and falling total revenue.

• MR shares the intercept point on the

vertical axis and has exactly twice the slope of
AR.
Profit and loss

• Economists define profit as the difference between the total revenue received by a firm and
the total costs that it incurs in production:

profits = total revenue − total cost = TR - TC

• However, The economist’s view is rather wider than the view of an accountant since the
accountant’s approach does not fully recognise the full private costs of economic activity.

The total (private) cost for an entrepreneur should consist of:

1. money paid out to factors of production(explicit).

2. an allowance for anything owned by the entrepreneur and used in the production process,
such as any loans, that may have been made available to the business.

3. Theconcept of opportunity cost is relevant. The entrepreneur may have capital that could have been used
elsewhere at no risk and this would have earned an income. So, this cost needs to be taken into
account(implicit).
Normal, abnormal and subnormal profits

• An entrepreneur, therefore, will expect a minimum level of profit to reflect what could have
been earned elsewhere with the resources that are available. In economics, this is known as normal profit:
entrepreneur’s reward as a cost of production because without it, nothing would be produced by the firm.

• Crucially, normal profit is included in the total costs of a firm:

Profit = Total revenue – total costs, including normal profits

If the total revenue equals total cost, the economist sees the firm as making normal profit,
as it is covering the opportunity cost of production.

• Any profit over and above normal profit is known as supernormal(abnormal) profit:
Supernormal profit = Total profit – normal profit
Where supernormal profits are being earned this is a signal for more firms to enter a market.

• Subnormal profit is when the profit that is earned by a firm is less than normal profit. Its
significance is that if a firm is making subnormal profit then it may decide to withdraw from a
market in the long run.
Profit maximising

• Traditional economic analysis has tended to start from the premise that firms set out with
the objective of maximising profits.

An application of the marginal principle shows how:

1. Suppose a firm realises that its marginal revenue is higher than its marginal cost of production. What
does this mean for profits? If it were to sell an additional unit of its output, it would
gain more in revenue than it would incur additional cost, so its profits would increase.

2. Similarly, if it found that its marginal revenue was less than marginal cost, it would be
making a loss on the marginal unit of output, and profits would increase if the firm sold
less.

3. This leads to the conclusion that profits will be maximised at the level of output at
which marginal revenue (MR) is equal to marginal cost (MC). Indeed, this MR = MC rule is a
general rule that tells a firm how to maximise profits in any market situation.
KEY TERMS
firm (business): an organisation that produces output (a good or service)

short run: the period in which at least one factor of production is in fixed supply

production function: a relationship that embodies information about technically efficient ways of combining
labour and other factors of production to produce output

law of diminishing returns: a law stating that if a firm increases its inputs of one factor of production while
holding inputs of other factors fixed, eventually the firm will get diminishing marginal returns from the variable
factor

total cost: the sum of all costs that are incurred in producing a given level of output (including opportunity cost)

average total cost: total cost divided by the quantity produced; sometimes known as unit cost
KEY TERMS
marginal cost: the cost of producing an additional unit of output

sunk costs: costs incurred by a firm that cannot be recovered if the firm ceases trading

fixed costs: costs that do not vary with the level of output in the short run

variable costs: costs that do vary with the level of output

long run: the period over which the firm is able to vary the inputs of all its factors of production

increasing returns to scale: when a percentage increase in inputs results in a larger percentage

increase in output

decreasing returns to scale: when a percentage increase in inputs results in a smaller percentage

increase in output
KEY TERMS
constant returns to scale: when a percentage increase in inputs results in the same percentage

increase in output

economies of scale: occur for a firm when an increase in the scale of production leads to

production at lower long-run average cost

internal economies of scale: economies of scale that arise from the expansion of a firm

external economies of scale: economies of scale that arise from the expansion of the industry in which a firm is
operating

diseconomies of scale: occur for a firm when an increase in the scale of production leads to higher long-run
average costs
KEY TERMS
minimum efficient scale: the level of output at which long_x0002_run average cost stops falling as output

increases

total revenue: the revenue received by a firm from its sales of a good or service; it is the quantity sold, multiplied
by the price

average revenue: the average revenue received by the firm per unit of output; it is total revenue divided by the
quantity sold

marginal revenue: the additional revenue received by the firm if it sells an additional unit of output

normal profit: the return needed for a firm to stay in a market in the long run

supernormal, abnormal or economic profits: profits above normal profits

subnormal profits: profits less than normal profits

 THANK YOU
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