Economies and Diseconomies of Scale | CFA Level I Economics
Welcome back! In this quick lesson, we’ll proceed to economies and diseconomies of scale and how they affect your business decisions in the long run. Let’s jump right in!
Understanding Economies of Scale
In the short run, your cafe’s average total cost may be constrained due to factors like limited space and equipment. However, as you open more cafes in the long run, the average costs can decrease as production increases. This effect is called economies of scale.
Economies of scale occur when the cost per unit of production falls as the firm increases its scale. They generally result from factors such as:
- Labor specialization
- Mass production
- Investment in more efficient equipment and technology
- Increased bargaining power with suppliers
As long as there are economies of scale, expanding your business can improve its competitiveness and profitability.
Constant Returns to Scale and Diseconomies of Scale
At some point, economies of scale hit a limit. This can result in:
- Constant returns to scale: Scaling up does not result in any economies of scale
- Diseconomies of scale: Scaling up further increases average costs
Diseconomies of scale can be due to:
- Inefficiencies from larger firms’ bureaucracy
- Challenges in motivating a larger workforce
- Barriers to innovation and entrepreneurial activity
Long Run Average Total Cost (LRATC) and Minimum Efficient Scale
Connecting the minimums of the short run average total cost (ATC) curves results in the long run ATC (LRATC) curve. The lowest point on the LRATC is the minimum efficient scale, where the average total cost of production is minimized.
If your cafe experiences diseconomies of scale, you’ll want to scale down to the minimum efficient scale to reduce costs and compete more effectively. Under perfect competition, firms must operate at the minimum efficient scale in the long run.
Operating at a different scale in the long run means your costs will be higher than the competition, and the market price won’t cover your costs.
And that’s a wrap on economies and diseconomies of scale! We’ve covered how scaling up or down can impact your business decisions and competitiveness