No Such Thing as a Free Lunch: Principles of Economics (Part 43)

"We have always known that heedless self-interest was bad morals; we know now that it is bad economics"

Franklin D. Roosevelt

Long-Run Cost and Output Decisions (Part E)

by

Charles Lamson 

Constant Returns to Scale

Technically, the term constant returns means that the quantitative relationship between input and output stays constant, or the same, when output is increased. If a firm doubles inputs, it doubles output; if it triples inputs, it triples output; and so forth. Furthermore, if input prices are fixed, constant returns imply that average cost of production does not change with scale. In other words, constant returns to scale mean that the firm's long-run average cost (LRAC) curve remains flat.

The firm in Figure 5 exhibits roughly constant returns to scale between scale 2 and scale 3. The average cost of production is about the same in each. If the firm exhibited constant returns at levels above 150,000 units of output, the LRAC would continue as a flat, straight line.

Economists have studied cost data extensively over the years to estimate the extent to which economies of scale exist. Evidence suggests that in most industries firms do not have to be gigantic to realize cost savings from scale economies. For example, automobile production is accomplished in thousands of separate assembly operations, each with its own economies of scale. Perhaps the best example of efficient production on a small scale is the manufacturing sector in Taiwan. Taiwan has enjoyed very rapid growth based on manufacturing firms that employ fewer than 100 workers.

One simple argument supports the empirical result that most industries seem to exhibit constant returns to scale (a flat LRAC) after some level of output. Competition always pushes firms to adopt the least-cost technology and scale. If cost advantages result with larger scale operations, the firms that shift to that scale will drive the smaller, less-efficient firms out of business. A firm that wants to grow when it has reached its "optimal" size can do so by another identical plant. It thus seems logical to conclude that most firms face constant returns to scale as long as they can replicate their existing plants. Thus, when you look at the developed industries, you can expect to see firms of different sizes operating with similar costs. These firms produce using roughly the same scale of plant, but larger firms simply have more plants.

Decreasing Returns to Scale 

When average cost increases with scale of production, a firm faces decreasing returns to scale or diseconomies of scale. The most often cited example of a diseconomy of scale is bureaucratic inefficiency. As size increases beyond a certain point, operations tend to become more difficult to manage. You can easily imagine what happens when a firm goes top-heavy with managers who have accumulated seniority and high salaries. The coordination function is more complex for larger firms than for smaller ones, and the chances that it will break down are greater.

A large firm is also more likely than a small firm to find itself facing problems with organized labor. Unions can demand higher wages and more benefits, go on strike, force firms to incur legal expenses, and take other actions that increase production costs. (This does not mean that unions are "bad," but instead that their activities often increase costs.)

Figure 6 describes a firm that exhibits both economies of scale and diseconomies of scale. Average costs decrease with scale of plant up to q* and increase with scale after that. This long-run average cost curve looks very much like the short-run average cost curves we have examined in the last several posts, but do not confuse the two:

Thus, the same firm can face diminishing returns---a short-run concept---and still have a long-run cost curve that exhibits economies of scale.

The shape of a firm's long-run average cost curve depends on how costs react to changes in the scale. Some firms do see economies of scale, and their long-run average cost curves slope downward. Most firms seem to have flat long-run average cost curves. Still others encounter diseconomies, and their long-run average costs slope upward.

It is important to most to note that economic efficiency requires taking advantage of economies of scale (if they exist) and avoiding diseconomies of scale. The optimal scale of plant is the one that minimizes average cost. In fact, as we will see in the next post, competition forces firms to use the optimal scale.

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 184-185* 

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