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Economies and diseconomies of scale

Economies of scale exist when long run average total cost decreases as output increases, diseconomies of scale occur when long run average total cost increases as output increases, and constant returns to scale occur when costs do not change as output increases.

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Video transcript

- [Lecturer] In the last video, we were able to construct here in red this long-run average total cost curve based on connecting the minimum points or the bottoms of the U's of our various short-run average total cost curves. Each of those short-run average total cost curves were based on a certain amount of fixed cost in the short run, but in the long run, you can change your fixed costs. And here are fixed costs with the number of trucks. And so, we can vary it to optimize for a certain amount of quantity. Now when we did that, you could see a little trend here especially as we go up to, the way I drew it, it wouldn't necessarily be up to 200 or whatever you're producing, but the way I drew it, you see that this part right over here, it looks like our long-run average total cost curve is declining down. So, one way to think about it is, we are getting more and more efficient at producing our tacos in the long run as we product more of them until we get to 200 tacos. And so, at this part of our curve, we are experiencing economies of scale. And we've talked about where economies of scale can come from. It can come from specialization of labor or even machines. Specialization. So, as you get more and more scale, you can have different parts of your process specializing in making the taco shells or grating the cheese or cooking the meat, whatever it is. So, there is a specialization. You could get better at sourcing. So, as you get more scale, you might be able to order more of your supplies at a time, so you get better deals. You might be able to even, who knows, at some point, start a farm yourself and then cut out the middleman, and so forth and so on. Now as we get past that point, we see that our long-run average total cost curve, at least in this example, started to trend up. And so, this part of the curve, you could say that we are experiencing diseconomies of scale. Diseconomies of scale. So, what would cause diseconomies of scale? Well, these would most typically happen because what are known as coordination issues. As an organization grows, you have more people, more resources that you have to coordinate. And so, that complexity can sometimes make an organization more inefficient. There's other diseconomies of scale. At some very large scale, you might be depleting all of the low-hanging fruit of your inputs, and so, you have to pay more for some of your inputs. Maybe you've already depleted the people who are willing to work for less, so you have to raise wages, or you've depleted a lot of the resources you need, so you have to find new, more expensive resources. Now in this curve, it's not as obvious, but you can also have a notion of constant returns to scale. So, if we had a long-run average total cost curve that looked something like this, let me draw it over here, then in this section right over here, as the average total cost, the long-run average total cost is going down, that would be economies of scale. This section over here, as the long-run average total cost is going up, that would be our diseconomies of scale. But this section over here where it is constant, you might guess what that is called. That is called constant economies of scale or constant returns to scale, sometimes known as efficient scale.