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Economies of Scale

Economies of Scale

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Published by Azeem Asim Mughal

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Published by: Azeem Asim Mughal on Nov 17, 2009
Copyright:Attribution Non-commercial

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11/19/2009

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ECONOMIES OF SCALECOST ADVANTAGES THAT A BUSINESS OBTAINS DUE TO INCREASE IN ITS SCALE OFPRODUCTION. i.e. WHEN A UNIT IS PRODUCING MORE UNITS OF PRODUCTION IN THESAME SPAN OF TIME WITH A LARGER FACILITY, THEN ITS FIXED COSTS AND TOTALCOSTS ARE SPREAD OVERT A LARGE NUMBER OF UNITS PRODUCED. IT MEANS THATWE WILL HAVE LOWER AVERAGE TOTAL COSTS.ECONOMIES OF SCALE IS A LONG RUN CONCEPT.ECONOMIES OF SCALE CAN BE ACHIEVED IN TWO WAYS.1.HIGH FIXED COSTS AND CONSTANT MARGINAL COSTS.2.LOW OR NO FIXED COSTS WITH DECREASING MARGINAL COSTS.EXAMPLE:SUPPOSE A UNIT IS PRODUCING 100 UNITS WITH FOLLOWING INVESTMENTS;CPAITAL: 10 + LAND:10 + LABOR: 10 + FIXED COSTS: 10; HENCE TC=40THEN AC = TC / Q; 40/100=0.4 NOW SUPPOSE THAT THE SAME UNIT DOUBLES ITS PRODUCTION WITH AN INCREASEIN THE FIXED FACTORS OF PRODUCTION. NOW THE INVESTMENTS ARE;CPAITAL: 20 + LAND:20 + LABOR: 20 + FIXED COSTS: 10; HENCE TC=70THEN AC = TC / Q; 70/200=0.35SO WE SEE A DECLINE IN THE AVG. TOTAL COST PER UNIT WITH AN INCREASE IN THEPAYMENTS TO THE FIXED FACTORS OF PRODUCTION.THE CHART SHOWS THAT BY INCREASINGTHE PRODUCTION FROM Q TO Q2, WE GETA GRADUAL DECLINE IN THE COST FROMC TO C1. THIS GRADUAL DECREASE IN THECOST IS KNOWN AS ECONOMY OF SCALE.ALSO WE NOTE THAT AT Q2 LEVEL OFPRODUCTION THE COST IS AT ITS LOWESTPOINT. THIS POINT IS CALLED THEOPTIMUM EFFICIENCY POINT. AT THISPOINT THE BUSINESS IS OBTAININGMAXIMUM ECONOMIES DUE TO INCREASEIN THE PRODUCTION. BEYOND THATPOINT, WE SEE A GRADUAL INCREASE INTHE LRAC CURVE. THE CURVE IS NOWPOSITIVELY SLOPING. HENCE WE SAY THAT IF WE INCREASE PRODUCTION BEYONDTHE OPTIMUM EFFICIENCY POINT, THE BUSINESS WILL SUFFER FROM DISECONOMIESOF SCALE AND WE WILL HAVE INCREASING AVERAGE TOTAL COSTS.

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