The Expansion Path of a Firm 

In this article we will discuss about:- 1. Meaning of

Expansion Path 2. Types of Expansion Path 3. Equations.
Meaning of Expansion Path:
We know that the production function of the firm

q = f(x,y)                             (8.21)

gives us the isoquant map of the firm, one isoquant (IQ) for each
particular level of output, and the cost equation of the firm

C = rXx + rYy                        (8.54)

gives us the family of parallel iso-cost lines (ICLs), given the prices
of the inputs rX and rY, one ICL for one particular level of cost. The
IQ-map and the family of ICLs have been given in Fig. 8.14. If we
now join the point of origin 0 and the points of tangency, E 1, E2, E3,
etc., between the IQs and the ICLs by a curve, then this curve (OK in
Fig. 8.14) would give us what is known as the expansion path of the
firm.
The expansion path is so called because if the firm decides to
expand its operations, it would have to move along this path. Let us
note that the firm may expand in two ways.

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First, it may want to expand by successively increasing its level of

cost or its expenditure on the inputs X and Y, i.e., by using more
and more of inputs, and, consequently, by producing more of its
output.

Second, the firm may decide to expand by increasing its level of

output per period. This the firm may do by increasing the
expenditure on the inputs, i.e., by using more and more of them.
 Fig. 8. 14 The expansion path of a firm
Types of Expansion Path:
(a) Expansion by Means of Increasing the Level of
Expenditure on the Inputs:
In Fig. 8.14, let us suppose that, initially, the firm’s level of cost is
such that its ICL is L1M1 and output-maximisation subject to cost
constraint occurs at the point of tangency, E1, between the ICL, L1M1,
and an IQ which is IQ1. At E1 the firm uses X1 of the first input and
y1 of the second input to produce the maximum possible output, say,
q1, which is represented by IQ1.
Now, if the firm decides to expand by increasing the cost level from
the level of L1M1 to that of L2M2, then the firm would be in output-
maximising equilibrium at the point of tangency E2 (x2, y2), on IQ2,
using more of the inputs, x2 > x1 and y2 > y1, and producing an output
level, say, q2, q2 > q1, since IQ2 is a higher isoquant than IQ1.
In the same way, if the firm decides to expand further, it would
increase its cost level from that of L2M2 to that of L3M3 and it would
produce the maximum output subject to the cost constraint at the
point of tangency E3 (x3, y3) on IQ3 using more of the inputs, x3 >
x2 and y3 > y2, and producing a higher level of output, say, q3, q3 > q2,
since IQ3 is a higher IQ than IQ2.
The process of expansion of firm’s operations through increases in
the level of cost may go on in this say so long as the firm decides in
its favour. If we now join the point of origin O and the points E 1, E2,
E3, etc. by a path, then we would obtain the firm’s expansion path
OK in Fig. 8.14.
That is, if the firm expands by increasing its level of cost, it would
have to move successively from one equilibrium point to another
along this expansion path.

We have joined the path through the equilibrium points E1, E2, etc.
with the point of origin O, because if the firm moves backward along
the expansion path by decreasing the cost level then it would be
moving from the initial equilibrium point, say, E3 to E2, then from
E2 to E) and would approach the point O which would be the
limiting point in this process.
As the firm’s cost level decreases and tends to zero, the input
quantities and the output quantity would all decrease and tend to
zero, and thus the point of origin O would be the limiting point.

(b) Expansion by Means of Increasing the Level of Output:

In Fig. 8.14, let us suppose that initially the firm decides to produce
q1 of output which can be produced at any point on the isoquant,
IQ1. The firm would be in cost-minimising equilibrium at the point
E1 which is the point of tangency between IQ1 and an iso-cost line
say, ICL1. At the point E1, the firm would use Xi and y] quantities of
the two inputs and its cost amounts to, say, C1, which is the
minimum possible.
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The firm may now decide to expand by increasing its level of output
from q1 to q2 on IQ2. If the firm makes this decision, its cost-
minimising equilibrium will be obtained at the point of tangency
E2 (x2, y2) on L2M2 using more of the inputs, x2 > x1 and y2 > y1 and
incurring a cost level C2 on L2M2, which is the minimum possible
required to produce the output of q2. However, C2 > C1 since L2M2 is a
higher ICL than L2M2.
In the same way, the firm may decide to increase again its level of
output from q2 to q3 on IQ3. In this case, the firm’s equilibrium point
would be the point of tangency E3 (x3, y3) on the ICL, L3M3. At E3, the
firm would use still more of the inputs, x3 > x2 and y3 > y2, incurring
a cost level C3 on L3M3, which is the minimum required for
producing q3 of output. However, C3 > C2 since L3M3 is a higher ICL
than L2M2.
The firm’s process of expansion may go on like this as long as it
decides to expand. The expansion path again would be OK that
would start from the point of origin O and pass through the points
E1, E2, E3, etc.
If the firm decides to contract and produce less of output, then the
limiting point of the process of contraction would be the point of
origin O, where the firm’s use of the inputs, its cost level and output
would all tend to zero.

The Equation of the Expansion Path:

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Each point on the expansion path like OK in Fig. 8.14, is a point of

tangency between an isoquant and an iso-cost line. Therefore, at
each point on the expansion path, we have numerical slope of the IQ
= numerical slope of the ICL

⇒ MRTSX,Y = rX/rY
⇒ fX/fY= rX/rY = constant [... rX and rY are given and constant] (8.64)
Therefore, (8.64) gives us the equation of the expansion path.

Internal vs. External Economies of Scale:

What’s the Difference?
Internal Economies of Scale
An internal economy of scale measures a company's efficiency of production.
That efficiency is attained as the company improves output when the average
cost per product drops. This type of economy of scale is a consequence of a
company's size and is controlled by its management teams such as workforce,
production measures, and machinery. The factors, therefore, are independent
of the entire industry.

There are several different kinds of internal economies of scale. Technical

economies of scale are achieved through the use of large-scale capital
machines or production processes. The classic example of a technical internal
economy of scale is Henry Ford's assembly line. Another type occurs when
firms purchase in bulk and receive discounts for their large purchases or a
lower cost per unit of input. Cuts in administrative costs can cause marginal
productivity to decline, resulting in economies of scale.
What Is Relevant Cost?
Relevant cost is a managerial accounting term that describes avoidable costs
that are incurred only when making specific business decisions. The concept
of relevant cost is used to eliminate unnecessary data that could complicate
the decision-making process. As an example, relevant cost is used to
determine whether to sell or keep a business unit. The opposite of a relevant
cost is a sunk cost, which has already been incurred regardless of the
outcome of the current decision.

Example of Relevant Cost

Assume, for example, a passenger rushes up to the ticket counter to purchase
a ticket for a flight that is leaving in 25 minutes. The airline needs to consider
the relevant costs to make a decision about the ticket price. Almost all of the
costs related to adding the extra passenger have already been incurred,
including the plane fuel, airport gate fee, and the salary and benefits for the
entire plane’s crew. Because these costs have already been incurred, they are
sunk costs or irrelevant costs. The only additional cost is the labor to load the
passenger’s luggage and any food that is served mid-flight, so the airline
bases the last-minute ticket pricing decision on just a few small costs.

Types of Relevant Cost Decisions

Continue Operating vs. Closing Business Units
A big decision for a manager is whether to close a business unit or continue to
operate it, and relevant costs are the basis for the decision. Assume, for
example, a chain of retail sporting goods stores is considering closing a group
of stores catering to the outdoor sports market. The relevant costs are the
costs that can be eliminated due to the closure, as well as the revenue lost
when the stores are closed. If the costs to be eliminated are greater than the
revenue lost, the outdoor stores should be closed.

Make vs. Buy

Make vs. buy decisions are often an issue for a company that requires
component parts to create a finished product. For example, a furniture
manufacturer is considering an outside vendor to assemble and stain wood
cabinets, which would then be finished in-house by adding handles and other
details. The relevant costs in this decision are the variable costs incurred by
the manufacturer to make the wood cabinets and the price paid to the outside
vendor. If the vendor can provide the component part at a lower cost, the
furniture manufacturer outsources the work.

Factoring in a Special Order

A special order occurs when a customer places an order near the end of the
month, and prior sales have already covered the fixed cost of production for
the month. If a client wants a price quote for a special order, management
only considers the variable costs to produce the goods, specifically material
and labor costs. Fixed costs, such as a factory lease or manager salaries are
irrelevant, because the firm has already paid for those costs with prior sales.

 
Diseconomies of scale happen when a business' economy of scale stops
functioning, which leads to a rise in marginal costs—instead of a decrease—
when output increases.

External Economies of Scale

External economies of scale are generally described as having an effect on
the whole industry. So when the industry grows, the average costs of business
drop. External economies of scale can happen because of positive and
negative externalities. Positive externalities include a trained or specialized
workforce, relationships between suppliers, and/or more innovation. Negative
ones happen at the industry levels and are often called external
diseconomies.

There are several contributing factors behind external economies of scale.

When competing companies set up shop in one area, specialized workers will
seek employment. An example of this would be the IT industry in Silicon
Valley, which has attracted a special set of skilled workers. Secondly, certain
industries may become so important, they can develop bargaining power with
politicians and local governments. This, in turn, can lead to more favorable
treatment in the form of subsidies or other concessions. The oil industry has a
long history of subsidies in the United States, which were historically given to
continue a steady flow of domestic supply.

Profit Maximization Model

In traditional economic model of the firm it is assumed that a firm’s
objective is to maximise short-run profits, that is, profits in the
current period which is generally taken to be a year. In various
forms of market structure such as perfect competition, monopoly,
monopolistic competition the traditional microeconomic theory
explains the determination of price and output by assuming that
firm’s aim is to maximise current or short-run profits. This current
short-run profit maximisation model of the firm has provided
decision makers with useful framework with regard to efficient
management and allocation of resources.

Profit is a difference between total revenue and total cost. It may be

noted that the concept of cost used in economic theory and
managerial economics is different from the concept of accounting
cost used by accountants. This difference in the concepts of costs
makes the concept of profits used in economic theory different from
that used in its calculation by the accountant.

It is to state here that economic profits is the difference between

total revenue and economic costs. Thus,

=TR-TC

It can be seen from the upper part of Figure 2.1 that profits start
declining as output is expanded beyond OQ. Therefore, a firm which
aims to maximise profits will produce output level of OQ, and will
charge a price of its product which buyers are prepared to pay
depending on the demand conditions.

Since price or average revenue equals total revenue divided by a

level of output, price charged by the firm at output level OQ is given
TR/OQ or QJ/OQ

The simple profit-maximizing model of the firm provides very

useful guidelines for the decision making by the firm with regard to
efficient resource management.

Baumoul’s Sales Maximization

Model
https://www.economicsdiscussion.net/revenue/maximisation/baumols-sales-or-revenue-
maximisation-with-diagram/18735

Marris’s Model of the

Managerial Enterprise
https://www.economicsdiscussion.net/articles/marriss-model-of-the-managerial-enterprise/5600

Williamson’s Model of
Managerial Discretion
https://www.economicsdiscussion.net/firm/williamsons-model-of-managerial-discretion/5718