Question

FIRM XYZ in its annual meeting, the President indicated to Stockholders that "the more the firm produced, the lower the average cost of production".

a. What economic concept can be attributed to this phenomenon?

b. What factors can cause this?

c. What 5 factors can reverse this trend?

Answer 1

When the President of the firm XYZ indicated that 'the more the firm produced the lower the average cost of production' he/she was talking about Economies of scale.

This economic concept dates back to Adam Smith's book on economic development - 'An inquiry into nature and causes of the wealth of nations' (1976), where he talked about how returns due to division of labor increase with the size of the market. With increased market size production is increased to meet the market demand. This expansion creates a division of labor and reduces costs.

However, since then today various factors can be attributed to the generation of economies of scale this explanation is still relevant.

'Economies of scale refer to the cost advantages a firm gets when it starts producing at a larger scale or expanding its production. As output increases the firm's average cost of production declines until a certain point. Technically it usually happens when the firm's MC (Marginal Costs) < AC (average costs).

b.) Various factors are responsible for the economies of scale to set in, we discuss 5 of them:-

1. If the firm operates at large scale workers can specialize in the activities in which they are most productive.
2. The scale provides flexibility. By varying the combination of input, firms can optimally organize the production process in an efficient manner.
3. The firm by buying inputs in bulk may negotiate lower prices and the firm can take advantage of the combination of lower cost inputs.
4. Fixed costs are constant irrespective of the level of production. If fixed costs constitute greater chunk of total costs then expansion in production brings about lesser costs per unit.
5. With larger production greater credit can be obtained from financial institutions resulting in which can be used to spend on R&D activities and technology thereby bringing in improved productivity.

c.) 5 Factors than reverse this trend-

1. In short run with lesser factory space and machinery may make it difficult for workers to perform effectively.
2. Managing a larger firm may become difficult and complex with increased tasks.
3. Available supplies of key inputs may be limited causing their prices to rise over time.
4. Failure demand- if increased production does not get a market where it can be profitably sold, then it creates costs due to failing to meet demand.
5. Inflation in supply side factors or supply shocks causing increased costs for the same amount of inputs. Government policies on cleaning up environment etc pushes up overhead costs.