Notes on: The Relationship Between Marginal and Average

and Economies of Scale

As I said in class, I am posting notes about the relationship between marginal and average.
I am also including notes about economies of scale. This is a topic I will discuss in
lecture on Monday; these notes should help you for the homework.

I. Marginal and Average

We have been discussing the ideas of “marginal cost” and “marginal product.” In very
general terms, the “marginal” unit is the additional or new unit. Marginal cost is the
additional cost that results from producing an additional unit of output. Marginal product
of some input is the additional amount of output that is produced from adding an
additional unit of a certain input.

The “average” involves all units. The “marginal” unit affects the average. This can be
illustrated with an example.

Consider GPA’s. We have a GPA for a certain term and then there is a cumulative GPA
– the average of all of our term GPA’s. Consider the following table of GPA’s.

Current GPA Cumulative

Term (this term only) GPA
1 4 4
2 3.5 3.75
3 3 3.5
4 2.5 3.25
5 3 3.2
6 3.2 3.2
7 3.9 3.3
8 4.9 3.5

When looking at this table, we should notice a few points.

• For each term the “current GPA” is the new GPA, or the “marginal GPA”
• The cumulative GPA is the average of all GPA’s up until that term (includes all
GPA’s before that term, including that term)
• NOTE: when the marginal is below the average, the average falls. We can notice
this specifically for terms 1 – 5.
• NOTE: when the marginal is above the average, the average increases. We can
notice this for terms 7 and 8.

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The intuition behind this is that if the new grades are higher than the old average, the
average must go up. Similarly, if the marginal (new) grades are below the average, then
the average must fall.

If the marginal is increasing (in this case, it is, eventually), then:

• When the marginal is below the average, the average is decreasing (see above).
• When the marginal is above the average the average is increasing (see above).
• The marginal is equal to the average only when the average is at a minimum (see
above, term 6).

These points can be seen by looking at a plot of the above data:

Current and Cumulative GPA

4
Marg GPA
GPA

3
Avge GPA
2

0
0 2 4 6 8 10
Term

II. Economies of Scale

Definition: An industry (or production function) is said to exhibit economies of scale if

in the long run average total cost decreases.

OR If all inputs are increased by a factor of a > 1 , then output increases by a factor of
more than a ( f (aK , aL) > af ( K , L) ).

I found econometric data (econometrics is a field of economics that combines economics

and statistics – it analyzes real life economic activity by applying statistical tools) that
estimates the production function for different industries in different countries.

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According to this data specific industries that exhibit economies of scale are the railroad
industry in America and the chemical industry in India.

A possible story for why the railroad industry exhibits economies of scale could be that
the tracks for the railroad are a significant and costly initial investment. Once the tracks
are set, the railroad can increase output (number of passengers) just by adding trips of the
train. The only additional costs of running the train more often would be the labor to
operate the train and fuel to run the train (relatively low costs). Thus as output increases,
the average total cost will decrease.

For the chemical industry in India, an explanation could be that as labor is added (more
scientists working together) there could be spillover of knowledge – two scientists
working together think of better ideas than one scientist working alone. Also, for the
production of chemicals, the processes could complement each other. The production of
one chemical could have a by-product that could be used to make another chemical.
Thus as output of both increase, the average total cost decreases.

Definition: An industry (or production function) is said to exhibit constant returns to

scale if in the long run average total cost is constant.

OR If all inputs are increased by a factor of a > 1 , then output increases by a factor
exactly equal to a ( f (aK , aL) = af ( K , L) ).

According to the data I found specific industries that exhibit constant returns to scale are
the paper industry in America and the cotton industry in India.

This seems reasonable for both industries. If all inputs are doubled for each industry,
then just about double the output should be produced.

Definition: An industry (or production function) is said to exhibit diseconomies of scale

if in the long run average total cost is increasing.

OR If all inputs are increased by a factor of a > 1 , then output increases by a factor less
than a ( f (aK , aL) < af ( K , L) ).

According to the data I found one specific industry that exhibits diseconomies of scale is
the electricity industry in India. An explanation for this is that as electricity travels along
electrical cables it loses “energy.” If all inputs to electricity (say coal, the machines in
the factory and the electrical cables) are doubled, the amount of electricity that reaches
consumers (at the end of the cables) will be less than double because some “energy” has
been lost in transit.

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An intuitive way to think of these three terms is, if all inputs double ( a = 2) , will output
double (constant returns to scale), more than double (economies of scale) or less than
double (diseconomies of scale)?

When it comes to testing whether or not a production function exhibits constant returns to
scale, economies of scale or diseconomies of scale (which you are asked to do in
Homework III), I think it is beneficial to ask the question posed above. If inputs double,
what will happen to output?

More specifically, consider the production function f ( K , L) = K a Lb . To determine what

kind of “scale” this function exhibits we want to know what happens to f (aK , aL) .
Specifically, consider a = 2 . Then f (aK , aL) = f (2 K ,2 L) = (2 K ) a (2 L) b = 2 a +b K a Lb .
We want to compare f (aK , aL) to a * f ( K , L) (when inputs double, what happens to
output, is it doubling, less than doubling or more than doubling).

Note that above f (2 K ,2 L) reduces to 2 a + b K a Lb which is equal to 2 a+ b f ( K , L) .