Chapter 7:

Economies
of Scale
Table of Contents
The concept of economics of scale

The concept of returns to scale

Causes of economics of scale and dis-

economics of scale

The implications of economics of scale

Test for returns to scale

 Learning Outcomes
Able to distinguish the concept of economies of size,
economies of scale and returns to scale.

Able to distinguish the concept of constant returns to scale,

increasing returns to scale and decreasing returns to scale.

Able to explain the implications of economies of scale and

returns to scale.

Able to test the type of returns to scale base on the

production function.
 The Concept of Economies of Size
Economics of size refers to a situation in which the
decrease in the average cost of a production in the
long run as a result of an expansion in production
levels.

Costs per unit output fall with an increase in output at

any point in time.

Decreasing in marginal cost and existence of fixed

cost in production.

Economies of size is achieved when more goods

can
be produced on a larger scale with lower costs.
The Concept of Diseconomies
of Size
Diseconomies of size are the forces that
cause larger firms and governments to
produce goods and services at
increased per-unit costs.

Theconcept is the opposite of

economies of size.
Cont.
 Causes for economics of size
The spreading of fixed cost over a large
scale of output.
Economies of specialization
Increasing workers' skills
Lower input costs
Improvements in technology
More efficient transportation costs
Efficient management
Economic of Scale
# Economics of scale refers to a situation in which the
decrease in the average cost of a production in the
long run as a result of an expansion in production
levels and input bought in a bulk size.

# Costs per unit output fall with a decrease in input

price due to decreasing in marginal cost and
existence of fixed cost in production and hence
increase in output at any point in time

# Economies of scale is achieved when more goods

can be produced on a larger scale with lower
costs.
 Economies of size vs
economies of scale
For economies or diseconomies of size to take place, all that is
required is that the output level change. All inputs need not
change proportionately.

However, if economies or diseconomies of scale are to take

place, not only must output change but each of the inputs
must change in the same proportion to the others.
For example, the term economies or diseconomies of scale
could be used to describe what happens to per unit costs of
production when all inputs are doubled, tripled, quadrupled,
or halved.

The term economies or diseconomies of size could be used to

describe what happens to per unit costs of production when
output is doubled, tripled, quadrupled, or halved but input
levels do not necessarily increase in the same proportionate
amounts.
Economic of scale vs Returns to
scale
Economic of scale vs
Returns to scale
Implications from Economies of
Scale and increasing returns to
scale

Production becomes more efficient

Productivity will increase
The increase in profit
The lifespan of the business will last
longer
Test for returns to scale

Production function curve and isoquant map

Degreeof homogeneities from the

production function

Output elasticity with respect to the scale

Production function curve
1 variable input

Y Y Y
Y=f
Y=f
(X)
(X)
Y=f
(X)

X X X

Constant returns Decreasing returns Increasing returns

to scale to scale to scale
Isoquant Map (2 variable
input)
Constant returns to scale The distance of
isoquant curve shifts upward is the same

Decreasing returns to scale - The distance of

isoquant curve shifts upwards is further away

Increasing returns to scale - The distance of

isoquant curve shifts upwards is more closely
Homogeneous Production
Functions
Degree of homogeneities
The production function Y = f (X1, X2, X3,.Xn) is homogenous with
degrees of n if:

f(tX1, tX2, tX3,. tXn) = t f (X1, X2, X3,.Xn)

Step to find the degree of homogeneities

1) Multiply all inputs with a constant t
2) Get a new output value
3) Make sure whether the constant t can be factored out from the
original function - if yes, the function is homogeneous

4) Check the power of (n) at constant t - degree of homogeneities

If n> 1, increasing returns to scale
n <1, decreasing returns to scale
n = 1, constant returns to scale
 Example 1
The production function for a sugar cane as
follow:
Q = 3X + 4XY + Y
Where Q = Production of sugar cane in
tone
X = Total of area planted
Y = Total of labor
Question:
What kind of returns to scale for the production
of sugar cane?
Example 2
Exercises: