Q.
a) Explain the meaning of 'economies of scale' and distinguish between internal and external economics. (10 marks)
b) Explain the relation of short-run average costs to long-run average cost. Show in diagrammatic form. (10 marks)
(20 marks, 2011 Q4)
A.
a) Meaning of 'economies of scale' is 'the property whereby long-run average total cost (ATC) falls as the quantity increases.
Internal and external economies of scale.
b) Fixed cost becomes variable in the long-run as the firm may build more factories, employ new machineries and close up old ones. Therefore, over long time, the efficiency of production achieve a better cost equation, giving an economies of scale.
The above graph depicts the short-run higher Average Total Cost (ATC), a long-run lower ATC which is the economies of scale. In layman term, when the firm becomes bigger, it's fixed cost resources can be better utilized. Like the case of operating 24/7 of a power plant, the wastage of restarting the turbine which takes away a lot of cost is avoided. Similarly, operating an airport at full capacity with 24/7 would reduce wastage of fixed cost investment like Run Way, huge parking space and air-conditioning. Imagine to re-start the air conditioning to cool down the enormous space every morning would take time and energy/cost of electricity.
In a factory, if the operation is 24 hours with shifts, workers are rotated to fully utilize the machineries and thus increased output with reduced average unit cost. Although in the short-run, the cost will run high as efficiency has not achieve optimal level, in the long-run average cost will certainly come down as workers become specialized and thus are able to increase output per unit time. In another aspect, raw material purchase can be in tender and in bulk, thus getting them at lower unit cost. It also reduces wastage of mis-fit e.g. furniture, left over planks can be utilized for smaller parts instead of being thrown away.
Cost of fund may also be cheaper as banks are willing to negotiate for a better (lower) rate in larger loan value over a longer repayment period. Property sale can also be contracted out to marketing companies, group of legal offices and thus enjoys a lower per unit cost of expenditure.
Ref:
Own account with graph from Mankiw, N G. 2012. Principles of economics. South-western Cengage Learning. Page 271-273.
