PROJECT

ON

COST CURVES

AND

ECONOMIC OF SCALE

Submitted by: - JATIN Trika (91012)

Submitted To: - Anju Katyal
Cost curve
In economics, a cost curve is a graph of the costs of production as
a function of total quantity produced. In a free market economy,
productively efficient firms use these curves to find the optimal
point of production, where they make the most profits. There are a
few different types of cost curves, each relevant to a different area
of economics.
•

The Short Run average total cost curve (SATC or

SAC)

Typical short run average cost curve

The average total cost curve is constructed to capture the relation

between cost per unit and the level of output, ceteris paribus. A
productively efficient firm organizes its factors of production in
such a way that the average cost of production is at lowest point
and intersects Marginal Cost. In the short run, when at least one
factor of production is fixed, this occurs at the optimum capacity
where it has enjoyed all the possible benefits of specialization and
no further opportunities for decreasing costs exist. This is usually
not U shaped, it is a checkmark shaped curve. This is at the
minimum point in the diagram on the right.Example: Q=2K.5L.5
STC=Pk(K)+Pw(Q2/4K) SATC or SAC= (Pk(K)/Q)+Pw(Q/4K)
The long-run average cost curve (LRAC)

Typical long run average cost curve

Essentially, the long-run average cost curve depicts what the

minimum per-unit cost of producing a certain number of units
would be if all productive inputs could be varied. Given that
LRAC is an average quantity, one must not confuse it with the
long-run marginal cost curve, which is the cost of one more unit.
The LRAC curve is created as an envelope of an infinite number of
short-run average total cost curves. The typical LRAC curve is U-
shaped, reflecting economies of scale when negatively-sloped and
diseconomies of scale when positively sloped. Contrary to Viner,
the envelope is not created by the minimum point of each short-run
average cost curve. This mistake is recognized as Viner's Error.

In a long-run perfectly competitive environment, the equilibrium

level of output corresponds to the minimum efficient scale, marked
as Q2 in the diagram. This is due to the zero-profit requirement of
a perfectly competitive equilibrium. This result, which implies
production is at a level corresponding to the lowest possible
average cost, does not imply that other production levels are not
efficient. All points along the LRAC are productively efficient, by
definition, but are not equilibrium points in a long-run perfectly
competitive environment.

In some industries, the LRAC is always declining (economies of

scale exist indefinitely). This means that the largest firm tends to
have a cost advantage, and the industry tends naturally to become a
monopoly, and hence is called a natural monopoly. Natural
monopolies tend to exist in industries with high capital costs in
relation to variable costs, such as water supply and electricity
supply.

The average cost is the total cost divided by the number of units
produced.

The marginal cost curve (MC)

Typical marginal cost curve

A marginal cost that graphically represents the relation between

marginal cost incurred by a firm in the short-run product of a good
or service and the quantity of output produced. This curve is
constructed to capture the relation between marginal cost and the
level of output, holding other variables, like technology and
resource prices, constant. The marginal cost curve is U-shaped.
Marginal cost is relatively high at small quantities of output, then
as production increases, declines, reaches a minimum value, then
rises. The marginal cost is shown in relation to marginal revenue,
the incremental amount of sales that an additional product or
service will bring to the firm. This shape of the marginal cost curve
is directly attributable to increasing, then decreasing marginal
returns (and the law of diminishing marginal returns - Diminishing
returns).
Combining cost curves

Cost curves in perfect competition compared to marginal revenue

Cost curves can be combined to provide information about firms.

In this diagram for example, firms are assumed to be in a perfectly
competitive market. The marginal cost curve will cut the average
cost curve at its lowest point. In a perfectly competitive market a
firm's profit maximising price would be at or above the price at
which the average cost curve cuts the marginal cost curve. If the
marginal revenue is above the average total cost price the firm is
deriving an economic profit.

Economies of scale in the indian cement

industry
The paper purports to investigate the existence or otherwise of
economies of scale in the Indian cement industry. The
investigation is attempted through the estimation of cost-output
(sales) relationships both from the time series and cross-section
data and both at the industry level and at the firm level.
Furthermore, at the industry level the cost-output relationships
have been estimated separately for All-India, Bihar, and Madras,
the regional classification for which the time-series data are
available. The relationships between the cost components (material
cost, labour cost and depreciation cost) and the output have also
been determined to identify the sources of economies or
diseconomies of scale. It is found that the industry is dominated by
the L-shaped average cost curve and horizontal marginal cost
curve. In other words, the industry is found to be still operating in
the first half of the U-shaped average cost curve and thus cement
firms have not yet reached their optimum size. Significant
economies of scale exist only with respect to labour costs in All-
India and Bihar and total costs in Associated Cement Companies
Ltd, Jaipur Udyog Ltd, Mysore Cement Ltd and Sone Valle
Portland Cement Company Ltd; significant diseconomies exist
only with respect to total cost and material cost in Madras
industries. Inter-regional comparison has indicated that expansion
of the industry in places other than Bihar and Madras and
contraction of Madras firms will be beneficial from the side of
cost. Among the four cement firms considered the Associated
Cement Companies is enjoying the maximum economics of scale.
Its sales elasticity of total cost at sample means is 0.42.

Economy of scale
Economies of scale, in microeconomics, are the cost advantages
that a business obtains due to expansion. They are factors that
cause a producer’s average cost per unit to fall as scale is
increased. Economies of scale is a long run concept and refers to
reductions in unit cost as the size of a facility, or scale, increases.[1]
Diseconomies of scale are the opposite. Economies of scale may
be utilized by any size firm expanding its scale of operation. The
common ones are purchasing (bulk buying of materials through
long-term contracts), managerial (increasing the specialization of
managers), financial (obtaining lower-interest charges when
borrowing from banks and having access to a greater range of
financial instruments), and marketing (spreading the cost of
advertising over a greater range of output in media markets). Each
of these factors reduces the long run average costs (LRAC) of
production by shifting the short-run average total cost (SRATC)
curve down and to the right.

Overview
Economies of scale is a practical concept that is important for
explaining real world phenomena such as patterns of international
trade, the number of firms in a market, and how firms get "too big
to fail". Economies of scale is related to and can easily be confused
with the theoretical economic notion of returns to scale. Where
economies of scale refer to a firm's costs, returns to scale describe
the relationship between inputs and outputs in a long-run (all
inputs variable) production function. A production function has
constant returns to scale if increasing all inputs by some proportion
results in output increasing by that same proportion. Returns are
decreasing if, say, doubling inputs results in less than double the
output, and increasing if more than double the output. If a
mathematical function is used to represent the production function,
returns to scale are represented by the degree of homogeneity of
the function. Production functions with constant returns to scale
are first degree homogeneous; increasing returns to scale are
represented by degrees of homogeneity greater than one, and
decreasing returns to scale by degrees of homogeneity less than
one.

The confusion between the practical concept of economies of scale

and the theoretical notion of returns to scale arises from the fact
that large fixed costs, such as occur from investment in a factory or
from research and development, are an important source of real
world economies of scale. In conventional microeconomic theory
there can be no increasing returns to scale when there are fixed
costs, since this implies at least one input that cannot be increased.

A natural monopoly is often defined as a firm which enjoys

economies of scale for all reasonable firm sizes; because it is
always more efficient for one firm to expand than for new firms to
be established, the natural monopoly has no competition. Because
it has no competition, it is likely the monopoly has significant
market power. Hence, some industries that have been claimed to be
characterized by natural monopoly have been regulated or
publicly-owned.

In the short run at least one factor of production is fixed. Therefore

the SRAC curve will fall and then rise as diminishing returns sets
in. In the long run however all factors of production vary and
therefore the LRAC curve will fall and then rise according to
economies and diseconomies of scale.

There are two typical ways to achieve economies of scale:

1. High fixed cost and constant marginal cost

2. Low or no fixed cost and declining marginal cost

Economies of scale refers to the decreased per unit cost as output

increases. More clearly, the initial investment of capital is diffused
(spread) over an increasing number of units of output, and
therefore, the marginal cost of producing a good or service is less
than the average total cost per unit (note that this is only in an
industry that is experiencing economies of scale).

An example will clarify. AFC is average fixed cost.

If a company is currently in a situation with economies of scale,

for instance, electricity, then as their initial investment of $1000 is

spread over 100 customers, their AFC is .

If that same utility now has 200 customers, their AFC becomes

... their fixed cost is now spread over 200 units of

output. In economies of scale this results in a lower average total
cost.

The advantage is that "buying bulk is cheaper on a per-unit basis."

Hence, there is economy (in the sense of "efficiency") to be gained
on a larger scale.

Economies of scale tend to occur in industries with high capital

costs in which those costs can be distributed across a large number
of units of production (both in absolute terms and, especially,
relative to the size of the market). A common example is a factory.
An investment in machinery is made, and one worker, or unit of
production, begins to work on the machine and produces a certain
number of goods. If another worker is added to the machine he or
she is able to produce an additional amount of goods without
adding significantly to the factory's cost of operation. The amount
of goods produced grows significantly faster than the plant's cost
of operation. Hence, the cost of producing an additional good is
less than the good before it, and an economy of scale emerges.
Economies of scale are also derived partially from learning by
doing.
The exploitation of economies of scale helps explain why
companies grow large in some industries. It is also a justification
for free trade policies, since some economies of scale may require
a larger market than is possible within a particular country — for
example, it would not be efficient for Liechtenstein to have its own
car maker, if they would only sell to their local market. A lone car
maker may be profitable, however, if they export cars to global
markets in addition to selling to the local market. Economies of
scale also play a role in a "natural monopoly."

Typically, because there are fixed costs of production, economies

of scale are initially increasing, and as volume of production
increases, eventually diminishing, which produces the standard U-
shaped cost curve of economic theory. In some economic theory
(e.g., "perfect competition") there is an assumption of constant
returns to scale.

Examples

Economies of scale — As a firm doubles output, the total cost of

inputs less than doubles
Diseconomies of scale — As a firm doubles its output, the total
cost of inputs more than doubles.