Relationship between average cost and output

In the previous lesson we learned that average cost is the total cost divided by output. In other words, the average cost is the cost of producing one unit.

Relationship between average cost and output can be shown using Average Cost Curve(also called Average Total Cost Curve).

Average Cost Curve

Average Cost Curve

From the above diagram we can see that up to certain level of production, average cost decreases. However, after a certain level of production, average cost starts to increase.

When average cost decreases as output increases, it is known as economies of scale.

Economies of scale can happen due to many reasons.

One reason is that as the level of output increases, the fixed cost is spread over all the units of output, therefore average fixed cost keeps on decreasing.

Average Cost Curve

 

Types of economies of scale

Purchasing economies:
When business buys in large quantities, they are able to get discounts and special prices because of buying in bulk. This reduces the unit cost of raw materials and a firm gets an advantage over other smaller firms.
Marketing economies:
The cost of advertising and distribution rises at a lower rate than rises in output and sales. In proportion to sales, large firms can advertise more cheaply and more effectively than their smaller rivals.
Financial economies:
A larger company tends to present a more secure investment; they find it easier to raise finance.Banks and other lending institutions treat large firms more favorably and these firms are in a position to negotiate loans with preferential interest rates. Further, large companies can issue shares and raise additional capital.
Managerial economies:
A large company benefits from the services of specialist functional managers. These firms can employ a number of highly specialized members on its management team, such as accountants, marketing managers which results in better decision being taken and reduction in overall unit costs.
Technical economies:
In large scale plants there are advantages in terms of the availability and use of specialist, indivisible equipment which are not available to small firms. Large manufacturing firms often use flow production methods and apply the principle of the division of labour. This use of flow production and the latest equipment will reduce the average costs of the large manufacturing businesses.

When average cost increases as output increases, it is known as diseconomies of scale.

Tha following could be the reasons for diseconomies of scale

1. Poor communication in a large firm

2. Alienation: Working in a highly specialized assembly line can be very boring, if workers become de motivated. In a large firm there is an increased gap between top and bottom.

3. Lack of control: when there is a large number of workers it is easier to escape with not working very hard because it is more difficult for managers to notice those who take free rides.

4. Loss of control over costs – big businesses may lose control over fixed costs such as expensive head offices, management expenses and marketing costs. There is also a risk that very expensive capital projects involving new technology may prove ineffective and leave the business with too much under-utilized capital.

Next topic: Total and average revenue

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