Chapter 2: Cost and Choice

Costs cannot be realised. They must remain forever in a world of projecting, fantasising or
imagining.

Gerald O’Driscoll and Mario Rizzo

Story:

The anecdote of the lawyer and secretary at Koch Industries illustrates how value creation
depends on the recognition of costs.

• First visit: The secretary insisted on doing the photocopying because the lawyer’s
time was worth more given his high pay; using him for photocopies would waste
resources.

• Second visit: The secretary refused, since her own work (drafting a contract on
deadline) was now more valuable than taking time for photocopies.

This story shows how opportunity-cost reasoning is embedded in organizational

decisions. The secretary’s judgment reflected an understanding that costs are not just
explicit expenses but also the value of the best alternative forgone.

The chapter aims to help managers internalize this reasoning:

• Short-term decision: How much output to produce given the existing plant size.

• Long-term decision: What size of plant to build in the first place.

Crucially, costs are not purely objective. They are subjective judgments, just like value.
Unfortunately, many textbooks wrongly suggest that supply-and-demand analysis
combines objective costs with subjective value. In reality, costs themselves are
subjective, because they reflect individual opportunity costs.

Rather than simply trying to “cut costs,” managers should confront and understand
them—seeing how costs shape choices and strategies.

Essence

The core message is that costs are opportunity costs, not objective numbers, and they
are as subjective as value. Good decision-making—whether at the level of an individual
secretary or a corporate manager—depends on recognizing how alternative uses of time
and resources affect value creation.

Lesson

• Value creation requires knowing the real cost of an activity, not just its price tag.

• Opportunity costs shift depending on circumstances: what is costly at one time

may not be at another.

• Managers must internalize the subjective nature of costs to make better choices
about production, plant size, and resource allocation.

• Cost-cutting is not the ultimate goal; cost awareness is.

Relation to Economics

This ties into several economic principles:

 • Opportunity cost: Every choice has a trade-off, measured not in money alone but in
the value of the best alternative forgone.

• Subjectivity of costs: Just as preferences make demand subjective, opportunity

costs make supply decisions subjective.

• Short-run vs. long-run analysis:

o Short run → utilization of fixed resources (e.g., existing plant).

o Long run → adjusting fixed resources themselves (e.g., building a new plant).

• Managerial economics: Decisions about allocation, outsourcing, and production

must balance subjective opportunity costs against expected value creation.

2.1 Opportunity Cost

The key idea is that costs must be understood through the lens of opportunity-cost
reasoning, not accounting entries.

• Example: Choosing between £50, £20, and £10 notes.

o If you choose the £20 note, accounting would say the cost is “0” (since no
money was spent).

o Economics, however, says the true cost is the next best alternative (NBA)
forgone.
 o In this case, the NBA is the £50 note, making the cost of choosing £20 equal
to £50.

Thus, costs are actions not taken—not receipts or invoices. George Shackle described
costs as a “skein of imagined alternatives”, since they always involve what we could have
done but didn’t.

Economists define cost in two steps:

1. Identify your next best alternative (NBA).

2. Assign its monetary value.

Because NBAs are hypothetical (the things we didn’t choose), we never actually see
costs—we only infer them.

Essence

Cost is not about money spent; it is about the value of the forgone alternative. The cost of
choosing £20 is not £0, but the £50 note that was sacrificed.

Lesson

• Costs are rooted in choice and sacrifice, not accounting entries.

• The next best alternative is the true measure of cost.

 • Opportunity costs are invisible—because they are tied to paths not taken—yet they
are central to sound decision-making.

Relation to Economics

• Opportunity cost: Economics redefines cost as what is given up, not what is paid.

• Decision-making: Every choice (like picking £20) implies rejecting the more
valuable option (£50).

• Subjectivity of costs: Just as value is subjective, identifying NBAs requires

judgment about what the “best forgone alternative” is.

• Philosophical economics: Unlike accounting, economics treats cost as a

conceptual, unseen but very real factor in choices.

In short:

Accounting cost of £20 = £0

Economic cost of £20 = £50 (the NBA forgone)

—----

This section emphasizes the importance of distinguishing opportunity (economic) costs

from accounting costs and how this perspective creates a competitive advantage.

• Opportunity Costs = hidden/implicit costs → always defined as the next best

alternative (NBA).
 • Economic Value Added (EVA): A method (developed by Joel Stern, trademark of
Stern Stewart & Co.) to highlight the hidden cost of capital and measure true value
creation for equity holders.

• Key Difference:

o Accounting profit = revenues > accounting costs.

o Economic profit = revenues exceed both accounting costs and the return
that could be earned from the NBA (e.g., cost of capital).

o If profits are less than the NBA, the company is economically destroying
wealth, even if it shows high accounting profits.

• Peter Drucker’s insight: Until profits exceed the cost of capital, a business is
running at an economic loss.

EVA has limitations—especially at lower organizational levels due to shared resources

and transfer pricing—but it is still superior to ignoring opportunity costs.

The author illustrates this with the example of reading a book:

• The true cost of reading isn’t the price you paid (£30+), but what else you could be
doing instead.

• Therefore, the author’s obligation is to provide enough value to outweigh your

forgone alternatives, not just match the sticker price.
Cost, Definition – [The chooser’s] own evaluation of the enjoyment or utility that he
anticipates having to forego [sic] as a result of selection among alternative courses of
action.

Essence

Cost ≠ money spent.

Cost = value of the next best alternative forgone.

Economic profit = profit beyond the cost of capital.

Until then, a firm is consuming more resources than it creates.

Lesson

• Always account for opportunity costs, not just accounting costs.

• EVA is a practical tool to measure value creation by factoring in cost of capital.

• Even high reported profits can hide economic losses if resources could have been
better deployed elsewhere.

• The true cost of any choice (like reading a book) is not the price, but the utility of
what was sacrificed.

Relation to Economics

• Opportunity cost principle: Core to economics; always about foregone

alternatives.
 • Corporate finance connection: EVA integrates economic thinking into
management by aligning profit with value creation above capital costs.

• Capital as NBA: Cost of capital is the benchmark NBA—firms must beat this to truly
create wealth.

• Subjectivity of costs: The true cost of reading isn’t the book price but the foregone
enjoyment/utility of other activities.

In short:

• Accounting view: Profit if revenue > expenses.

• Economic view: Profit only if returns exceed NBA (cost of capital). Otherwise, the
firm is destroying value.

—----------

Summary

This section highlights how economists and accountants differ in their definition of
profit, directly tied to the concept of opportunity cost.

• Accountant’s view of profit: Profit = money received – money spent.

• Economist’s view of profit: Profit = revenue – (explicit costs + opportunity costs).

 o If your next best alternative (NBA) is equally rewarding, your economic profit
= 0, even if accounting profit looks high.

Examples used:

1. MBA teaching (£1,000/day):

o 3-day program = £3,000 cheque.

o Accountant → profit = £3,000.

o Economist → profit = 0 (NBA is teaching elsewhere for same rate).

o If paid £1,250/day → true economic profit of £750 (signal that one choice
creates more wealth than the other).

2. Albrecht Dürer (Renaissance artist):

o Despite finishing a valuable painting, he recognized his opportunity cost (200

ducats from other work) reduced his “profit.”

3. Marissa Mayer (Google → Yahoo, 2012):

 o Salary at Google: ~$2M.

o Salary at Yahoo: ~$6M.

o Despite already being wealthy, her jump in pay suggests she was earning
below her true market value before. From an economic perspective, she
was making a loss at Google relative to her NBA.

Core insight:

• Economic profit = rare. These “pure profit opportunities” are what entrepreneurs
seek.

• In equilibrium, firms earn zero economic profit, because all resources (labor,
capital, etc.) are already being rewarded at their opportunity cost.

• “No such thing as a free lunch”: All actions require giving up alternatives →
always an opportunity cost.

Essence

• Accounting profit looks only at explicit monetary gains.

• Economic profit factors in the value of the next best alternative.

 • Economic profit provides a market signal to allocate resources to their most
productive use.

Lesson

• Economic profit is a rarity; when it exists, it signals opportunities for

entrepreneurship.

• High income ≠ economic profit if the person could have earned more elsewhere.

• In long-run equilibrium, firms earn zero economic profit because competition

ensures resources are rewarded at their opportunity cost.

• Always evaluate choices by what they displace—the unseen alternatives.

Relation to Economics

• Opportunity cost principle: Profit must be understood in terms of forgone

alternatives, not just cash inflows.

• Entrepreneurship: Rooted in discovering “pure profit” opportunities before

competition erases them.

• Equilibrium concept: Zero economic profit doesn’t mean firms fail—it means
resources are being fully compensated.
 • Labor market example: Even highly paid individuals (Mayer, Dürer) may be at an
economic loss if their NBA is higher.

In short:

• Accountant: “You made £3,000 profit.”

• Economist: “No, your profit is £0—unless you’ve beaten your NBA.”

—---------

“What didn’t happen is often as important as what did happen.”

2.2 Diminishing marginal returns

The passage explains how the law of diminishing marginal returns (DMR) works and why
it matters in economics by using the example of a restaurant.

• It begins with a simple production function, where output depends on two key
factors of production: capital (meaning physical capital such as plant, machinery,
and equipment) and labour. Over the short run, capital is assumed to be fixed, so
the only input that can vary is labour, measured for example in hours per week.

• At zero labour, output is naturally zero. As the firm hires more workers, output
initially rises sharply, because workers can specialize, divide tasks, and organize
as a team—captured in the saying “many hands make light work.” But since
capital is fixed, there is a limit to how effectively additional workers can use the
same equipment and space.

• Coordination becomes harder as the team grows—“too many cooks spoil the
broth.” Eventually, the gains in output slow down. Beyond a certain point, each
extra worker adds less and less to total output, and finally, adding even more
workers can cause output to peak and then fall, as overcrowding and inefficiency
set in.
This is the essence of the law of diminishing marginal returns: as increasing units of a
variable resource (labour) are combined with a fixed resource (capital), output increases
at a decreasing rate.

• At the point of diminishing returns, it takes successively larger amounts of the

variable factor to expand output by one unit. Put simply, as output expands,
marginal productivity—the extra output gained from an extra input—will
eventually decline.

This concept also explains how real wage rates are determined. If the 10th worker raises
total output from 200 units to 240 units, their marginal product is 40 units. As more
workers are hired, there is a point where the marginal product peaks, then falls to zero,
and eventually becomes negative (meaning extra workers actually reduce total output).

Total output itself reaches its maximum when marginal product is zero, and falls once
marginal product is negative.

• Economists give monetary value to each worker’s contribution by multiplying the

marginal product by the price of the good, yielding the marginal revenue product
(MRP)—the market value of the work done by that worker.

• In a competitive market, equilibrium wages reflect this value: your wage should
equal your marginal productivity.

The lesson for economics is that DMR affects costs and pricing. When marginal
productivity falls, more inputs are required to produce an additional unit of output, so the
marginal cost (MC) of production rises.

There is also a relationship between marginal cost and average cost (AC): if MC is lower
than AC, it pulls the average down—just like a student’s grade below their average lowers
the average. But once diminishing returns set in and MC starts rising, eventually AC will
also rise.

In summary, the passage highlights a fundamental economic principle: the law of

diminishing marginal returns links the production function to both wages and cost
structures. It shows why firms face rising marginal costs, how wages are tied to marginal
productivity, and why efficiency gains from adding inputs are limited when capital is
fixed. This concept underpins the behavior of firms, the formation of prices, and the
distribution of income in an economy.

—--------
The passage explains the crucial difference between fixed costs, variable costs, and sunk
costs, and why understanding these concepts is vital for sound economic decision-
making.

A fixed cost is a cost that remains unchanged regardless of output, while a variable cost
changes with the level of output.

• The author uses a humorous Alan Bennett anecdote to illustrate this: when Miss
Shepherd requests “just half a cup” of coffee, it’s funny because most of the costs—
boiling the kettle, spooning coffee granules, adding sugar and milk, stirring—are
fixed. The variable costs, like the extra coffee or milk for half or full cup, are very
low, so her attempt to “save” the host effort is economically insignificant.

This distinction matters because not all costs should influence decisions. For example, a
company with two business units, one making £5,000 profit and another £40,000, also
has £20,000 of corporate overhead (such as rent, administrative expenses, joint
marketing). The overall business is profitable because total profits (£45,000) exceed
overhead. If the finance director arbitrarily allocates the overhead evenly—“charging”
£10,000 to each unit—it would look like the first unit is making a £5,000 loss, while the
second makes £30,000. This might tempt management to close the first unit.

• But this would be a mistake: fixed costs like overhead are economically
irrelevant to the decision because both units have a positive marginal
contribution—they both add to covering fixed costs. The assigned overhead is
merely for reporting purposes; in economics these costs are effectively sunk, and
should not “cloud your judgment.”

The text then illustrates the danger of the sunk cost fallacy with the case of Concorde.

• The British and French governments invested over £1 billion to develop the
supersonic passenger jet. Only 14 planes were built, and operations ran at a
significant loss. Faced with the choice to stop funding or continue in hopes of
recovering losses, policymakers kept investing to avoid “wasting” the initial
outlay.

• But the initial investment was a sunk cost—a cost incurred due to an irreversible
decision. The rational economic choice was to cut losses and reallocate
resources to projects with higher economic value. Instead, they delayed, wasting
even more resources until external shocks—the 2000 Air France crash and
September 11 attacks—forced Concorde’s abandonment in 2003.
The lesson is clear: sunk costs should never drive current or future decisions.
Economically, only future costs and benefits matter. Yet, the sunk cost fallacy is
common because admitting a sunk cost often means admitting past mistakes, which is
psychologically hard.

In economic terms, understanding fixed costs, variable costs, and sunk costs helps
managers and policymakers make rational choices:

• Fixed costs are unaffected by output changes and should not distort decisions
about whether to continue operations.

• Variable costs determine the marginal cost of producing extra output and are
crucial for pricing and production decisions.

• Sunk costs—past, irreversible expenditures—must be ignored in forward-looking

analysis, despite the emotional temptation to “recover” them.

This principle lies at the heart of efficient resource allocation, ensuring firms and
governments avoid waste and base decisions on marginal analysis and future economic
value, not past expenses.

—----------

The passage builds on the concepts of fixed costs, variable costs, sunk costs, and
marginal analysis, showing how they guide economic decision-making and prevent
costly errors.

First, it stresses that when fixed costs are treated as sunk—at least in the short term—
they must be ignored in decision-making.

A sunk cost has no opportunity cost, meaning it cannot be recovered and will occur
regardless of the decision. If a cost cannot be affected, it provides no useful
comparison between options.

Therefore, the focus should be on variable costs and the relationship between revenue
and variable costs, because these are the costs you can control in the short run.

This leads to the shutdown condition, a key economic rule:

 • A business unit should remain open as long as it can cover its variable costs,
even if it cannot fully cover fixed costs in the short run.

• Fixed costs are irrelevant to the decision of whether to open or shut down in the
short run because they are sunk—they must be paid whether or not the business
operates.

• In the long run, however, the firm must eventually cover total costs (variable +
fixed). If it cannot, it must exit the market, sell the business, or liquidate assets.

The passage applies this logic to a real-world example: advising a local probation service.
Although the public sector shows a higher average cost than the private sector across all
output levels, this does not automatically mean the private company is cheaper. The
public service’s higher average cost stems from higher fixed costs, which are irrelevant
in a marginal decision.

What matters is marginal cost—the cost of handling one additional case. The public
sector may actually have a lower marginal cost, meaning it can process each extra case
more cheaply than the private company.

This illustrates the lesson of marginal analysis:

• Economic thinking focuses on additional benefits and additional costs of the

next decision—“the margin.”

• Looking at total or average costs can be misleading if sunk costs inflate averages.

• Decisions must be forward-looking, not anchored to past expenses.

The same principle explains the success of low-cost carriers like easyJet. Traditionally,
airlines filled about 70% of seats, leaving many seats empty. But the marginal cost of an
extra seat is essentially 0—the plane is already flying, and adding a passenger costs
virtually nothing. Selling any unused seat for any price above zero contributes directly to
profit. Low-cost carriers exploited this by drastically reducing prices to fill more seats,
demonstrating how pricing based on marginal cost can transform an industry.

Finally, the passage warns managers to watch for transferred costs, or externalities—
situations where the decision maker does not bear the full cost of their actions.

Examples range from one department imposing costs on another to colleagues who make
others handle their travel booking or photocopying.

Such externalities distort the true signal of value creation, creating hidden cross-
subsidization.

The economist’s solution is to internalize the externality: ensure that decision makers
bear the costs of their actions, aligning private incentives with total social or
organizational costs.

Economic Essence and Lessons

• Ignore sunk costs: They have no opportunity cost and must not influence forward-
looking decisions.

• Shutdown condition: Stay open if revenue covers variable costs in the short run;
only exit when total costs cannot be met in the long run.

• Focus on marginal analysis: Make decisions based on marginal costs and

marginal benefits, not on inflated average costs.

• Price based on marginal cost: Like low-cost airlines, pricing can exploit situations
where the marginal cost of serving an extra customer is close to zero.
 • Internalize externalities: Ensure costs created by one party are borne by the same
party, preventing distorted decision signals.

In economics, these principles ensure efficient resource allocation, prevent the sunk
cost fallacy, and create incentives that reflect the true economic value of actions and
decisions.

—--------------

The passage ties together the key cost concepts—average cost, marginal cost, marginal
revenue, and the shutdown condition—to explain how a firm makes its supply decision
and, ultimately, how a market supply curve is formed.

Shape of the Average Cost Curve

To understand a firm’s short-term output decision, we start with the behavior of average
costs as output expands. Three forces determine the curve’s shape:

1. Average fixed costs (AFC) fall as output increases because a fixed numerator
(total fixed cost) is spread over a larger denominator (more units of output). This
always puts downward pressure on average costs.

2. Over some range of output, the variable input (for example, labour) exhibits
increasing returns to scale—workers specialize and become more efficient—
further lowering average costs.

3. But eventually, the law of diminishing returns sets in. As more labour is used while
capital is fixed, marginal productivity declines, and average costs begin to rise.

These forces create the classic “U-shaped average cost curve”. It might be steep or
shallow and may bottom out at different output levels, but because diminishing returns
inevitably appear, the “U” shape is universal.
Why Marginal Cost Curves Slope Upward

The law of diminishing marginal returns explains why marginal cost (MC) rises as output
grows: as you employ more labour, each extra unit of input produces less additional
output, so the cost per extra unit rises.

But there’s another reason: opportunity cost. The more labour you dedicate to one
production plan, the more you deny that labour to alternative uses, raising the
opportunity cost of producing extra units.

In contrast, marginal value curves (for consumers) slope downward: as people consume
more, the marginal benefit of each additional unit falls because it satisfies less urgent
needs. This contrast—upward-sloping marginal cost curves and downward-sloping
marginal value curves—is central to how markets find equilibrium.

Decision-Making at the Margin

Consumers act when expected marginal benefit exceeds expected marginal cost.
Firms act similarly: they compare marginal revenue (MR)—the revenue earned from
selling one more unit—with marginal cost (MC).

• In a perfectly competitive market, marginal revenue equals the market price of

the good.

• If MR > MC, the firm sells the extra unit for more than it costs to make, so producing
more boosts profit.

• If MR < MC, producing another unit costs more than it earns, so the firm reduces
output.

The firm reaches profit maximization when MR = MC. This is the classic rule for optimal
output.
The Two-Step Output Decision

The firm’s short-run supply decision unfolds in two steps:

1. Shutdown condition: First, decide whether to open at all. If revenue covers

variable costs, the firm should remain open even if it cannot fully cover fixed costs,
because those fixed costs are sunk in the short term.

2. Profit-maximizing output: If the firm stays open, it then chooses the level of output
where marginal revenue equals marginal cost.

From Marginal Cost to the Supply Curve

Combining these two steps reveals something fundamental:

• The portion of the marginal cost curve that lies above the shutdown point—
where the firm at least covers variable costs—is the firm’s supply curve.

This means that the supply curve is not an abstract concept but directly reflects the firm’s
cost structure and marginal decision-making.

Economic Essence and Lessons

• U-shaped average cost curves arise from the interplay of falling average fixed
costs, early increasing returns, and eventual diminishing returns.

• Marginal cost curves slope upward because of diminishing productivity and

rising opportunity costs.

• Firms maximize profit by producing where marginal revenue equals marginal cost,
mirroring how consumers act where marginal benefit equals marginal cost.
 • The shutdown condition ensures firms operate in the short run if variable costs
can be covered, even when fixed costs are not.

• The firm’s supply curve is simply the marginal cost curve above the shutdown
point, linking cost theory to the market supply side.

In economics, this framework shows how individual firm behavior—based on costs,

revenue, and marginal analysis—aggregates into the market supply curve, forming one
half of the price mechanism that drives market equilibrium.

2.3 Economies of Scale

The passage explains how economies of scale allow large firms to achieve significant cost
efficiencies, benefiting both the business and consumers, while also raising questions
about the balance between firm size and market efficiency.

Economies of Scale and Cost Efficiency

The central idea is that big isn’t always bad. In fact, in many cases, operating on a large
scale is the only way to generate the efficiency needed to bring a product to market at an
affordable price.

A striking example is Bic and the ballpoint pen:

• In the past, standard writing pens cost around $12.50, roughly a week’s worth of
average earnings.

• Bic exploited economies of scale—buying in bulk, streamlining production, and

mass-producing pens.
 • Within three years, Bic was selling 40 million pens per year, and by 2016, sales
reached 7 billion pens, with the average price falling to just 10 cents.

This was profitable for Bic and transformative for consumers, who now had cheap, high-
quality writing instruments.

Scale and Incentives to Economize

Being large also creates stronger incentives to reduce costs in other ways:

• Firms selling in huge volumes can justify large investments to reduce per-unit
costs, even if the savings are tiny on each unit.

• The bigger the firm, the greater the potential gains from recycling or finding
productive uses for waste.

For example, McDonald’s once reduced their napkin size by just one inch, which saved 3
million pounds of paper per year. For a small firm, this tiny change would hardly matter;
for a giant like McDonald’s, the scale makes such savings economically significant.

Trade-Off: Firm Efficiency vs. Market Efficiency

These examples show that large-scale operations can drive greater efficiency and ensure
that society makes the best use of scarce resources. However, there is also a challenge:

• We must weigh the efficiency of the firm against the efficiency of the market as a
whole.

• While economies of scale lower costs and prices, very large firms might also raise
questions about competition and whether their size remains in the consumer’s
long-term interest.
The text hints that this issue—whether bigger firms ultimately benefit or harm
consumers—will be explored further.

Economic Essence and Lessons

• Economies of scale mean that as a firm increases output, average costs fall,
enabling mass production and dramatically lower prices.

• Large-scale production allows companies to make tiny cost-saving innovations

that become hugely valuable when multiplied across millions or billions of units.

• Resource efficiency improves when large firms economize on materials (as in

McDonald’s napkin example), which can save enormous amounts of scarce
resources.

• However, market efficiency must also be considered: while big firms can reduce
costs and prices, their size can create market power or reduce competition, which
has broader economic implications.

In economics, this illustrates how scale and efficiency interact: large firms can create
consumer benefits through lower prices and better resource use, but society must
continually assess whether the efficiency gains of size outweigh potential risks to
competition and market health.

—---------

This passage uses a football (soccer) analogy to explain the short run vs. long run in
economics, particularly how time horizons affect decisions about resources, costs, and
planning.
Short Run: Managing with Fixed Constraints

In the short run, some factors of production (like factory size, equipment, or staff) are
fixed, so managers must focus on the optimal use of existing resources.

• Example: Rafael Benitez, hired as Chelsea’s interim manager in 2012–2013.

o He knew his position was temporary, so his strategy was to maximize

results with the players already available.

o He had little influence on player transfers and no reason to plan for the
team’s long-term development.

o His task: “What is the best use of my current resources?”

o Result: Won the 2013 Europa League, a clear short-term success.

This captures the economic short run: you work with what you have and aim for efficiency
given existing constraints.

Long Run: Planning When All Costs Are Variable

The long run means the planning horizon when all costs are variable—you can change
even the resources that were previously fixed.

• This doesn’t mean fixed costs disappear, but rather you have the freedom to
decide which fixed costs to commit to (for example, whether to build a bigger
factory or hire more permanent staff).
 • Key question: “How does scale impact long-run costs?”

Example: Arsène Wenger at Arsenal (1996–2018).

• With long-term security, he could sign young players with raw potential, develop
them, and sell at peak value, fitting the club’s conservative business model.

• He could plan for future success, not just immediate wins.

• Despite several trophyless years, his long-run planning eventually paid off with
multiple FA Cups and a sustainable club model.

• His key question: “What resources do I need?”

This reflects the economic long run, where businesses can adjust all factors of production
to reshape cost structures and scale operations.

Economic Lessons

• Short run vs. long run:

o Short run – Some inputs are fixed; focus is on using current resources
efficiently.

o Long run – All inputs are variable; focus is on planning and selecting the
optimal scale of operations.
 • Planning horizon: A concept that captures the long run as the period when a firm
can choose which fixed costs to incur.

• Scale and costs: Over the long run, firms evaluate economies or diseconomies of
scale, asking how changes in scale will affect average costs.

Essence

The difference between the short run and long run is not about time measured in days or
years, but about flexibility of decision-making:

• Short run = “How can I win with the resources I already have?” (Benitez).

• Long run = “What resources should I build or acquire for sustainable success?”
(Wenger).

In economics, recognizing this distinction is crucial for decisions on production,

investment, and cost management, showing how strategic planning horizons shape the
efficiency and growth of a firm.

—--------------

This section explains why the long-run average cost (LRAC) curve is “U”-shaped,
focusing on economies of scale and economies of scope—two key reasons why big
firms can be more cost-efficient.

Long-Run Average Cost (LRAC) Curve

• Like in the short run, the LRAC is “U”-shaped:

 o At first: Average costs fall as output rises because fixed costs are spread
over more units.

o Eventually: Costs rise again when firms grow too large and experience
diseconomies of scale (coordination problems, bureaucracy).

Economies of Scale: Falling Average Costs as Firm Size Grows

Economies of scale occur when average cost (AC) decreases as production increases.
They can be internal (within the firm) or external (within the industry).

Internal Economies of Scale

(average costs depend on the firm’s own size)

• Technical:

o Learning by doing

o More efficient machinery

o Specialization of workers

o Better use of waste products

• Commercial:
 o Bulk buying (input discounts)

o Spreading advertising costs across more units

• Financial:

o Easier access to cheaper finance (banks view big firms as less risky)

• Managerial:

o Spreading the cost of HR, legal, accounting teams over more output

• Risk-bearing:

o Can invest in R&D and diversify products to spread risk.

External Economies of Scale

(average costs depend on the size of the industry or cluster, not just one firm)

• Political: Greater lobbying power to influence policy.

• Infrastructure: Shared transport hubs, communication networks.

 • Access to raw materials & skilled labour: Easier sourcing within an established
industry.

• Knowledge spillovers: Publicly funded research or shared technical know-how.

• Foot traffic: High customer density benefits all firms in an industry cluster.

Real-World Examples

• Big-box retailers (Staples, out-of-town supermarkets):

o Secure exclusive supplier deals—suppliers compete to sell, pushing prices

down.

o Both retailer and supplier share the profit from large-scale efficiency.

Economies of Scope: Cost Savings from Producing Multiple Products

Economies of scope occur when it’s cheaper to produce multiple goods together than
separately.

• Firms share physical assets, R&D, or technical know-how across product lines.

• Example: BMW’s Xdrive gear shift

 o Designed to fit their entire range of vehicles, spreading the R&D cost.

o Smaller firms making specialized versions cannot match this cost efficiency.

Economic Takeaways

• Big isn’t automatically bad—large firms can lower costs and use resources more
efficiently.

• Internal economies of scale reward firms that expand production.

• External economies of scale reward industries that grow as a whole.

• Economies of scope let big firms diversify cheaply and serve larger markets.

Essence

The long-run “U-shaped” cost curve reflects that initial growth lowers costs (economies
of scale and scope), but beyond a certain point, diseconomies can push costs back up.
This explains why some industries naturally favor large-scale operations and why
diversification strategies can be a powerful source of competitive advantage.

—-----------

Core Idea

Firms can lower their average costs at first through economies of scale and sometimes
economies of scope, but this cannot continue indefinitely.
Eventually diseconomies of scale set in, making average costs rise again, which places a
natural limit on how big firms can efficiently grow.

Economies of Scale – When Bigger is Cheaper

Definition: As output expands, average costs (AC) initially fall because costs are spread
over more units and operations become more efficient.

Why AC Falls:

• Fixed costs spread across more units.

• Specialization & division of labor—workers and machinery become more efficient.

• Bulk buying power—lower input prices when purchasing at scale.

• Better financing & managerial specialization—large firms get cheaper credit and
can afford expert departments.

The Myth of Infinite Growth

Some critics of capitalism argue that average cost curves slope downward forever,
implying firms could grow without limit and concentrate capital into massive
“behemoths.”

Reality: This is impossible because at some point:

• Marginal costs rise,

 • Diminishing returns dominate, and

• Average costs begin to increase.

This turning point creates diseconomies of scale.

Diseconomies of Scale – When Bigger Becomes Inefficient

As firms expand beyond the optimal size, the following factors drive average costs
upward:

Key Drivers:

• Managerial costs:

o More layers of hierarchy → higher expenses for coordination, control, and

monitoring.

• Local knowledge limits:

o Large organizations can lose touch with local market conditions.

• Innovation & creativity constraints:

o Bureaucracy slows decision-making and stifles creativity.

 Real-World Example:

• The Economist (July 2008) warned that mega-banks like Citigroup (Citi) and AIG
had become “too complex for anyone to run.”

• Managers of FTSE 100 companies reportedly laugh at the idea that scale
automatically brings efficiency—they know from experience that complexity often
leads to waste.

Optimal Scale Varies by Industry

The “right” size for a firm is set by where the long-run average cost (LRAC) curve is at its
lowest.

Industries Where Large Scale Works:

• High fixed costs + low managerial costs mean size delivers efficiency.

o Examples:

▪ Energy companies

▪ Telecommunication firms

▪ Franchised fast-food chains

 o ➡ Few “boutique oil companies” exist because scale is critical.

Industries Where Smaller Scale Is Optimal:

• Where creativity, craftsmanship, or local adaptability matter.

o Examples:

▪ High-quality restaurants

▪ Plumbers

▪ Estate agents (real estate brokers)

Industries with Flat Long-Run Costs:

• Size gives little cost advantage.

o Example: Consulting – giant firms like Accenture compete effectively with

small specialist partnerships at similar cost structures.

Big vs. Small: Competing Advantages

An advertisement by DHL perfectly captures the tension:

 • A small-business manager complains about the market power of large
competitors.

• A large-company manager complains that startups are more agile.

➡ Lesson: Both large and small firms enjoy unique advantages—market power vs.
flexibility. There is no universal winner.

Knowledge-Intensive Firms: “Economies of Ideas”

Pharmaceutical companies highlight a special case:

• They benefit from economies of ideas:

o The larger the firm, the higher the chance of hiring the researcher who
discovers the next blockbuster drug.

• BUT:

o Working with genius talent can be risky.

o The Economist notes that “talent-driven firms can be torn apart by feuds
or rendered dysfunctional by egocentric behaviour.”

➡ Scale helps attract talent but can create internal conflicts.

Economic & Policy Insight

• Capitalism does not inevitably produce endless corporate giants.

o Average cost curves are not downward-sloping forever.

• The optimal scale depends on:

o The balance of economies (falling costs from growth) and

o Diseconomies (rising costs from complexity).

• The best policy approach is to let firms experiment and discover their efficient
scale through market forces.

Bottom Line

• Early growth brings economies of scale and scope, lowering costs and rewarding
efficiency.

• But eventually, diseconomies of scale—managerial complexity, loss of local

knowledge, and reduced innovation—push costs back up.
 • The result is a U-shaped long-run average cost (LRAC) curve.

• Optimal firm size varies by industry:

o Large scale for high fixed-cost sectors (energy, telecoms).

o Small or mid-size for creativity-based or service industries (restaurants,

consulting).

Efficient markets allow firms to find this “sweet spot” naturally.

2.4 — Cost vs. Waste

Opportunity Cost & Hidden Costs in Management Decisions

Key Concept – Opportunity Cost

Opportunity cost is the value of the next best alternative that is sacrificed when a decision
is made. Managers must constantly ask:

• “What am I giving up by choosing this option?”

• “Is this the best use of my time, people, and resources?”

When opportunity costs are hidden or ignored, organizations waste time and money
without realizing it.

Hidden Costs of Meetings

 • Time as a True Cost:

o Average office worker: 16 hrs/week in meetings → ¼ of that time wasted.

o Civil servants: 22 hrs/week, ⅓ of that time wasted.

• A one-hour meeting with 6 people = 6 hours of total labor time.

• Meetings seem free because there’s no receipt, but the real cost equals the value
of what those people could be doing instead (their market wage approximates
this).

Insight: If managers were billed for participants’ time, meetings would be fewer,
shorter, and more productive.

Real-World Applications & Examples

1. Koch Materials Company (KMC)

• Situation: Profitable asphalt plant in Iowa. No intention to move.

• Observation: A sales rep noticed a casino searching for land nearby.

• Decision: Recognized that the casino valued the land more → sold the property.
 • Lesson: By understanding opportunity cost, KMC moved resources (land) to a
higher-value use, earning more than if they kept the plant.

2. Economic Value Added (EVA)

• EVA is a financial management technique that embeds opportunity-cost thinking in

company decisions.

• It ensures managers consider the true cost of using capital and resources.

3. Hidden Costs of Office Space – BT Example

• Some companies like BT charge managers £8,000 per desk/year to make costs
visible.

• If a team often works remotely, a manager cannot justify that expense.

• Response: Move to a location that costs £6,000 per desk, conserving budget.

• Result:

o Manager saves resources for higher-value needs.

 o Freed-up office space goes to a team that values it more.

Lesson: When costs become visible, resources shift from low-value to high-value
uses—this is exactly how markets allocate efficiently.

Managerial Takeaways

• Make hidden costs explicit—time, space, capital all have opportunity costs.

• Treat every meeting, asset, or resource as having a real economic price.

• Use opportunity-cost reasoning to drive decisions that maximize value creation.

• When markets expose costs, decision-making becomes clearer and more

efficient.

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Opportunity-Cost Reasoning & the Right Way to Manage Costs

Practical Ways to Apply Opportunity-Cost Thinking

• Standing Meetings:

o Holding meetings standing up makes them substantially quicker, while

research shows decision-making quality stays the same.
 o Some firms schedule meetings right before lunch for a similar effect—
people naturally keep them short.

• Historical Example – King Ferdinand I of Romania (Pelisor Castle):

o His chest-height desk with no chair forced him to work and hold meetings
standing up, encouraging brevity.

Lesson: Simple structural choices can internalize opportunity-cost reasoning by

making time spent more valuable.

Costs Are Subjective

• Nick Hornby – Fever Pitch Example:

o While house-hunting near Arsenal’s Highbury stadium, Hornby pretends

that football crowds are a nuisance to negotiate a lower price.

o In reality, as an ardent Arsenal fan, living close to the stadium is a benefit,

not a cost.

Key Insight:

• One person’s cost can be another’s benefit.

• Costs, like value, are subjective—what is costly for one may be desirable for
another.
Costs Signal Scarcity, Not Something to Eliminate

• Costs are the market’s way of showing resource scarcity.

• Managers must expose hidden costs and optimize resource use, but:

Optimize, don’t just minimize.

o Cutting costs ≠ Eliminating waste.

o Blind, across-the-board cuts:

▪ May seem fair and low-cost to implement, but

▪ Show a lack of insight and leadership—they signal you don’t know

where the real waste is.

▪ Avoid making tough decisions about where waste actually occurs.

Managerial Responsibility:

• Find and eliminate true waste, not just slash budgets.

 • Courageous leadership means identifying specific inefficiencies rather than hiding
behind blanket cost cuts.

Core Managerial Takeaways

• Use structural nudges (like standing meetings) to shorten low-value activities.

• Recognize that costs are subjective—different stakeholders assign different

values.

• Treat costs as signals of scarcity: analyze them to guide resources to their highest-
value use.

• Do not equate cost-cutting with good management—focus on eliminating waste

and optimizing resources, not on indiscriminate reductions.