COSTS

Assumptions

• Two inputs are used together in production.

• Inputs are homogeneous in themselves.

• The level of technology is constant.

• Input prices (wage w, interest rate i) are constant.

1. Total Costs

“Total Fixed Cost (TFC)”

• This is the cost that the firm incurs independent of the level of output. In other words, it
is the payment the firm must make for fixed inputs (K = capital).

• The total fixed cost curve is drawn as a horizontal line because fixed costs do not
change with output. In the graph, quantity (Q) is shown on the horizontal axis and fixed
costs on the vertical axis.

“Total Variable Cost (TVC)”

• This is the cost the firm incurs depending on the level of output. In other words, it is the
payment the firm makes for variable inputs (L = labor).

• The total variable cost curve increases first slowly and then rapidly as output increases.

“Total Cost (TC)”

• Total cost is the sum of total fixed cost and total variable cost:

• Total cost increases slowly at first, then more rapidly as output increases. The shape of
the TC curve is determined by the TVC curve.

• Total cost is a function of the level of output and therefore is written as:

Important Note

The reason TC and TVC curves increase slowly at first and then rapidly is the Law of
Diminishing Returns.

The vertical difference between the TC and TVC curves (|K–L|) is equal to total fixed cost (TFC) at
every output level.
I. Cost Analysis

Cost analysis examines all expenditures necessary for a firm to produce output. In
microeconomics, the concept of cost includes both explicit monetary payments and implicit
opportunity costs arising from the use of resources owned by the firm.

1. Explicit (Accounting) Costs

Explicit costs are the actual monetary payments a firm makes to purchase or hire inputs used in
production. These include:

• Wages paid to workers,

• Rent paid for land or buildings,

• Interest paid on borrowed capital,

• Payments for raw materials, utilities, and other operating expenses.

Since these payments are recorded in accounting books, they are called accounting costs.

2. Implicit (Economic) Costs

Implicit costs (also called imputed or opportunity costs) are the value of resources owned by
the firm and used in production without explicit payment.
Examples:

• The income the owner forgoes by working in the firm instead of elsewhere,

• The return that could have been earned if the firm’s own capital had been invested in an
alternative project.

Even though no monetary payment is made, these costs reflect sacrificed opportunities and
therefore are part of economic cost.

3. Economic Cost and Profit

Economic cost is the sum of explicit and implicit costs:

Economic profit is defined as:

A firm earns:

• Normal profit if economic profit = 0,

• Supernormal profit if economic profit > 0,

• Economic loss if economic profit < 0.

For firms aiming to maximize profit, total economic cost—i.e., the sum of explicit and implicit
costs—must be considered when choosing the optimal production level.
A. Short-Run Cost Analysis

Short-run cost analysis is based on the assumption that at least one input is fixed (usually
capital, K) while the other input (usually labor, L) is variable. Output can be changed only by
altering the quantity of the variable input.

Short-run analysis relies on the following assumptions:

• Only one input is variable (labor), while the other is fixed (capital).

• Inputs are combined according to a given technology.

• Inputs can substitute each other to some degree.

• The level of technology and input prices (wage w, interest rate i) are constant.

Short-run costs are categorized as follows:

1. Total Fixed Cost (TFC)

• The cost incurred for fixed inputs,

independent of the level of output.

• Since the firm must pay for fixed inputs

regardless of production level, TFC remains constant.

Graph: A horizontal line parallel to the quantity axis.

2. Total Variable Cost (TVC)

• The cost associated with variable inputs and

thus changes with the level of output.

• In the short run, labor is typically the variable input:

• Due to the Law of Diminishing Marginal Returns, TVC:

o increases slowly at first,

o then rises rapidly as output expands.

3. Total Cost (TC)

Total cost is the sum of fixed and variable costs:

 • The TC curve has the same shape as the TVC curve but is vertically higher

by the amount of TFC.

• TC increases slowly at first, then more steeply, again due to diminishing returns.

Relationship:

4. Cost Curves and Production Relationship

The shapes of TVC and TC curves are fundamentally determined by the marginal productivity of
the variable input. As the marginal product rises, costs increase slowly; as marginal product
declines, costs begin to rise rapidly.

This explains why:

• TC and TVC curves are initially flatter,

• but become increasingly steeper at higher levels of output.

2. Average Costs

Average cost measures reflect a firm’s per-unit cost of production. They are derived by dividing
total cost components by the level of output (Q). These measures allow firms to evaluate
efficiency and identify the optimal scale of production in the short run.

The three key average cost concepts are:

1. Average Fixed Cost (AFC)

2. Average Variable Cost (AVC)

3. Average Total Cost (ATC or AC)

Each is explained in detail below.

2.1 Average Fixed Cost (AFC)

Average fixed cost is the fixed cost per unit of output. Since total fixed cost (TFC) is constant at
all output levels:

Key Properties

• AFC always declines as output increases because a

constant cost is spread over a growing quantity.

• The AFC curve is downward-sloping, approaching zero but never touching the
horizontal axis.

• AFC explains the “spreading effect” of fixed costs: higher production reduces the burden
of fixed expenses per unit.
2.2 Average Variable Cost (AVC)

Average variable cost is the variable cost per unit of output:

Given that:

and

AVC can be rewritten as:

Key Properties

• The AVC curve is U-shaped.

o Initially declines because increasing marginal returns cause output to grow

faster than labor input.

o Later rises due to the Law of Diminishing Returns, as each additional unit of
labor adds less to output.

• AVC reaches its minimum point where average product of labor (AP_L) is maximized.

• Since wage (w) is constant, AVC is essentially the inverse of the average product curve.

Relationship with Production Theory

• When AP_L increases → AVC decreases.

• When AP_L decreases → AVC increases.

Thus, AVC mirrors the productivity behavior of the variable input.

2.3 Average Total Cost (ATC or AC)

Average total cost represents the total cost per unit of output:

Since total cost is the sum of fixed and variable costs:

Key Properties

• The AC curve is also U-shaped, combining the effects of decreasing AFC and U-shaped
AVC.

• At low output levels:

o AFC decreases rapidly and pulls AC downward.

• At higher output levels:

o AVC rises quickly due to diminishing returns, pulling AC upward.

• The AC curve reaches a minimum point where marginal cost (MC) intersects it.

2.4 Relationship Between AC, AVC, and AFC

From the identity:

AC = AFC + AVC

• The vertical distance between the AC and AVC curves is AFC.

• As output increases, AFC decreases, so the gap between AC and AVC narrows.

• At large output levels:

o AC and AVC become close,

o but never intersect, because AFC never becomes zero.

2.5 Graphical Interpretation and Key Insights

1. AC lies above AVC

Because:

AFC > 0

AC is always greater than AVC, and the difference shrinks as output grows.

2. Minimum Point Relationship: AC, AVC, and MC

• The MC curve intersects both AVC and AC at their minimum points.

• When MC < AVC or AC → AVC and AC decrease.

• When MC > AVC or AC → both increase.

Thus, MC drives the shape of both average cost curves.

3. Slope Interpretation Using TC and TVC Curves

• The slope of a ray drawn from the origin to a point on the TC curve equals AC at that
output level.

• The slope of a ray drawn from the origin to

the TVC curve equals AVC.

 • The minimum AC corresponds to the point where a ray from the origin is tangent to the
TC curve.

4. Three Stages of Production and Cost Behavior

1. Stage I

o MC < AVC

o Both AVC and AC decrease.

2. Stage II

o Starts where MC = AVC

o Ends where MC = AC

o Rational production range: MC is rising; AVC and AC eventually rise.

3. Stage III

o MC > AC

o Costs rise rapidly; production becomes inefficient.

Summary Table

Cost Measure Formula Shape Key Determinant

AFC TFC / Q Downward-sloping Spreading fixed cost

AVC TVC / Q U-shaped Productivity of variable input

AC (ATC) TC / Q U-shaped Combined effect of AFC + AVC

3. Marginal Cost (MC)

Marginal cost is the additional cost incurred by producing one more unit of output. It reflects
how total cost changes as output changes, and therefore plays a critical role in production
decisions and cost minimization.

Formally, marginal cost is defined as:

In the continuous form:

Because fixed costs do not change with output, marginal cost is also equal to the change in
total variable cost:
3.1 The Shape of the Marginal Cost Curve

The MC curve is U-shaped, reflecting the behavior of marginal product in the short run:

• Initially decreasing MC:

At low levels of output, increasing marginal product causes MC to fall.

• Eventually increasing MC:

As production expands, the Law of Diminishing Marginal Returns sets in: additional
units of labor contribute less to output, making the cost of producing an extra unit rise.

Thus, the U-shape of the MC curve mirrors the inverted U-shape of the marginal product curve.

3.2 Relationship Between Marginal Cost and Marginal Product

Since labor is the variable input and wage is constant:

Implications

• When marginal product (MP_L) rises → MC falls.

• When marginal product declines → MC rises.

Thus, the MC curve is the mirror image of the MP curve.

3.3 MC and the Total Cost Curve

Graphically:

• The slope of the TC curve at any quantity equals the

MC at that quantity.

• When TC increases at a decreasing rate, MC declines.

• When TC increases at an increasing rate, MC rises.

• The point where TC changes from decreasing to increasing curvature corresponds to the
minimum point of MC.

3.4 MC as the Key Driver of Other Cost Curves

Marginal cost determines the behavior of both AVC and AC:

• When MC < AVC → AVC decreases.

• When MC > AVC → AVC increases.

 • When MC < AC → AC decreases.

• When MC > AC → AC increases.

Intersection Points

• MC intersects AVC at AVC’s minimum point.

• MC intersects AC at AC’s minimum point.

This is because average measures reach their minimum when marginal equals average.

3.5 Graphical Relationships Summarized

1. MC cuts AVC and AC at their minimum points.

Because average values fall when the marginal is below them, and rise when marginal is above.

2. MC is below AVC and AC when they are decreasing.

Costs fall as long as MC contributes less than the average.

3. MC is above AVC and AC when they are increasing.

Costs rise when the additional unit becomes more expensive than previous units.

3.6 MC and Variable Cost Area

The area under the MC curve up to any output level equals the total variable cost (TVC):

(As shown in the provided note:

“The area under the marginal cost curve equals total variable cost.”)

3.7 Total Cost–Marginal Cost Relationship

From the TC curve:

• A line drawn from the origin that is tangent to the TC curve

indicates the minimum AC point.

• At this quantity:

MC = AC

• The slopes of lines drawn from the origin to different

points on the TC curve reflect AC at those quantities.

• The slope of the TC curve at any point is MC.

Thus, TC–AC–MC relationships are geometrically consistent.

3.8 Marginal Cost and the Three Stages of Production

Based on the production–cost connection:

Stage I

• MC < AVC

• Both AVC and AC fall.

Stage II (efficient production range)

• MC intersects AVC and later AC.

• MC rises as diminishing returns dominate.

Stage III

• MC > AC

• Costs increase sharply; production is irrational beyond this point.

Summary of Marginal Cost

Concept Formula Behavior Determinant

Marginal product of
Marginal Cost ΔTC / ΔQ U-shaped
labor

MP↑ → MC↓; MP↓ →

Relation to MP MC = w / MP_L Diminishing returns
MC↑

Relation to AVC & Intersects at minimum Drives average cost

Curvature of TC
AC points curves

4. The Three Stages of Production

In the short run, where one input is variable (labor, L) and the other is fixed (capital, K), the
relationship between labor and output creates three distinct stages of production. These
stages are directly linked to marginal cost (MC), average variable cost (AVC), and average total
cost (AC).

The stages are determined by the behavior of:

• Marginal Product (MP_L)

• Average Product (AP_L)

• Marginal Cost (MC)

• Average Variable Cost (AVC)

• Average Total Cost (AC)

Stage I: Increasing Returns (Rational Expansion Phase Begins)

Definition:
Stage I begins at zero input and ends where the average product of labor (AP_L) reaches its
maximum.
Characteristics

• MP_L > AP_L, and both are rising initially.

• MC < AVC, and both cost curves are decreasing.

• Labor becomes increasingly productive.

• Cost per unit falls rapidly.

Interpretation

Production in this region is inefficient because the firm has not yet

used its fixed input (capital) effectively. Output increases more than proportionally to labor
input.

Stage II: Diminishing Returns (Rational Production Region)

Definition:
Stage II begins where AP_L is maximum and ends where MP_L becomes zero.

Characteristics

• MP_L is positive but declining.

• AVC and MC reach their minimums and begin to rise.

• MC intersects AVC and AC within this stage.

• AP_L declines, but labor still adds positively to total output.

Interpretation

• This is the only rational production stage.

• Firms operate here because:

o Each additional unit of labor still increases output,

o But at a decreasing rate,

o Allowing cost-minimizing optimization.

Stage III: Negative Returns (Irrational Region)

Definition:
Stage III begins when MP_L becomes negative.

Characteristics

• MP_L < 0, meaning additional labor reduces total output.

• MC > AC and AVC, and cost curves rise sharply.

• Excess labor disrupts production efficiency.

Interpretation

• No rational firm operates in this stage.

 • Adding more labor wastes resources and increases costs disproportionately.

5. The Capacity Problem (Kapasite Sorunu)

Short-run capacity is determined by the behavior of the average cost (AC) curve. A firm’s
position on the AC curve indicates whether it is operating below capacity, at capacity, or above
capacity.

1. Under-Capacity (Eksik Kapasite)

Definition:
The firm operates under capacity when it produces at a quantity where AC is decreasing.

Graphically:

If output = Q₁, where AC slope is negative:

• The firm is not fully utilizing its fixed resources.

• Per-unit cost continues to fall with additional production.

• There is spare capacity—additional output reduces AC.

2. Full Capacity (Tam Kapasite)

Definition:
Full capacity occurs at the minimum point of the AC curve (Q₂).

Characteristics

• AC is minimized.

• MC = AC at the lowest point.

• Fixed and variable inputs are used most efficiently.

Interpretation

• This is the level of optimal efficiency in the short run.

• Producing more or less than Q₂ increases average cost.

3. Over-Capacity (Aşırı Kapasite)

Definition:
The firm operates beyond capacity when it produces at a quantity where AC is increasing (Q₃).

Implications

• Costs rise as output expands.

• Labor and machinery become over-utilized.

• Congestion and inefficiencies appear due to diminishing returns.

Interpretation

Producing beyond Q₃ is undesirable unless the firm expects higher prices that justify higher cost
per unit.
Summary Table

Concept Output Range Cost Behavior Production Behavior

Stage I 0 → max AP_L AC, AVC, MC decrease Increasing returns

Stage II max AP_L → MP_L = 0 MC rises, cuts AVC & AC Diminishing returns (rational)

Stage III MP_L < 0 AC, AVC, MC rise sharply Negative returns

Capacity: Under AC decreasing Not fully effective use Spare capacity

Capacity: Full AC minimum MC = AC Efficient capacity

Capacity: Over AC increasing Over-utilization Congestion

B. Long-Run Cost Analysis

In the long run, all inputs are variable, and firms have full flexibility to adjust plant size, labor
usage, and technology. Unlike the short run—where at least one input is fixed—the long run
allows firms to choose the most efficient combination of inputs for any desired level of output.

Long-run cost analysis focuses on:

1. Long-Run Total Cost (LRTC)

2. Long-Run Average Cost (LRAC)

3. Long-Run Marginal Cost (LRMC)

4. Economies and Diseconomies of Scale

5. Least-Cost Input Combinations (Isoquants & Isocosts)

6. Relationship between Short-Run and Long-Run Costs

1. Long-Run Total Cost (LRTC)

Since all inputs are variable, long-run total cost is the minimum cost of producing any given
output level using optimally chosen input combinations.

• Firms choose combinations of labor (L) and capital (K) that lie on the lowest-cost
isocost line tangent to a given isoquant.

• Every output level corresponds to an optimized input combination.

Thus, LRTC is not simply the sum of fixed and variable cost—it is the optimized envelope of all
possible short-run cost functions.
2. Long-Run Average Cost (LRAC)

The LRAC curve shows the minimum average cost of producing each output level when the
firm can adjust all inputs freely.

Shape

LRAC is typically U-shaped, but generally flatter than short-run average cost curves.

Its shape reflects:

• Economies of scale (cost advantages as output increases)

• Constant returns to scale

• Diseconomies of scale (cost disadvantages when scale becomes too large)

3. Long-Run Marginal Cost (LRMC)

LRMC represents the additional cost of producing one more unit of output in the long run.

Properties

• LRMC intersects LRAC at LRAC’s minimum point.

• When LRMC < LRAC → LRAC decreases.

• When LRMC > LRAC → LRAC increases.

4. Economies and Diseconomies of Scale

A. Economies of Scale (Ölçek Ekonomileri)

Occurs when increasing output reduces average cost:

Reasons (from page content):

• Increased specialization of labor and capital

• Better utilization of fixed resources

• Technological advantages in larger-scale production

• Spreading of management and R&D costs

• More efficient use of equipment

B. Constant Returns to Scale

Occurs when increasing output does not change average cost:

 • Output increases proportionally with inputs.

• Firm operates at its most productive range.

C. Diseconomies of Scale (Olumsuz Ölçek Ekonomileri)

Occurs when increasing output increases average cost:

Causes (as noted in the material):

• Managerial difficulties in large organizations

• Coordination and communication problems

• Worker inefficiencies or low motivation

• Congestion of production facilities

• Hiring of increasingly less productive inputs

5. Isoquants and Isocosts in Long-Run Cost Minimization

Isocost Line

Represents all combinations of labor and capital that cost the same amount:

Isoquant

Shows all input combinations that produce a fixed output level.

Optimal Combination

The cost-minimizing input combination occurs where the isoquant is tangent to the isocost
line:

This tangency defines the lowest-cost input bundle for producing each output level, and
tracing these points forms the LRAC curve.

6. Relationship Between Short-Run and Long-Run Costs

Long-run cost curves are the envelope of short-run average cost curves (SRACs). Each SRAC
corresponds to a specific plant size or capital level.
Key Points from the Pages

• LRAC touches each SRAC at its minimum point.

• When the firm grows, it shifts to a new SRAC with a more efficient plant size.

• LRAC forms a smooth, U-shaped curve connecting the minimum points of many SRACs.

Interpretation

• A firm chooses the SRAC curve that minimizes cost for the desired output.

• Long run gives flexibility → firm picks the optimal scale plant.

• Short run restricts flexibility → firm is stuck with one plant size.

Summary of Long-Run Cost Analysis

Concept Explanation

LRTC Minimum total cost with variable inputs

LRAC Per-unit cost in long run; U-shaped

LRMC Cost of one more unit; intersects LRAC at minimum

Economies of Scale LRAC falls with output

Diseconomies of Scale LRAC rises with output

Isocost + Isoquant Tangency yields cost-minimizing input mix

SRAC–LRAC Relationship LRAC is the lower envelope of SRACs

3. Changes in the Isocost Line

The isocost line represents all combinations of labor (L) and capital (K) that a firm can purchase
for a given total cost level.
Its general form is:

Solving for K:

Thus:

• Vertical intercept = (C/r)

• Slope = (-w/r)

• Horizontal intercept = (C/w)

An isocost line changes position or slope depending on changes in the firm’s total cost, wage
rate, or rental rate of capital.

Below are the three types of changes explained exactly as in the page.

A. Changes in Total Cost (C)

1. Increase in Total Cost

• When total cost increases, the isocost line

shifts outward (parallel shift).

• Both intercepts ((C/r) and (C/w)) increase.

• Slope does not change.

Interpretation:
The firm can purchase more labor and capital at every input ratio.

2. Decrease in Total Cost

• When total cost decreases, the isocost line

shifts inward (parallel shift).

• Both intercepts decrease.

• Slope remains unchanged.

Interpretation:
The firm’s budget constraint tightens; it can hire fewer inputs at every combination.

B. Changes in Input Prices

1. Changes in Wage (w)

a. Increase in Wage

• The isocost line becomes steeper

(slope becomes more negative: (-w/r) increases in magnitude).

• Vertical intercept ((C/r)) stays the same.

• Horizontal intercept ((C/w)) moves left

because labor becomes more expensive.

Conclusion:
The firm substitutes away from labor toward capital (capital becomes relatively cheaper).

b. Decrease in Wage

• The isocost line becomes flatter.

• Vertical intercept stays the same.

• Horizontal intercept moves right (labor becomes cheaper).

Conclusion:
The firm uses relatively more labor.

2. Changes in Rental Rate of Capital (r)

a. Increase in r (price of capital rises)

• Vertical intercept ((C/r)) moves downward.

• Horizontal intercept remains unchanged.

• The isocost line becomes flatter.

Conclusion:
The firm substitutes labor for capital.

b. Decrease in r (price of capital falls)

• Vertical intercept moves upward.

• Horizontal intercept does not change.

• The isocost line becomes steeper.

Conclusion:
The firm uses relatively more capital.

C. Simultaneous Changes in Input Prices

When both input prices change simultaneously, the shape and position of the isocost line
depend on:

• the relative magnitude of the price changes, and

• whether one input becomes relatively cheaper.

Possible outcomes:

• Rotation + shift outward

• Rotation + shift inward

• Pure rotation if total cost remains the same

• Parallel shift if both prices change proportionally

Interpretation:
The firm adjusts its input mix to the new relative prices, moving to a different tangency point
with the isoquant.

Summary of All Isocost Line Changes

Change Effect on Isocost Line Result

↑ Total Cost Parallel outward shift More inputs affordable

↓ Total Cost Parallel inward shift Fewer inputs affordable

Change Effect on Isocost Line Result

Labor substituted with

↑ Wage (w) Steeper line; L-intercept shrinks
capital

Capital substituted with

↓ Wage (w) Flatter line; L-intercept expands
labor

↑ Rental rate (r) Flatter line; K-intercept drops Use more labor

↓ Rental rate (r) Steeper line; K-intercept rises Use more capital

Both prices Rotation + shift (depends on relative

New optimal combination
change change)

C. Producer Equilibrium (Least-Cost Production)

For producer equilibrium, the following assumptions hold:

• The firm must use its total cost completely.

• The firm aims to maximize profit.

Under these assumptions, with fixed production technology, the firm reaches equilibrium at the
point where it produces the highest possible output at the lowest possible cost.

At the equilibrium point (E_1), the marginal rate of technical substitution equals the ratio of
input prices:

Explanation

At the firm’s equilibrium, the isoquant and the isocost line are tangent to each other. At this
point, the firm minimizes cost by equalizing the marginal product per lira spent on each input.

Important Note

A firm minimizes its total cost by equalizing the marginal products per lira spent on each input.

D. Changes in Producer Equilibrium

1. Change in the Price of One Input

If total cost (TC), technology (T), and capital price (i) remain constant, but the wage rate
increases, the isocost line rotates inward (toward the vertical axis).
 • The slope becomes steeper.

• The new equilibrium becomes point (E2).

If the wage decreases, the isocost line rotates outward

(toward the horizontal axis).

• The slope becomes flatter.

• The new equilibrium becomes point (E1).

2. Change in Total Cost (Shift in Cost Opportunities)

When input prices (w, i) and technology (T) remain constant, if total cost rises, the isocost line
shifts outward parallel to itself, leading to a new equilibrium (E2).

If total cost decreases, the isocost line shifts inward,

and equilibrium moves to point (E1).

Important Note

The path formed by successive equilibrium points

as cost conditions change is called the expansion path.

3. Change in Production Technology

If input prices (w, i) and total cost remain constant but technology changes, the isoquant shifts.

• If new technology requires less input, the isoquant moves toward the origin.

• If production requires more input, the isoquant shifts away from the origin.

Thus, the point of tangency between the isoquant and the isocost line changes.
E. Long-Run Average Cost Curve (LRAC)

The LRAC curve represents the minimum cost per unit of output in the long run.

Key Features

• LRAC is also called the envelope curve or planning curve, because it envelops many
short-run average cost curves (SRAC).

• LRAC is U-shaped in general.

1. Long-Run Average Cost Curve and Scale Economies

The LRAC curve has three regions:

I. Region (Economies of Scale)

• LRAC slope is negative (declining).

• As SRAC curves decline, LRMC curves are tangent to LRAC.

• The SRMC curve intersects the SRAC curve to the right of its minimum.

Interpretation:
The firm experiences increasing returns to scale, meaning average cost falls as the scale of
production increases.

II. Region (Constant Returns to Scale)

• LRAC is flat (horizontal).

• SRAC is tangent to LRAC at its minimum.

• SRMC intersects SRAC at the minimum point as well.

Interpretation:
The firm experiences constant returns to scale, meaning average cost remains constant as
output increases.

III. Region (Diseconomies of Scale)

• LRAC slope is positive (rising).

• SRAC is tangent to LRAC but now the SRMC curve

intersects SRAC to the left of its minimum.

• LRAC rises as output expands.

Interpretation:
The firm experiences decreasing returns to scale, meaning average cost rises with expansion.

F. Economies of Scale

1. Internal Economies of Scale

Internal economies occur within the firm and reduce average costs as production expands.
Disadvantages arising from scale are called internal diseconomies.

Graphical Summary

• LRAC decreases in the region of economies of scale.

• LRAC increases in the region of diseconomies.

Sources of Economies and Diseconomies

Economies or diseconomies may arise from:

• Management efficiency

• Marketing and sales

• Transportation

• Inventories and storage

• Specialization of labor and technology

Important Note

In many exam questions, “economies of scale” is shorthand for positive economies of scale
unless otherwise specified.

Learning Curve

Beyond scale effects, firms may experience cost reductions from learning by doing.
As workers gain experience, the average cost of production decreases even at a fixed scale of
operation.

This is illustrated through a learning curve, where average cost declines as cumulative
production experience increases.

2. External Economies

External economies arise from the scale of the industry as a whole.

• If the industry grows and this reduces costs, it is a positive external economy.

• If it increases costs, it is a negative external economy.

Graphical Summary

• Positive external economies shift LRAC downward.

• Negative external economies shift LRAC upward.