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Firm's Cost of Production and Output Increase
Discuss whether the average cost of production always decreases when a firm increases the total output that it produces.
Firm Behavior and Strategies
Frequently asked question
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The average cost of production does not always decrease when a firm increases the total output it produces.
There are several reasons why the average cost of production might decrease as output increases:
➡️1. Economies of scale: A firm may experience economies of scale, where the total cost rises by less than the total output. This can occur due to various factors such as specialization, bulk purchasing, and improved efficiency. As the firm produces at a larger scale, it can spread its fixed costs over a higher output, resulting in lower average costs.
➡️2. Buying/purchasing economies of scale: When a firm increases its output, it may be able to negotiate discounts or lower prices when purchasing raw materials in bulk. This reduces the average cost of production and contributes to cost savings.
➡️3. Technical economies of scale: With higher output, a firm may invest in larger and more cost-efficient technological equipment. This can lead to increased productivity and lower average costs per unit of output.
➡️4. Managerial economies of scale: As the firm expands its output, it may employ specialist staff or adopt more efficient management practices. This can improve coordination and decision-making, leading to lower average costs.
➡️5. Financial economies of scale: Increasing output can provide the firm with access to larger loans or the ability to issue shares at a lower price. This allows the firm to finance its operations at a lower cost, reducing average costs.
However, there are also reasons why the average cost of production might not decrease as output increases:
➡️1. Diseconomies of scale: In some cases, a firm may experience diseconomies of scale, where the total cost rises by more than the total output. This can occur due to issues such as inefficiencies in coordination, increased communication complexities, and challenges in managing larger operations. Diseconomies of scale can lead to higher average costs per unit of output.
➡️2. Communication problems: As a firm expands its output, communication challenges may arise. Ideas may not be effectively communicated or may be misunderstood, leading to inefficiencies and higher costs.
➡️3. Poor industrial relations: Increasing output may strain industrial relations within the firm. Strikes, conflicts, or difficulties in managing a larger workforce can increase costs and hinder productivity.
➡️4. External diseconomies of scale: Factors outside the firm, such as congestion or scarcity of resources in the industry or region, can lead to increased costs of production as output increases. This can offset any potential cost savings from economies of scale.
In conclusion, while there are various factors that can contribute to lower average costs of production as a firm increases its total output, there are also factors that can lead to higher average costs. It is important to consider the specific circumstances and dynamics of the firm, industry, and market to determine whether the average cost of production will decrease or increase with increased output.
- Definition of economies of scale
- Importance of understanding economies of scale
II. Reasons why a firm may experience economies of scale (up to ➡️5 marks)
- Economies of scale due to total cost rising by less than total output
- Buying/purchasing economies of scale
- Technical economies of scale
- Managerial economies of scale
- Financial economies of scale
- R&D economies of scale
- External economies of scale due to industry growth
III. Reasons why a firm may not experience economies of scale (up to ➡️5 marks)
- Diseconomies of scale due to total cost rising by more than total output
- Diseconomies of scale making the firm slower to respond to changing market conditions
- Communication problems
- Poor industrial relations
- External diseconomies of scale
IV. Average cost diagram (up to ➡️2 marks)
- Correctly labelled diagram showing economies and diseconomies of scale
- Summary of key points
- Importance of considering economies of scale in business decisions.
Up to ➡️5 marks for why it might:
• The firm may experience economies of scale - total cost will rise by less than total output (long run average cost may fall as output increases) -.
• The firm may experience buying/purchasing economies of scale - may be offered a discount price when buying raw materials in bulk -.
• The firm may experience technical economies of scale - larger, more cost efficient technological equipment may be purchased to produce a higher output -.
• The firm may experience managerial economies of scale - specialist staff may be employed when output is high -
• The firm may experience financial economies of scale - as output increases, it may be able to borrow more cheaply / or sell its shares at a lower price -
• The firm may experience R & D economies of scale - the R & D expenditure can be spread over a higher output -.
• The industry may also be growing in size - enabling advantage to be taken of external economies of scale -.
Up to ➡️5 marks for why it might not:
• The firm may experience diseconomies of scale - total cost may rise by more than total output (long run average cost may increase as output increases) -.
• The firm may experience diseconomies of scale - this may make the firm slower to respond to changing market conditions / more difficult to keep costs down -.
• The firm may experience communication problems - ideas may not be communicated or may be misunderstood -.
• The firm may experience poor industrial relations - e.g. strikes may increase costs of production -.
• External diseconomies of scale may occur - e.g. pushing up the costs of production -.
Up to ➡️2 marks for a correctly labelled average cost diagram which shows economies and diseconomies of scale as an alternative to describing average costs rising / falling as output increases