Economies of Scale

Economy of scale is a concept explained under the theory of microeconomics that deals with concept of production and cost. The theory is widely used in manufacturing units and production firms to optimize the overall output. The question is how economies of scale help in optimizing the firms output. The concept states that a firm is having economies of scale when with every with of increase in output of the firm the cost per unit decreases. For example, if a firm that produces 1000 footballs a day and per unit cost of the firm is $10 plans to produce more football and for every unit increase in production the cost per unit decreases then the firm has economies of scale. The concept of average cost and marginal cost must be explained in this part to discuss the topic further. The average cost that generally refers to the per unit cost is the cost that a firm deduce by dividing the total cost of the firm by the total number of unit produced by it. For example, if a football manufacturing firms produces 1000 footballs a day and total cost incurred by the firm to produce the daily output is $10000, then the cost of producing one football can be calculated as $10000/1000, which gives $10 as the cost of production per football. On the other hand, marginal cost is the cost of producing one more unit of product; in this case, it is football. Thus, if the firm produces one more unit beyond 1000, cost of adding that unit to production is $5, and for adding another one unit is $7, then the cost of producing extra is known as marginal cost of the firm. Here, the marginal cost is lower than the average cost of production, therefore it can be said that the firm has economies of scale. With decreasing marginal cost of production, the average cost of production decreases too and is the effect of economies of scale. Hence, when a firm has economies of scale then only the marginal cost is lower than the average cost. From this concept, it is derived that a firm has economies of scale until when the marginal cost equals average cost. The economic theory of cost give the notion that marginal cost curve is upward sloping and the average cost curve is U-shaped. It means that marginal cost increases with every unit addition to the output and for average cost, it decreases until a level of output and then it again increases. The point where marginal cost curve and average cost curve intersects is the point at which the economies scale benefit of a firm ends. After this point, the marginal cost curve runs above the average cost curve and the concept of diseconomies of scale pops up in this region.

Diminishing Marginal Returns

The diminishing marginal returns is a concept of microeconomics and is explained by the production and cost theory of the subject. The concept is related to the factors of production. To understand the concept considering the case of the football firm assumed above, in production of the football the main factors of production are labour, stitching machine, raw material and electricity that runs the machines. It is given that the firm is operating at optimum level of production. Now, if the numbers of workers are increased keeping the other production factors constant then it is found that the productivity of the workers has decreased, that means, before increasing the number of workers the productivity of the workers given as 10 football per worker per day. After increasing workers, suppose by 10 numbers decreases the overall productivity of the factor that is, each worker now produces 9 footballs per day. However, the total production of the firm increases. Therefore, workers contribute less than earlier due to unit increase in the number of worker. This fall in productivity of workers due unit increase in the factor is known as the diminishing marginal returns.

How Economies of Scale compare to Diminishing Marginal Returns

The above discussion regarding economies of scale and diminishing marginal returns leads to the understanding that economies of scale is a positive factor for a firm where as diminishing marginal returns is a negative factor for a firm. The economies of scale reflects the whole production process efficiency of a firm and in case of diminishing marginal returns the contribution of a single input used in the production process. However, both economies of scale and diminishing returns can exit together.