Long-Run Average Cost

Economies of scale are the result of: (1) increased resource specialization, (2) decreased resource prices, (3) increased bi-product use, (4) increased auxiliary activities, and (5) the geometric relation between volume and area.

Increased Resource Specialization

This specialization enhances the productivity of both labor and capital. The average cost of producing a Stuffed Amigo with one "generic" worker using a "generic" sewing machine might be $1. However, 10 specialized workers using 10 specialized machines might be able to produced Stuffed Amigos at an average cost of 50 cents each.

Decreased Resource Prices

The best example of this is electricity. Expanding the production of Wacky Willy Stuffed Amigos from a small one room shop with one person operating one sewing machine eight hours a day to a 100,000 square foot factory with 5,000 sewing machines being operated by three shifts of workers 24 hours a day, also uses more electricity. The local electric company is likely to charge The Wacky Willy Company a lower price per kilowatt hour of electricity for the larger operation. It can do this because the average cost of using the fixed capital of its generator and distribution system is less with additional production and sales.

Increased Bi-product Use

For example, the one-worker, one-machine production of Wacky Willy Stuffed Amigos generates waste fabric. The amount, however, is so small that it is not worth the effort to do anything but toss it in the trash. However, producing Stuffed Amigos in a 100,000 square foot factory with 5,000 sewing machines being operated by three shifts of workers 24 hours a day, the volume of waste fabric is enormous. This fabric can be shredded, mixed with a latex adhesive, and used by Natural Ned's Garden Emporium to mold lawn ornaments. While Natural Ned has little use for a handful of fabric scraps, a truckload is a different story. By selling these bi-products, The Wacky Willy Company effectively reduces the cost of producing Stuffed Amigos.

Increased Auxiliary Activities

However, should Wacky Willy expand to a 100,000 square foot factory with 5,000 sewing machines being operated by three shifts of workers 24 hours a day operation, then it also buys substantially more fabric. It might buy so much fabric that the fabric supplier sets up a fabric production facility adjacent to the Wacky Willy factory. A sewing machine repair service might also set up nearby. A trade school that does nothing but train sewing machine operators to be hired by The Wacky Willy Company might even be established in close proximity. Having these support activities close to the Wacky Willy factory lowers the average cost of producing Stuffed Amigos by reducing the cost of these inputs.

Geometric Relation Between Volume and Area

Now suppose the size of the cube is doubled. Of course, the key question is what it means to "double" the cube size. Does this double the volume to two cubic feet or doubling the surface area to 12 square feet? To make the calculations easier, consider a third meaning, doubling the length of each side from one foot to two feet, such that the cube that is two feet on each side.

This doubling of the dimensions results in a volume of eight cubic feet, clearly eight times the volume of the original cube. The surface area now consists of six sides, each of which is four square feet, for a total of twenty-four square feet. This is four times as much surface area as the six square feet of our original cube.

What has happened? By using four times as much material to build the second cube, there is eight times as much volume inside the cube. The average cost (in terms of the surface material) of producing work space (volume) is less for the larger cube than the smaller one.

In other words, the cost of building a 100,000 square foot Wacky Willy factory is less than twice the cost of constructing a 50,000 square foot factory. This reduces the average cost of larger scale Stuffed Amigos production.

Not the Short Run

• The Short Run: Because short-run average total cost is the combination of average fixed cost and average variable cost, the source of short-run decreases in average total cost is two-fold. First, total fixed cost is spread over larger quantities, meaning average fixed cost declines with greater production. Second, increasing marginal returns in the early stages of production causes a decrease in average variable cost. The resulting decrease in average total cost only occurs in the short run.


• The Long Run: In the long run, there are no fixed inputs. As such, because there is no fixed cost and no average fixed cost, there can be no decline in average fixed cost. Moreover, marginal returns do not guide production in the long run, so increasing marginal returns is not relevant. Instead decreasing long-run average cost results from resource specialization, resource prices, bi-product use, auxiliary activities, and the relation between volume and area.