Principles of Economics/Economies of Scale

Adding capital

Growing firms add capital - often in the form of factories or machines - to increase their output. However, additional capital do not act the same as the original set of capital. At first, added capital may greatly increase productivity. However, additional units of capital become less cost-effective because of diminishing marginal returns, increasing costs, and loss of efficiency. Hence the latter short run supply curves begin to shift upward. In the graph, additional units of capital introduce new supply curves shifted rightward from the previous ones.

Economies of scale

From these various short run supply curves we can construct a long run supply curve that shows the minimum costs (assuming flexible and optimal use of labor) as capital changes. The long run supply curve connects the minimums of the short run curves and is considerably more stretched. At the beginning, where the long run supply (cost) is decreasing, the firm (or industry) is experiencing increasing returns to scale because a unit of resources yields more returns. In the center point, the minimum of the long run, the firm (or industry) is experiencing constant returns to scale. After that point, the firm (or industry) is experiencing decreasing returns to scale for similar reasons. Different industries have a different apportionment of these three segments, with some (such as agriculture) having consistently large spans of constant returns to scale.

Long run supply

Firms generally rush to be the first to reach the long run minimum, because this would give them a comparative advantage over other firms (lower average production costs). Firms rarely choose to go beyond this point because then their costs would begin to increase once again.