Short Run Average Cost
Let’s say we have a news website, think Buzzfeed, and we hire people to write articles. Shown above is the marginal cost and average cost per article written.
Shape of the Average Cost Curve
The average cost curve starts out really high. We have to take into account fixed costs, meaning renting the office space, buying computers, etc. Once we start adding people, the cost increases by each person’s salary, so the average cost goes down. As we see in red, the marginal cost decreases, this is because at some point, the marginal benefit increases. Consider 1 staff writer vs 2 staff writers. They can share ideas, brainstorm and come up with more articles than if there was just one. So if the first writer costs $5000/month and produces 100 articles, their marginal cost is 50 dollars. If the second writer, who works better with the fisrt produces 150 articles, their marginal cost is 33.3 dollars. Eventually, however, an additional writer will not help. For example, at some point, there simply won’t be that many new news stories to cover, so they will produce 50 articles, costing 100 dollars.
Marginal cost starts increasing faster and faster, until the average cost increases too.
Beginning: Dominated by fixed cost (rent)
Middle: Marginal cost decreases (or increases below average cost)
End: Marginal cost increases because workers are no longer productive.
In the long run
As we can see, if we seek to produce 300 units, we have three options. We can open up a small store (AC1), where it would cost us a lot to produce 300 units, because workers would have to work overtime, or the store would be overstaffed. Alternatively, we can open up a giant factory and produce 300 units. However, the fixed costs would be gigantic, and it would not work. The goldilocks amount would be opening a medium sized store, (AC2) and produce it for cheaper! Just as we showed before, this is better.
Constant Average Price
For every amount we want to produce, we can increase our capital to the point where the cost is a minimum. Consider the curve above have a minimum at 300 units. If we just build that same store in another town, we will be able to get double the production (600 units) at the same price/unit.
Economies of Scale
As a factory gets bigger, it generally gets cheaper. That’s why Amazon’s factories are massive and Tesla’s gigafactory is gigantic. We can specialize labor, get goods for cheaper.
Diseconomies of Scale
Sometimes, it costs more money the bigger you get. You have more people, more resources to organize. This is the case for colleges for example. You have deans and assistant deans. Also, companies have to spend more resources organizing.
Putting it All Together
It turns out that all business are all three. At first, expanding the company makes the business function as an economy of scale. Then, you expand some more and have to hire an HR department. This is a constant return to scale. Then, you expand some more, and now you have middle managers, managers above them, 15 departments, and now it’s a diseconomy of scale.