International Trade Theory and Policy
by Steven M. Suranovic

Trade 80-1

Economies of Scale and Returns to Scale

Economies of scale in production means that production at a larger scale (more output) can be achieved at a lower cost (i.e. with economies or savings). A simple way to formalize this is to assume that the unit-labor requirement in production of a good is a function of the level of output produced. In the adjoining diagram we present a graph of the unit-labor requirement in steel production as a function of the scale (level of output) of production. At production level Q1S, the unit-labor requirement is given by a1LS. If production were to rise to Q2S, then the unit-labor requirement would fall to a2LS. This means that at the higher level of output, it requires less labor (i.e. fewer resources or cost) per unit of output than it required at the smaller scale.

With a simple adjustment it is possible to show that economies of scale in production is equivalent to increasing returns to scale. Increasing returns to scale in production means that an increase in resource usage , by say x%, results in an increase in output by more than x%. In the adjoining diagram we plot labor productivity in steel production when production exhibits increasing returns to scale. [This graph is derived by plotting the reciprocal of the unit-labor requirement (i.e. 1/aLS) for each output level in the above diagram.]

Note that as output (scale) increases from Q1S to Q2S, labor productivity (given by the reciprocal of the unit-labor requirement) also rises. In other words, output per unit of labor input increases as the scale of production rises, hence increasing returns to scale.

Another way to characterize economies of scale is with a decreasing average cost curve. Average costs, AC, are calculated as the total costs to produce output Q, TC(Q), divided by total output. Thus AC(Q) = TC(Q)/Q. When average costs decline as output increases it means that it becomes cheaper to produce the average unit as the scale of production rises, hence economies of scale.

Economies of scale are most likely to be found in industries with large fixed costs in production. Fixed costs are those costs that must be incurred even if production were to drop to zero. For example fixed costs arise when large amounts of capital equipment must be put into place even if only one unit is to be produced and if the costs of this equipment must still be paid even with zero output. In this case the larger the output, the more the costs of this equipment can be spread out among more units of the good. Large fixed costs and hence economies of scale are prevalent in highly capital intensive industries such as chemicals, petroleum, steel, automobiles etc.

International Trade Theory and Policy - Chapter 80-1: Last Updated on 2/15/07