AQA A-level Economics: Costs of production and economies and diseconomies of scale (7136) – Revision Notes

Condensed recall for the AQA AS and A-level Economics specification (version 1.3, 29 June 2022), A-level sub-sections Costs of production and Economies and diseconomies of scale (3.1.4.4 and 3.1.4.5 on the AQA website, 4.1.4.4 and 4.1.4.5 in the combined PDF). For full explanations read the study guide, then test yourself with the practice questions. Hub: AQA A-level Economics. Tracker: printable checklist. Not sure where to begin? Try the free diagnostics. All firms and figures are invented.

Definitions

Term	Meaning
Fixed cost	Does not vary with output in the short run (rent, insurance)
Variable cost	Varies with output (materials, piece-rate labour)
Total cost	Fixed cost plus variable cost
Average cost	Total cost per unit
Marginal cost	Cost of producing one more unit
Short run	Period when one or more inputs cannot be changed
Long run	Period when every input can be changed, so no fixed costs
Internal economy of scale	Lower unit cost from the firm’s own growth
External economy of scale	Lower unit cost from growth of the industry or area
Diseconomy of scale	Unit cost rises as scale rises
LRAC	Lowest unit cost of each output when plant size can be chosen
Minimum efficient scale (MES)	Smallest output reaching the lowest LRAC

Formulas

TC  = FC + VC
AFC = FC / Q       AVC = VC / Q       AC = TC / Q = AFC + AVC
MC  = ΔTC / ΔQ   (also ΔVC / ΔQ)
Unit labour cost = wage per worker / output per worker

Method: completing a cost table

1. Find FC. It is the total cost at zero output, or TC minus VC.
2. VC = TC minus FC at each output.
3. MC = this TC minus the previous TC.
4. AVC = VC / output. AC = TC / output. Check AC = AFC + AVC.
5. Mark where AVC and AC are lowest and check MC is below them before and above them after.

Worked reminder: a print shop (invented)

Fixed costs are 80. Total cost is given.

Output	TC	VC	MC	AFC	AVC	AC
1	120	40	40	80.00	40.00	120.00
2	150	70	30	40.00	35.00	75.00
3	170	90	20	26.67	30.00	56.67
4	200	120	30	20.00	30.00	50.00
5	245	165	45	16.00	33.00	49.00
6	310	230	65	13.33	38.33	51.67

The fifth unit costs 45, below the previous average of 50, so average cost drops to (200 + 45) / 5 = 49. The sixth costs 65, above 49, so AC rises to 310 / 6 = 51.67. The lowest AC sits where MC crosses it, between outputs 5 and 6.

Shapes of the curves: reasons in a line each

Curve	Shape	Reason
AFC	Falls throughout	Fixed cost spread over more units
MC	Falls then rises	Gains from specialisation, then diminishing returns
AVC	U-shaped	Follows MC but changes more slowly
AC	U-shaped	AFC falls fast at first; AVC rises later

MC meets AVC and AC at their minimum points. Shifts: higher fixed costs lift AC and TC only. Lower factor prices or higher productivity lower MC, AVC and AC. A change in output is a movement along the curves.

Factor prices, productivity and input choice

• A rise in the price of a factor raises costs. If firms can substitute, they use less of it and more of the cheaper factor.
• Compare methods by total cost for the same output, then cost per unit.
• Higher productivity lowers unit cost: unit labour cost = wage / output per worker.
• Limits: capital is fixed in the short run, retraining takes time, and some tasks cannot be automated.

Worked reminder: two methods (invented)

Output is 300 units. Method A uses 6 workers and 2 machines; method B uses 2 workers and 5 machines. A machine costs 90 a day.

Wage	Cost of A	Cost of B	Per unit A	Per unit B	Cheaper
100	6 × 100 + 180 = 780	2 × 100 + 450 = 650	2.60	2.17	B
60	6 × 60 + 180 = 540	2 × 60 + 450 = 570	1.80	1.90	A

A fall in the wage from 100 to 60 makes the labour-intensive method cheaper.

Productivity example: a wage of 120 a day with 40 units per worker gives unit labour cost 3.00. If output per worker reaches 50, it falls to 2.40, a fall of 20%.

Economies and diseconomies of scale

Internal economies	Examples
Technical	Large machines, indivisibilities, increased dimensions
Purchasing	Bulk-buying discounts
Financial	Cheaper borrowing
Marketing	Advertising spread over more output
Managerial	Affordable specialist managers
Risk-bearing	Spread across products or markets

External economies: skilled labour pool, supplier cluster, shared infrastructure, local training college.

Internal diseconomies: communication, coordination and control problems; weaker motivation; duplication of tasks. External diseconomies: congestion, rising rents and wages, strained infrastructure.

Cause	Effect on LRAC
Internal economy or diseconomy	Movement down or up along the curve
External economy	Whole curve shifts down
External diseconomy	Whole curve shifts up

Returns to scale and costs

Double all inputs, with input prices unchanged:

• Output more than doubles (increasing returns): AC falls, an economy of scale.
• Output exactly doubles (constant returns): AC unchanged.
• Output less than doubles (decreasing returns): AC rises, a diseconomy of scale.

Worked reminder: 15 workers and 5 machines cost 900 and produce 400 units, so AC = 900 / 400 = 2.25. Tripling inputs costs 2,700 and produces 1,000 units, 2.5 times as much. AC = 2,700 / 1,000 = 2.70, up 20%. Decreasing returns, so a diseconomy.

Careful: lower input prices from bulk buying are an economy of scale without any physical gain in output per input.

LRAC, MES and industry structure

• LRAC is the lower boundary of the short-run average cost curves, one for each plant size.
• U-shaped: economies then diseconomies. L-shaped: economies, then flat. The flat part suggests diseconomies are weak or absent.
• Cost disadvantage of a small firm = its LRAC minus the LRAC at MES.
• Number of firms that fit at MES = market size / MES.
• If MES is a small share of the market: many firms, low barriers. If MES is a large share: few firms, high barriers, possibly natural monopoly.

Example: MES is 30,000 units and market demand is 120,000. 120 / 30 = 4 firms can operate at MES. If MES were 90,000, it would be 75% of the market and only one firm fits efficiently.

Chains of reasoning to rehearse

• Wage rise leads to a change of method. Wage rises, labour-intensive method costs more per unit, firm substitutes machines, labour demand falls. Evaluate: capital is fixed in the short run, so the response is bigger in the long run.
• Growth leads to lower unit costs. More output, fixed and overhead costs spread, bulk discounts, better machines, AC falls. Evaluate: only until MES; beyond it the curve may be flat or may turn up.
• High MES leads to few firms. Large minimum scale, new entrants face a big cost gap or heavy start-up spending, fewer rivals, less competition. Evaluate: how large MES is relative to the market, and whether external economies let small firms keep costs down.
• L-shaped LRAC. Past MES there is no clear penalty for size, so large firms hold no cost advantage over firms at MES, and many firms near MES can survive together if the market is big enough.

Must-know distinctions

Pair	Key difference
Fixed v variable	Responds to output or not
AC v MC	Per unit overall v cost of the next unit
Short run v long run	Some factor fixed v all variable
Economy of scale v increasing returns	Fall in cost per unit v rise in output per unit of input
Internal v external	The firm’s own size v the industry’s size

Quick self-test

1. A firm pays 150 a day in fixed costs and produces 25 units. Calculate AFC.
2. Total cost rises from 350 to 380 when output rises by one unit. State marginal cost.
3. AVC is 28 at output 15. Calculate VC.
4. TC is 480 at output 60. Calculate AC.
5. Total cost for 4 units is 200 and the fifth unit adds 45. Calculate the new AC.
6. State why AFC never rises as output rises.
7. Classify: a local training college supplies skilled labour to an industrial cluster.
8. Classify: delays occur because decisions pass through seven management layers.
9. Inputs triple, cost triples from 900 to 2,700, and output rises 2.5 times. State the returns to scale and the effect on AC.
10. MES is 40,000 units and market demand is 160,000. How many firms can operate at MES?

Answers

1. AFC = 150 / 25 = 6.
2. MC = 380 minus 350 = 30.
3. VC = 28 × 15 = 420.
4. AC = 480 / 60 = 8.
5. New AC = (200 + 45) / 5 = 49.
6. FC is constant, so FC divided by a larger output is always smaller.
7. External economy of scale.
8. Internal diseconomy of scale (communication).
9. Decreasing returns; AC rises from 2.25 to 2.70.
10. 160,000 / 40,000 = 4.

Where marks are usually lost

• Writing that cost curves “shift” when output changes. Output changes move you along the curve.
• Calling a rise in total cost a diseconomy of scale. Check average cost.
• Giving only a label such as “bulk buying” without saying it lowers average cost.
• Mixing up internal and external. Ask who gains: one firm (internal) or all firms in the area (external).
• Using AC where the question asks for MC, or dividing by the wrong output.
• Forgetting that fixed costs vanish in the long run.
• Stating that MES means the biggest output; it is the lowest output reaching minimum LRAC.
• Describing the L-shaped LRAC without saying what it implies for small firms and entry.

Official syllabus

AQA AS and A-level Economics specification, version 1.3 (29 June 2022), published by AQA, for first teaching from September 2015: A-level sub-sections Costs of production and Economies and diseconomies of scale.