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

This guide follows the AQA AS and A-level Economics specification (version 1.3, 29 June 2022) for the A-level sub-sections Costs of production and Economies and diseconomies of scale. The AQA website numbers them 3.1.4.4 and 3.1.4.5; the combined PDF prints the A-level content as 4.1.4.4 and 4.1.4.5. Every firm and figure below is invented. Use the revision notes for recall and the practice set to test yourself. The course hub is AQA A-level Economics, the printable checklist tracks coverage, and the free diagnostics show where to start.

What this guide covers

Specification point	You must be able to
Fixed and variable costs	Define and distinguish them; classify examples
Marginal, average and total costs	Calculate each from data
Short-run and long-run costs	Explain the difference
Shapes of cost curves	Draw, interpret and explain the reasons
Factor prices and productivity	Explain the effect on costs and on the choice of inputs
Internal and external economies of scale	Categorise and give examples
Diseconomies of scale	Give reasons
Returns to scale	Link them to economies and diseconomies
LRAC, L-shaped LRAC, minimum efficient scale	Explain the shapes and the effect on industry structure and barriers to entry

The law of diminishing returns and the definitions of returns to scale are taught in the neighbouring part of the specification; here they appear only as reasons behind cost shapes.

Fixed, variable and total cost

Fixed costs stay the same whatever the output, within the short run: rent, insurance, a loan repayment, a salaried manager. They are paid even at zero output. Variable costs rise with output: raw materials, hourly-paid labour, power used by machines.

Total cost (TC) = fixed cost (FC) + variable cost (VC).

The short run is a time frame in which the firm cannot change at least one of its inputs, so some costs are fixed. In the long run all factors can be varied, so every cost is variable and there are no fixed costs.

Average and marginal cost

AFC = FC / Q      AVC = VC / Q      AC = TC / Q = AFC + AVC
MC  = ΔTC / ΔQ

Marginal cost is the cost of producing one more unit. Fixed costs do not affect it, so it can be found from the change in either TC or VC.

Worked example 1: a stool workshop (invented)

Fixed costs are 60 a day. The marginal cost of each extra stool is given; everything else is built from it.

Output	MC	VC	TC	AFC	AVC	AC
1	30	30	90	60.00	30.00	90.00
2	24	54	114	30.00	27.00	57.00
3	18	72	132	20.00	24.00	44.00
4	20	92	152	15.00	23.00	38.00
5	26	118	178	12.00	23.60	35.60
6	34	152	212	10.00	25.33	35.33
7	44	196	256	8.57	28.00	36.57
8	56	252	312	7.50	31.50	39.00

Working for output 5: VC = 30 + 24 + 18 + 20 + 26 = 118. TC = 60 + 118 = 178. AC = 178 / 5 = 35.60. AFC = 60 / 5 = 12.00, and AVC = 118 / 5 = 23.60, so AFC + AVC = 35.60, matching AC.

Read the table: AVC is lowest at output 4 (23.00) and AC at output 6 (35.33). MC is below AC up to output 6 (34 against 35.33) and above it from output 7 (44 against 36.57).

The shape of the cost curves

Cost per unit
 |\                      MC
 | \                    /
 |  \     AC           /
 |   \    ___--------/--
 |    \_--     AVC   /
 |    _-___---------/
 |  AFC falls throughout
 +---------------------------- Output

• AFC falls continuously because the same fixed cost is spread over more units. It never reaches zero.
• MC falls then rises. At low output, adding variable workers to fixed capital allows specialisation and better use of equipment, so extra output costs less. Eventually the fixed factor is crowded and the law of diminishing returns begins to bite: each additional worker adds less to output, so each extra unit costs more.
• AVC is U-shaped for the same reason, but it moves more slowly than MC because it is an average.
• AC is U-shaped. It falls at first because AFC and AVC both fall, then rises once the rise in AVC outweighs the fall in AFC. The gap between AC and AVC is AFC, so the two curves converge as output grows.
• MC cuts AVC and AC at their lowest points. An average falls while the marginal figure is below it and rises while the marginal figure is above it. In the workshop table, AC falls to 35.33 because the sixth stool costs 34, below the previous average of 35.60. It rises at output 7 because that stool costs 44.

Moving versus shifting. A change in output moves the firm along its curves. A change in fixed costs shifts TC up or down by the same amount at every output, and shifts AC by less at higher outputs because the extra fixed cost is spread over more units; MC and AVC stay where they were. If the workshop’s fixed costs rise from 60 to 100, AC at output 6 rises from 35.33 to (100 + 152) / 6 = 42.00 while MC stays at 34. A fall in factor prices or a rise in productivity shifts MC, AVC and AC down together.

Factor prices, productivity and the choice of inputs

A firm chooses the mix of labour and capital with the lowest cost per unit for its target output. When one factor becomes dearer relative to another, it substitutes towards the cheaper one if technology allows.

Worked example 2: a tile firm (invented)

The firm makes 500 tiles a day. Method X uses 8 workers and 1 cutting machine. Method Y uses 3 workers and 3 machines. A machine costs 150 a day.

Wage per day	Method X cost	Method Y cost	X per tile	Y per tile	Cheaper
50	8 × 50 + 150 = 550	3 × 50 + 450 = 600	1.10	1.20	X
80	8 × 80 + 150 = 790	3 × 80 + 450 = 690	1.58	1.38	Y

The rise in the wage from 50 to 80 changes the cost-minimising method from labour-intensive to capital-intensive. At a wage of 60 both cost 630.

Productivity matters as much as the price. Unit labour cost = wage per worker / output per worker. With a wage of 96 a day and 48 units per worker, unit labour cost is 2.00. Training that lifts output to 60 units cuts it to 1.60. A pay rise to 108 with the same output of 60 gives 1.80: still below 2.00, so higher pay can sit alongside lower unit costs if productivity rises enough.

Evaluation: the switch may be slow in the short run because machines are fixed and retraining takes time, and some tasks cannot be mechanised.

Economies of scale

An economy of scale exists when long-run average cost falls as the scale of production rises.

Internal economies come from the growth of the firm itself:

Type	Source	Example
Technical	Large, efficient machines; indivisibilities; larger containers hold more for proportionately less cost	A bakery runs one large oven at near full capacity
Purchasing	Bulk-buying discounts	A chain negotiates lower flour prices
Financial	Large firms are seen as lower risk and borrow more cheaply	Lower interest rate on a bigger loan
Marketing	Advertising spread over more units	One national campaign for many outlets
Managerial	Specialist managers become affordable	A finance director for a large firm
Risk-bearing	Diversified products or markets spread risk	A firm selling in several regions

External economies arise when the industry as a whole expands in one location, whatever any single firm’s size: a pool of skilled labour, a cluster of specialist suppliers, a local college that trains for the trade, shared transport links. They lower costs for every firm in the cluster.

Diseconomies of scale

A diseconomy of scale exists when long-run average cost rises as scale increases.

Internal: communication slows down through many layers of management; coordination and control become harder; workers feel remote from decisions and effort falls; duplicated roles and bureaucracy add overheads.

External: the same cluster that brought benefits becomes congested. Rents and wages in the area are bid up, roads and ports are overloaded, and local suppliers may raise prices.

Moves or shifts? Internal economies and diseconomies are movements along one LRAC curve as the firm changes size. External ones shift the whole LRAC curve: external economies shift it down, external diseconomies shift it up.

Returns to scale and economies of scale

Returns to scale describe how output responds when every input is scaled up by the same factor. Economies of scale describe the change in cost per unit.

Worked example 3 (invented)

A firm uses 10 workers at 40 each and 4 machines at 100 each, producing 300 units. Cost = 400 + 400 = 800, so AC = 800 / 300 = 2.67.

• Double every input: cost = 1,600. Output rises to 690, which is 2.3 times as much (increasing returns). AC = 1,600 / 690 = 2.32, a fall of 13.0%. An economy of scale.
• Suppose instead output rises only to 560, 1.87 times as much (decreasing returns). AC = 1,600 / 560 = 2.86, a rise of 7.1%. A diseconomy of scale.
• Constant returns would leave AC at 2.67.

The link holds when input prices stay constant. If the firm’s larger demand bids up wages, it can have increasing returns and still face rising unit costs. Economies such as bulk-buying discounts are lower input prices, not extra output per unit of input.

LRAC, minimum efficient scale and industry structure

In the long run a firm can choose any plant size. Each size has its own short-run average cost curve. The long-run average cost (LRAC) curve touches the lowest of these at every output, so it is the lower boundary of all of them. Over the range of economies of scale it slopes down; if diseconomies arise it turns up, giving a U shape. An L-shaped LRAC falls and then stays flat: diseconomies are weak or absent, perhaps because good management, technology and multiple plants hold off the problems of size.

The minimum efficient scale (MES) is the smallest output at which LRAC touches its lowest level.

Worked example 4 (invented)

Output (thousands)	10	20	30	40	50	60	70	80
LRAC	9.0	7.2	6.0	5.2	4.8	4.8	4.8	4.8

LRAC first reaches its minimum of 4.8 at 50,000 units, so MES = 50,000 and the curve is L-shaped.

MES compared with the size of the market sets the industry structure:

• Market demand of 400,000 at an efficient price: 400 / 50 = 8, room for up to 8 firms at full efficiency. MES is 12.5% of the market, so competition is feasible and barriers from scale are low.
• Market demand of 100,000: room for 2 firms. MES is 50% of the market, so a new entrant must either win half the market or accept higher costs.
• Market demand of 60,000: MES is 83% of the market and one firm can supply nearly everything. This points to a natural monopoly.

A new entrant selling only 20,000 would have an LRAC of 7.2, which is 50% above the incumbent’s 4.8. A high MES is therefore a barrier to entry: entrants must come in on a large scale, with heavy start-up cost and the risk of failing, or on a small scale at a cost disadvantage that incumbents can exploit by cutting price.

Common errors

• Calling any rise in total cost a diseconomy. Total cost always rises with output; the test is average cost.
• Drawing MC through the wrong point. It cuts AC and AVC at their minima.
• Confusing a movement along LRAC with a shift. Internal effects move, external effects shift.
• Assuming every large firm has low unit costs. A firm below MES has higher unit costs than one at or above it.

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.