Pearson Edexcel IAL Economics: Economies of scale, profit and shutdown points (YEC11) – Revision Notes

These notes condense 3.3.2 items 3 and 4 of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11) specification, Issue 2, June 2018. They belong to Unit 3, Business behaviour, which the specification labels an IAL compulsory unit (full International A Level only, not IAS). Full explanations are in the study guide. Then use the practice questions, the course hub, the checklist and the free diagnostics. All figures here are invented.

Key definitions

Term	Meaning
Long run	Time span in which every input can be varied, so no cost is fixed
LRAC	Lowest average cost of each output when the firm can choose any scale
Economies of scale	A rise in output brings a fall in LRAC
Diseconomies of scale	A rise in output brings a rise in LRAC
Minimum efficient scale (MES)	Smallest output that achieves the lowest LRAC
Internal economy	Arises from the firm’s own growth: a movement along LRAC
External economy	Arises from growth of the industry: a shift down of LRAC
Normal profit	Minimum reward to keep the entrepreneur in the industry; counted as a cost
Supernormal profit	Profit above normal profit: AR > AC
Loss	Below normal profit: AR < AC
Short-run shutdown point	Where AR equals the minimum of AVC
Long-run shutdown point	Where AR equals the minimum of AC

Shape of LRAC

• Falling section: economies of scale (output grows by a larger percentage than total cost).
• Flat section: constant average cost.
• Rising section: diseconomies of scale (total cost grows by a larger percentage than output).
• MES is the first output on the lowest part of the curve.
• The curve may be U-shaped, or L-shaped if diseconomies never appear in the range.

Method for a table of LRAC.

1. Find the lowest LRAC. The lowest output reaching it is MES.
2. Work out the percentage change in LRAC between the outputs asked about.
3. Label: fall means economies, no change means constant, rise means diseconomies.
4. Link to total cost if asked: long-run total cost = LRAC x output.

Reminder. A firm’s LRAC is 4.00 at 200 units, so total cost is 800. At 500 units it is 3.00, so total cost is 1,500. LRAC falls (3.00 - 4.00)/4.00 = -25.0%, although total cost rose. Output rose 150.0% and total cost 87.5%.

MES and market size

Number of firms that can operate at MES = market quantity / MES.

• MES 250 units, market 1,500 units: 1,500/250 = 6 firms, so competition is possible.
• MES close to the whole market: one firm has the lowest cost, the market tends towards monopoly.
• Low MES relative to the market: many small firms can survive.

Internal economies

Type	One-line reason	Spreading example
Financial	Lower interest for large, lower-risk borrowers	Cheaper credit
Technical	Indivisible machines, specialised methods	Fixed 24,000 over 6,000 units is 4.00 each; over 24,000 it is 1.00
Managerial	Specialist managers become affordable	One planner serving a bigger operation
Marketing	Campaigns cost the same whatever the output	Fixed advertising spread over more units
Purchasing	Bulk-buy discounts	Lower price per unit on large orders
Risk bearing	Several products or markets spread risk	A fall in one market is cushioned by others

External economies

• Availability of skilled labour: colleges and trained workers cluster near the industry.
• Access to transport links: shared roads, rail, ports cut delivery costs.
• Sharing knowledge: ideas pass between firms and workers.

Result: the whole LRAC of every firm shifts down. Example: a 5% fall turns 7.20 into 6.84 and 12.00 into 11.40.

Diseconomies

Source	Chain of reasoning
Communication	More layers and people, so messages are slow or distorted, so decisions are late and costs rise
Coordination	More sites and departments, so plans clash, so duplication and delay raise unit costs
X-inefficiency	Weak monitoring or competition, so managers and workers tolerate waste, so actual cost is above the lowest possible

Links between n people = n(n - 1)/2. For 8 people that is 28; for 16 it is 120.

Profit and loss

Condition	Label
TR > TC	Supernormal profit
TR = TC	Normal profit only
TR < TC	Loss (below normal profit)

Profit or loss = (AR - AC) x quantity. Accounting profit is not economic profit: subtract the owner’s opportunity costs. Example: TR 90,000 and TC (including normal profit) 84,000 gives supernormal profit of 6,000.

Reminder. A shop shows accounting profit of 9,000. The owner could have earned 7,500 in a job and 800 in interest on the money tied up in the shop. Economic profit = 9,000 - 7,500 - 800 = 700, which is supernormal. If the forgone earnings were 9,400 in total, economic profit would be 9,000 - 9,400 = -400, a loss despite a positive accounting figure.

Shutdown rules

Position	Short run	Long run
AR > AC	Produce	Stay, may attract entry
AR = AC	Produce	Stay
AVC < AR < AC	Produce, loss smaller than fixed cost	Leave if it persists
AR < AVC	Shut down	Leave

Method in steps.

1. Fixed costs are sunk in the short run, so ignore them in the choice and compare AR with AVC.
2. Contribution = (AR - AVC) x quantity. If positive, produce.
3. Check: loss from producing = fixed cost - contribution. Loss from shutting = fixed cost.
4. For the long run compare AR with AC, which includes normal profit.

Reminder. AR 7.50, AVC 6.80, AC 8.20. Loss per unit is 8.20 - 7.50 = 0.70, but the contribution per unit is 7.50 - 6.80 = 0.70, so the firm keeps producing in the short run. If AR is 6.00 and AVC is 6.40, each unit adds a loss of 0.40, so it shuts.

Evaluation prompts

• Where is the firm relative to MES? Only below it do gains remain.
• Do consumers benefit? Only if competition forces lower costs into lower prices.
• Are external economies lasting? Congestion and higher land prices may reverse them.
• Is the fall in price temporary? Restart costs, lost customers and contracts can justify staying open.
• Long run versus short run: a loss may be bearable now but not for ever.

Chain for a scale answer. Output rises, so a fixed cost (such as a machine) is spread over more units, so average cost falls, so the firm can cut price or raise profit. Then evaluate: does the firm reach MES, does competition pass the saving on, and could diseconomies appear if it grows further?

Must-know distinctions

• Economies of scale (long run, all factors change) versus diminishing returns (short run, a factor is fixed).
• Internal (movement along the curve) versus external (shift of the curve).
• Normal profit (a cost) versus supernormal profit (extra).
• AVC (short-run shutdown) versus AC (long-run exit).
• Diseconomies of scale (curve rises) versus X-inefficiency (cost above the lowest possible).

Quick self-test

1. LRAC is 4.00 at 200 units and 3.00 at 500 units. What is the percentage change in LRAC?
2. Output rises 50% and total cost rises 80%. What happens to average cost, and by how much?
3. MES is 250 units and the market is 1,500 units. How many firms can reach MES?
4. Fixed advertising of 24,000 is spread over 6,000 units, then 24,000 units. Find the cost per unit each time.
5. Name the three external economies in the specification.
6. A firm has AR 7.50, AVC 6.80 and AC 8.20. Should it produce in the short run?
7. AR is 6.00 and AVC is 6.40. What should it do, and how much does each unit add to the loss?
8. TR is 90,000 and TC including normal profit is 84,000. What is supernormal profit?
9. Why is normal profit counted as a cost?
10. Define X-inefficiency.

Answers

1. (3.00 - 4.00)/4.00 = -25.0%.
2. 1.80/1.50 = 1.2, so average cost rises 20.0%: diseconomies.
3. 1,500/250 = 6 firms.
4. 24,000/6,000 = 4.00; 24,000/24,000 = 1.00.
5. Availability of skilled labour, access to transport links, sharing knowledge.
6. Yes. AR exceeds AVC by 0.70 a unit, which contributes to fixed cost, and the loss is smaller than shutting.
7. Shut down. Each unit adds a loss of 6.40 - 6.00 = 0.40.
8. 90,000 - 84,000 = 6,000.
9. It is the minimum reward (the opportunity cost of the owner’s time and capital) needed to keep the firm in the industry.
10. Producing at higher cost than necessary for the output, because there is little pressure or incentive to cut waste.

Where marks are usually lost

• Showing an internal economy as a curve shift.
• Stating a source (such as purchasing) without the reason cost falls.
• Treating a positive accounting profit as supernormal.
• Applying AC where AVC belongs in the short-run closure decision.
• Saying a firm shuts down whenever it makes a loss.
• Mixing diseconomies of scale with diminishing returns.
• Giving a calculation with no working or units.
• Concluding that lower costs always mean lower prices, with no evaluation.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics, Specification, Issue 2, June 2018 (first teaching September 2018), published by Pearson Education Limited. Section 3.3.2, items 3 and 4, in Unit 3: Business behaviour.