Pearson Edexcel International Advanced Level Economics: Economies of scale, profit and shutdown points (YEC11)

This guide follows the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11) specification, Issue 2, June 2018. It covers 3.3.2 items 3 and 4 (economies and diseconomies of scale; profits and losses). They sit in Unit 3, Business behaviour. The specification calls Units 1 and 2 the International AS (IAS) content and Units 3 and 4 the additional International A2 (IA2) content, and it labels Unit 3 an IAL compulsory unit, so this material is for the full International A Level only. Every firm and figure below is invented, and money is in currency units (cu).

Use the course hub and the checklist, then try the revision notes and the practice questions. For exam technique see exam preparation, and to find your weak spots take a free diagnostic.

Coverage map

Spec point	Outcome
3.3.2 3a	Link long-run cost curves to economies and diseconomies of scale
3.3.2 3b	Explain minimum efficient scale
3.3.2 3c	Distinguish internal from external economies of scale
3.3.2 3d	Explain financial, technical, managerial, marketing, purchasing and risk-bearing economies
3.3.2 3e	Explain external economies: skilled labour, transport links, sharing knowledge
3.3.2 3f	Explain diseconomies: communication, coordination, X-inefficiency
3.3.2 4a	Distinguish normal profit, supernormal profit and losses
3.3.2 4b	Explain short-run and long-run shutdown points

Long-run cost curves (3a)

In the long run a firm can vary all its inputs, so no cost is fixed. The long-run average cost (LRAC) curve plots the cheapest cost per unit of each output when the firm may choose whatever size of operation suits.

• Economies of scale: as output grows, LRAC falls.
• Diseconomies of scale: as output grows, LRAC climbs.

Test with percentages. If output rises by a larger percentage than total cost, average cost falls (economies of scale). If total cost rises by more, there are diseconomies.

Worked example 1. A courier firm in Country A (illustrative) has these long-run costs. Output is parcels per day.

Output	LRAC (cu)	Long-run total cost (cu)
100	12.00	1,200
200	9.60	1,920
300	8.00	2,400
400	7.20	2,880
500	7.20	3,600
600	7.80	4,680
700	8.40	5,880

• 100 to 200 parcels: output rises 100.0% but total cost rises (1,920 - 1,200)/1,200 = 60.0%. Average cost falls, so economies of scale.
• 500 to 600 parcels: output rises 20.0%, cost rises (4,680 - 3,600)/3,600 = 30.0%. Average cost rises, so diseconomies.
• 100 to 400 parcels: LRAC falls (7.20 - 12.00)/12.00 = -40.0%.

In words: with output on the horizontal axis and LRAC on the vertical axis, the curve slopes down from 12.00 to 7.20 at 400 parcels, runs flat to 500, then slopes up to 8.40 at 700.

Total cost rises throughout: falling average cost is not falling total cost.

Minimum efficient scale (3b)

Minimum efficient scale (MES) is the smallest output that achieves the lowest possible LRAC. By that scale the firm has used up the available economies of scale. In the example MES is 400 parcels: 7.20 is the lowest LRAC, and 400 is the first output that reaches it.

MES matters most against the size of the market.

• If the market takes 2,000 parcels a day, MES is 400/2,000 = 20% of it, so at most 5 firms can operate at MES.
• If MES were 1,500 parcels, there is room for only 2,000/1,500 = 1.33 firms. One large firm has the lowest costs, so the market tends towards monopoly.
• If MES were 40 parcels, room exists for 50 firms, so many small firms can survive.

Internal and external economies (3c)

An internal economy of scale is a saving the firm earns by expanding. It slides down its own LRAC curve.

An external economy of scale comes from the growth of the industry, usually in one area. It lowers the costs of every firm, so each firm’s whole LRAC curve shifts down.

Internal economies are a movement along LRAC and help one firm. External economies are a shift of LRAC and help all firms in the industry. Keep these apart in diagrams.

Sources of internal economies (3d)

Source	Why average cost falls	Illustration (cu)
Financial	Large firms look less risky, so lenders charge lower interest	Loan of 150,000: at 8% interest costs 12,000; at 5% it costs 7,500. Over 25,000 parcels that is 0.48 against 0.30 per parcel
Technical	Large machines are indivisible, and bigger output allows specialised methods	A sorting machine costing 90,000 a year: 3.00 per parcel at 30,000 parcels, 0.50 at 180,000
Managerial	Specialist managers become affordable	A planner paid 60,000: 1.50 per parcel at 40,000 parcels, 0.40 at 150,000
Marketing	A campaign costs the same whatever the output	A regional campaign of 27,000: 1.50 per parcel at 18,000, 0.30 at 90,000
Purchasing	Bulk orders earn discounts	Fuel at 1.40 a litre, or 1.26 on 50,000 litres or more: 60,000 litres saves 0.14 x 60,000 = 8,400, or 10.0%
Risk bearing	Several products or markets spread risk	See below

Risk bearing. A firm sells in one region and earns 200. If demand there falls 20%, revenue falls to 160, which is -20.0%. A firm earning 100 in each of two regions loses 20 in one, so revenue falls to 180, which is -10.0%.

Most sources spread a fixed or lumpy cost over more units, or use buying power. Name the source and give the reason.

Sources of external economies (3e)

• Availability of skilled labour. When many firms in one industry settle in one area, colleges and training follow, and skilled workers are easy to hire. Each firm spends less on training and recruitment.
• Access to transport links. Roads, rail or ports built for a growing industry cut delivery time and cost for every firm there.
• Sharing knowledge. Workers move between firms and ideas about methods spread, so each firm gains without paying for all of the research.

Worked example 2. A cluster of courier firms lowers every firm’s costs by 5%. The courier firm’s LRAC at 400 parcels falls from 7.20 to 7.20 x 0.95 = 6.84 cu. At 100 parcels it falls from 12.00 to 11.40. The whole curve shifts down; MES is still 400 parcels.

Sources of diseconomies (3f)

• Communication problems. In a large firm messages pass through many layers and may be delayed or distorted. The number of possible links between n people is n(n - 1)/2: 10 links for 5 people, 45 for 10 and 190 for 20. Staff double from 10 to 20, but links rise 4.2 times.
• Coordination problems. With many sites, products and departments, the firm struggles to keep schedules, suppliers and standards aligned, so decisions are slow.
• X-inefficiency. This is a failure to produce at the lowest cost possible for the output, because managers and workers have little pressure or incentive to cut waste. It is more likely when monitoring weakens as the firm grows, or where competition is weak.

Worked example 3. Return to the courier firm. Its true LRAC at 400 parcels is 7.20 cu. Suppose slack management leads to an actual average cost of 8.10 cu. The gap is 0.90 cu a parcel, which is 0.90/7.20 = 12.5% above the best achievable, or 0.90 x 400 = 360 cu a day of avoidable cost. This is X-inefficiency: the firm is above its LRAC, not just far along it. The specification lists it as a source of diseconomies, so use it to explain a rising LRAC, and note that it can occur at any size.

Normal profit, supernormal profit and losses (4a)

Economic cost includes the opportunity cost of the owner’s time and money. Normal profit is the least payment that stops the owner switching to another business. It counts as a cost, so average cost (AC) includes it.

• Normal profit: total revenue (TR) = total cost (TC), so average revenue (AR) = AC.
• Supernormal profit: TR > TC, so AR > AC. It is profit above normal profit.
• Loss (subnormal profit): TR < TC, so AR < AC. Reward is below the minimum needed.

Total supernormal profit or loss = (AR - AC) x quantity. A negative result is a loss.

Worked example 4. A small car wash in Country B (illustrative) cleans 1,000 cars a week. Total fixed cost is 1,800 cu, of which 500 cu is the owner’s forgone wage (normal profit); assume the owner’s time stays committed to the business in the short run, so this 500 is unavoidable. Average variable cost (AVC) is 3.20, so total variable cost is 3,200 and total cost is 5,000, giving AC = 5.00.

Price (AR)	TR	Profit or loss = TR - 5,000	Outcome
6.20	6,200	+1,200	Supernormal
5.40	5,400	+400	Supernormal
5.00	5,000	0	Normal profit only
4.00	4,000	-1,000	Loss
3.00	3,000	-2,000	Loss

At 5.40 the accounts show 5,400 - 4,500 = 900 cu of profit. Of that, 500 is normal profit and 400 is supernormal. At 4.00 the accounts show -500, but the economic loss is -1,000.

Supernormal profit signals that a market is worth entering, if barriers to entry allow it. Losses signal that resources would earn more elsewhere.

Shutdown points (4b)

Short-run shutdown point. In the short run fixed costs must be paid whether the firm produces or not, so they are sunk for this decision. It weighs the loss from producing against the loss from closing.

• If it shuts, it loses its fixed costs: -1,800 for the car wash.
• If it produces, it loses fixed cost minus the contribution (AR - AVC) x quantity.

So keep producing while AR >= AVC, because revenue covers all variable costs and part of fixed cost. Shut down when AR < AVC. The short-run shutdown point is where AR equals the minimum of AVC.

• At price 4.00: contribution = (4.00 - 3.20) x 1,000 = 800. Producing loses 1,800 - 800 = 1,000, which beats shutting at -1,800. Keep producing.
• At price 3.00: AR is below AVC, so each car adds a loss of 0.20. Producing loses 2,000, shutting loses 1,800. Shut down.

Long-run shutdown point. In the long run every cost is avoidable, so the firm must cover all of them, including normal profit. It should leave the industry when AR < AC. At 4.00 the car wash covers variable costs but not AC (5.00), so it continues in the short run and leaves if the position persists. The long-run shutdown point is where AR equals the minimum of AC.

Position	Short run	Long run
AR > AC	Produce, supernormal profit	Stay, may attract entrants
AR = AC	Produce, normal profit	Stay
AVC < AR < AC	Produce, loss minimised	Leave if it persists
AR < AVC	Shut down	Leave

Evaluation points

• Gains depend on where the firm sits relative to MES. Below it, growth cuts costs; beyond it, diseconomies can erase them.
• Lower costs need not mean lower prices. A firm with pricing power can pocket the saving as supernormal profit; competition pushes it through to consumers.
• Shutdown decisions turn on expectations. If a low price is temporary, rehiring costs and lost customers may justify producing at a loss. Contracts and redundancy costs also matter.

Common errors

• Drawing internal economies as a shift of LRAC, or external economies as a movement along it.
• Confusing diseconomies of scale (long run) with diminishing returns (short run, one factor fixed).
• Calling accounting profit supernormal without deducting the owner’s opportunity cost.
• Using AC rather than AVC for the short-run shutdown rule, or shutting down whenever there is a loss.

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.