The concept of economies of scale as designed in the discipline of microeconomics is about the cost implications which result from the expansion of a firm’s production capacity. It is a long-run view of the firm where the average unit cost of production decreases as the amount of production is scaled up. It is based on the basic precept that the total cost of production is categorized into two. The first is the variable costs. Variable costs vary with the level of production. As the quantity of production rises, the variable costs also rise. Fixed costs on the other hand do not vary with the level of production. Even as production rises, they remain constant. As such the total cost function is TC=FC+VC.
This being the case, the total cost is calculated by combining the two costs. The average unit cost of production is obtained by averaging the total costs with the amount of production as shown by the equation AC = TC / Q.
The fact that the fixed cost component does not rise with the rise in the level of output means that the average cost per unit decreases with an increase in the level of production. Only the variable cost and the quantity of output are increasing in an equation which can be rewritten as AC= (FC+VC)/Q.
It is therefore clear that economies of scale spread total costs over an even greater range of output hence lowering the unit cost of production which has the greatest influence on the price and hence competitiveness in the industry.
The graph on the beer brewing industry clearly demonstrates the effect of economies of scale prevalent. The continued lowering of the long-run average cost curve shows that expanding production lowers the cost per unit for beer. The implication here is that the beer industry is highly capital intensive. Capital intensity requires big investments in equipment, plant, and machinery most of which fall under the fixed cost category. It is the level of utilization of these investments which largely determines the cost per unit and hence the prices. This implies that for one to competitively engage in the beer industry, they must be able to capture a sizeable market size capable of keeping the unit costs low through maintaining a high level of production. In this case, the level of production which minimizes variable costs for the industry is 8 million barrels of output usually calculated on an annual basis. At this level of production, the unit cost is at its lowest level and the firm can sell at the lowest price.
Under normal circumstances, the firms operating in the industry produce at levels lower than the optimal but along the long-run average cost curve as shown below (Maaw Information, n. d., par1).
This implies that the short-run average cost is in line with the long-term goal of achieving low unit costs. The fact that the firm’s short-term average cost curve is above the long-run trend means that it is way off the mark on issues of efficiency and cost meaning that it is not able to effectively compete with competitors who can operate at much lower costs along with the trend. This being the case, it is evident that the firm is unable to survive in the industry as it will always be underpriced by the other firms.
Reference
Maaw Information. (n. d.). U-Shaped Long run Average Cost curve. (2010). Maaw.info. Web.