Lesson preview · Costs, revenue and profit
Costs and economies of scale
~8 min · Free to read
A small pizza shop pays 3,000 dollars a month in rent. Even in a month when it’s shut for repairs, it owes the full 3,000. Cheese, flour and the cooks’ hourly pay are different: the more pizzas, the bigger those bills. So what does one pizza cost to make? That depends on how many the shop makes.
Key Term
Fixed and variable costs
- Fixed costs (FC) stay the same however much a firm makes: rent, insurance, a manager’s yearly salary. The firm pays them even when it makes nothing. They stay fixed only for a while: once the lease ends, the owner can move to a bigger or smaller shop.
- Variable costs (VC) rise and fall with output: ingredients, packaging, and hourly pay for the staff who make the goods.
- Total cost (TC) is the two added together: .
Even at zero pizzas, total cost is 3,000 dollars: it starts at the fixed cost, not at zero. The more pizzas the shop bakes, the thinner that 3,000 is spread.
At 100 pizzas, the shop’s total cost is 4,500 dollars: 45 dollars a pizza. At 300 pizzas, total cost is 7,000 dollars, so each pizza costs 7,000 ÷ 300, about 23.33 dollars. That cost per pizza is average cost (AC): total cost divided by the number made. Spreading the rent over more pizzas pulls it down.
Cost per unit. At 300 pizzas: 7,000 ÷ 300 ≈ 23.33 dollars.
Marginal cost (MC) asks a different question: what does one more unit add to the bill? Going from 200 to 300 pizzas raises total cost from 5,500 to 7,000 dollars: 1,500 dollars for 100 extra pizzas, or 15 dollars each. The next 100 pizzas push total cost to 9,500 dollars: 2,500 dollars more, or 25 dollars each. Rent plays no part in marginal cost, because it doesn’t change.
The cost of the extra units only. From 200 to 300 pizzas: 1,500 ÷ 100 = 15 dollars.
Why does marginal cost rise once the shop is busy? Picture the kitchen in the evening rush: two ovens and one counter. In the short run, a period too short to change at least one input, the shop is stuck with that kitchen. One cook makes 24 pizzas an hour. A second adds 16 more, a third 12, a fourth only 6. They share the same ovens and get in each other’s way.
This is diminishing returns: when one input is fixed, each extra worker eventually adds less output than the one before. Say each cook earns 12 dollars an hour. The second cook’s pizzas cost 12 ÷ 16 = 0.75 dollars each in wages; the fourth cook’s pizzas cost 12 ÷ 6 = 2 dollars each. Each extra pizza needs more paid time, so marginal cost rises.
Key Term
Growing the firm: economies of scale
In the long run (long enough to change every input), no cost is fixed: the owner can build a bigger kitchen or open 30 shops. As the firm grows, its average cost often falls. These savings are economies of scale. They come from:
- Bulk buying: a chain buys cheese by the tonne at a lower price per kilo.
- Specialist managers (managerial economies): a big chain can afford a full-time buyer, accountant and marketer, each doing one job well.
- Bigger machines (technical economies): a big conveyor oven bakes far more pizzas an hour than a small one, for not much more money. Only a firm that sells lots of pizzas can keep one busy.
- Cheaper borrowing (financial economies): banks lend to big, established firms at lower interest rates.
Key Term
When growth goes too far
Past a certain size, average cost may stop falling and stay roughly flat: constant returns to scale. With 300 shops, messages pass through layers of managers. Head office loses track of what’s happening, and staff who feel like just a number work less hard. When these problems, called diseconomies of scale, take over, average cost rises again.
As a firm grows, its cost per unit falls, then levels off, then climbs: bigger is cheaper only up to a point.
Trap · Common Misconception
Diminishing returns are not diseconomies of scale
Both make costs rise, so they’re easy to mix up. Diminishing returns are short run: the kitchen is fixed, so each extra cook crammed into it adds less. Diseconomies of scale are long run: every input has grown, and the whole firm is hard to manage. Ask: is anything fixed? If yes, it’s diminishing returns.
Check yourself · no marks
Firm A keeps its factory but hires more workers, and each new worker adds fewer cars than the one before. Firm B builds a second factory and its cost per car falls. Which is diminishing returns, and which is economies of scale?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 6
Next month a pizza shop plans to bake twice as many pizzas. Which of its costs will rise?
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