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Explain How a Firm Can Experience Diminishing Returns in the Short-Run and Economies of Scale in the Long Run. (15 Marks)

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‘Bigger is better… Small is Beautiful… Size does not matter’.
Explain how a firm can experience diminishing returns in the short-run and economies of scale in the long run. (15 marks)

Economies of scale is a long-run concept experienced by firms whereby lower average costs is achieved as a result of an increase in the scale of production. It can occur both internally and externally. Examples of internal economies of scale include: technical, marketing, managerial, financial, network and specialisation of the workforce. The law of diminishing return states that as additional units of a variable factor (such as labour) are added to a fixed factor(such as premises), the extra unit of output from the variable factor will eventually diminish (this is a short-run concept).

<Insert cost curve envelope>

The above diagram illustrates a cost curve envelope. As a new firm starts to produce a good or service in an industry, they under produce at point Qa. The firm then starts to utilise their resources and eventually reach optimum efficiency as shown in the diagram above at point Qb. If a firm starts to overproduce and over utilise their resources due to massive order by a large firm required within a short time period, they will produce at point Qc at cost AC. At this point, each extra marginal unit of labour added to the fixed cost will produce fewer marginal units of labour and therefore the firm experiences the law of diminishing returns as total output is still increasing but at a diminishing rate.

In the long run a firm can overcome the problem of diminishing returns as it can vary its fixed factors. For instance, as the firm expands their premises (SRAS2) and produce at the same point Qc, they will experience a lower average cost at AC1 as demonstrated in the diagram above. This fall in average cost therefore illustrates economies of scale in the long...

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