In Business Economics, the short run is defined as the concept that within a certain period of time, in the future, at least one input is fixed while others are variable and the long run is defined as a period of time in which all factors of production and costs are variable. The law of diminishing returns is a short run concept, which states that increasing successive units of a variable factor to a fixed factor will increase output but eventually the addition to output will start to slow down and would eventually become negative. This is because if capital is fixed, extra labour will eventually get in each other’s way as they attempt to increase production. E.g. think about the effectiveness of extra employees in a factory that’s maximum workers is 100. If the firm employs 150 workers, then the productivity will eventually decrease, as they will get in each other’s way etc. However, this law only applies in the short-term, as in the long run, all factors are variable.
As you can see from the graph above, the average fixed cost (AFC) curve falls as output increases due to the fact that fixed costs are a decreasing proportion of total cost as output increases. Both the average total cost (ATC) and the average variable cost (AVC) curves fall, and then rise again. The curves start to rise after a certain point because diminishing return takes place. The distance on the y-axis between the ATC and the AVC represents the value of the average fixed cost (AFC). Just like the average variable cost and average total cost curves demonstrate, the marginal cost also falls, and eventually rises again as diminishing marginal returns take place.
Economies of scale, however, refer to the advantages that arise from large-scale production, which in turn results in a lower average unit cost (cost per unit). It explains the relationship between the long run average costs of producing a unit of good with increasing level of output. Unlike diminishing returns, economies of scale is a process that operates and is caused by a development over a long period of time. Economies of scale also have many sources whereas diminishing returns is the relationship between output and only one input of production.There are two different forms of economies of scale that could occur in a firm. The first is internal economies of scale. This refers to the advantages that are caused as a result of the expanding and growth of a firm/business. Internal economies of scale can be additionally categorized into commercial, managerial, financial and technical economies of scale.
Commercial economies of scale arise from the purchase of raw materials and the sale of finished goods. When the firm’s output increases, they order larger quantities of the raw materials (bulk buying) and therefore these raw material firms favour these businesses, and offer lower prices due to their ordering of higher quantities. Managerial economies of scale is a process that follows the principle of the division of labour and creates specialization due to the firm’s ability to employ specialized employees, and this causes an increase in production efficiency. A financial economy of scale is when a large firm benefits by getting better credit facilities e.g. credit at cheaper rates, being able to negotiate better finance deals etc. Finally, a technical economy of scale arises due to large-scale production because there is a technical advantage in the use of large machinery in the production process.
Technical economies of scale will most likely arise due to machinery being used in the production process, which are more efficient than human labour, and also require less maintenance, training and do not require payment. External economies of scale refers to the advantages firms/businesses can get as a result of the growth of the entire industry as a whole. Usually, the industry grows due to an improvement in a specific area of the industry, such as an increase in the local’s skill and training, and improving in the training facilities themselves, which causes an increase in the quality of training for the future employees or an increase in the foreign supply of labour with a higher skillset that before.