Cost II: Elasticity of scale

Summary

As economies near perfection, costs efficiency becomes increasingly crucial, so much so that investment plays a greater role. But just how and where that investment in cost management should be directed is the subject of our second LP on cost analysis.

Short run:

Long run:

Different levels of production have different cost levels. It is generally assumed that higher levels of production help drive down cost (by reducing fixed costs per unit, by lowering the price of raw materials and intermediate goods through increased bargaining power…). However, this is not necessarily the case when an increase in production leads to a jump in fixed costs that cannot be fully absorbed by the increase in production (purchasing a new, larger factory or a heavy investment in infra utilised machinery). To find out whether increasing production will increase efficiency (whether the increase in production will be greater than the increase in cost), we can measure elasticity.

This is the same as measuring the result of dividing the % change in output by the % change in input. When considering the diagram seen in the short run cost analysis entry, along phase one, when efficiency is increasing with production, μ > 1. When we reach the point of inflection, μ = 1, and when we begin to have diminishing returns to scale, output begins to grow slower than inputs, and μ < 1, which is in phase III.

We saw how our naturally preconceived notion that an increased production level is naturally more cost efficient isn’t always necessarily the case. In the next entry, we'll look at the reasons why changes in production can drive costs down (or up!).

Cost II: Returns to scale

Cost II: Economies of scale