No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Seven: Production: Man at Work 162 no resource conflicts (i.e., all the productive inputs are readily available on the market at the same price and capability). This gets more and more difficult as a firm’s size increases. With (2) increasing returns to scale, as a company doubles productive inputs, output will more than double , or 2Q < f(2L,2K). This would be the case where the business sees gains from specialization from the division of labor, and is able to use more specialized capital equipment. Smaller firms may especially find increasing returns to scale. Finally, (3) decreasing returns to scale occur when increasing the productive inputs will lead to a less than proportional increase in output, or 2Q > f(2L,2K). All firms will eventually get to the point of decreasing returns to scale due to diminishing returns to the quality of productive inputs. We may not see decreasing returns in practice; demand may not require high enough production to get to that point. But the conceptual law is still there: we know logically that eventually production would require inferior inputs resulting in decreased gains. You can think of any number of reasons why: the additional workers may not have the same skill level as the initial workers; the facility may not be in as good an area; or capital may not be as readily available or in the same quality as it was initially. This is a natural result of the fact that when an entrepreneur builds the first factory, he or she will pick the expected best location first— the best of every productive input at the cheapest cost to make sure this first factory is a success. Just as with the gains from specialization, it is possible that initial factory increases could lead to increased production at an increasing rate due to lessons learned in how to build and equip a factory. Eventually, however, the inputs used at subsequent factories will be less efficient than prior inputs, as illustrated in Figure 7.6 . The concept of returns to scale helps us think about how productive efficiency may change depending on the scale of production. But another aspect of the size of a firm is also crucial for entrepreneurs: the size of the firm may drive differential cost structures. If a firm’s costs per unit of production is decreasing as production increases, we say that firm is experiencing economies of scale . Many firms find this to be true—if they can buy resource inputs in bulk they can bargain for a cheaper price. Or similarly, if they can contract for a sustained rate of purchase they can likewise obtain a lower price. For example, United Airlines may contract with Boeing to purchase ten 777 aircrafts per year for the next ten years. This allows Boeing to likewise “right size” its production and gain efficiencies. Firms also become more efficient as they grow by spreading fixed costs across more units that are produced. If a firm sees costs rising as production increases, we say that firm is experiencing diseconomies of scale . Diseconomies of scale can be the result of increased communication costs, additional layers of management, or any other bureaucratic inefficiency. As firms get larger and larger, it becomes harder Figure 7.6, The Production Function with Diseconomies of Scale. Building additional factories adds to total output, but the increase diminishes the more factories one adds. TP 1 is the total product from the first factory, TP 2 is the total product from both the first and second factories, and so on. Labor or Capital with Additional Factories The Production Function Output TP 4 TP 3 TP 2 TP 1 Economies of scale: As a firm gets larger, it can often reduce costs by more efficiently purchasing resource inputs. Diseconomies of scale: As a firm gets larger, it may incur higher costs, typically due to bureaucratic inefficiencies.