Sectors with increasing returns

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Increasing returns to scale characterize businesses with large initial costs and relatively low costs of producing each unit of output. Computer chip manufacturers, pharmaceutical manufacturers, even brewers all appear to benefit from scale economies. In the beer market, brewing, bottling and shipping are all low cost operations relative to the capital cost of setting up a brewery. Consequently we observe surprisingly few breweries in any given producer, even in large land mass economies such as Canada or the US.

Large firms frequently encounter decreasing returns to scale. Figure 8.5 contains a curve that forms an envelope around the bottom of the various short-run average cost curves. This envelope is the long run average total cost (LATC) curve, because it defines average cost as we move from one plant size to another. Remember that in the long run both labour and capital are variable, and, as we move from one short-run average cost curve to another, that is exactly what happens—all factors of production are variable. Hence, the collection of short-run cost curves in Figure 8.5 provides the ingredients for a long-run average total cost curve 1 .

 Long-run average total cost is the lower envelope of all the short-run ATC curves.

The particular range of output on the LATC where it begins to flatten out is called the range of minimum efficient scale. This is an important concept in industrial policy, as we shall see in later chapters. At such an output level, the producer has expanded sufficiently to take advantage of virtually all the scale economies available.

 Minimum efficient scale defines a threshold size of operation such that scale economies are almost exhausted.