Introduction

Firms are central to the economy, they are bring together the different factors of production in order to create goods and services that can be sold in the market. Every firm, whether it is a sole trader with a single shop or a multinational corporation with offices across the globe, must constantly make decisions about production and price. These decisions are influenced directly by costs and revenues. Understanding the behaviour of firms requires careful study of how costs are structured, how they vary with output, and how revenues and profits are determined once products are sold.

When a firm decides how much to produce, it must consider not only the demand for its goods or services but also the resources required to supply them. Producing output requires factor of production inputs such as land, labour, capital, and enterprise. Land is rewarded with rent, labour with wages, capital with interest or dividends, and enterprise with profit. The combination of these factors of production incurs costs that the firm must cover before it can make any profit. In addition to costs, firms must also think about revenues, which represent the income they receive from selling their output. The difference between revenues and costs is profit, which is the ultimate financial reward that encourages entrepreneurs to take risks and operate in markets.

Types of Firm

A firm, sometimes referred to as a business, is defined as an organisation that brings together factors of production in order to supply goods or services. The scale and complexity of firms varies widely. At one end of the spectrum, a firm may consist of a sole trader running a small shop or providing a single service such as taxi driving. At the other end are multinational corporations such as Google, which coordinate thousands of workers, vast amounts of capital, and advanced technology across many countries. Between these two extremes lies a wide variety of firms, ranging from local businesses to national enterprises that operate throughout a country.

Regardless of size, the central purpose of all firms is to combine inputs and transform them into outputs that can be sold to consumers. Firms exist in order to reduce the costs of transacting in markets. If every individual attempted to produce goods and services independently, the effort would be inefficient and costly. By pooling resources and organising production centrally, firms achieve efficiency gains that make them the cornerstone of modern economies.

A key decision for every firm concerns the scale of its operations. Scale refers to the size of output that a firm is able to produce with the resources at its disposal. Some firms may find it advantageous to remain small, serving a local area with specialised services. For instance, a local gym may not need to expand beyond its immediate neighbourhood because its customers prefer convenience and personal interaction. By contrast, in industries such as transport, firms may benefit from operating on a national or global scale. British Airways, for example, must achieve large-scale operations in order to cover routes worldwide.

The scale of firms also depends on the technology of the industry. In certain sectors, technology enables production to be efficient even at a small scale. In other sectors, such as car manufacturing, efficiency requires the use of large plants and high levels of capital investment. Thus, the structure of costs and the availability of technology determine whether small firms can survive or whether only large firms can operate successfully.

Firms also vary in the scope of markets they serve. Some firms operate exclusively within their local area. Others expand to serve national markets, selling goods and services across the entire country. The largest firms become international or multinational corporations, serving markets in multiple countries and often producing goods in different locations around the world. The strategic choice of market scope is closely tied to a firm’s cost structure, revenue potential, and opportunities for economies of scale.

The Short Run and the Long Run

Every firm must decide how much output it is going to produce. This decision is not only about how many units of a good or service to place on the market but also about how to combine the necessary factors of production to make that output possible. To produce anything at all, a firm must secure inputs such as labour, land, capital, and enterprise. Labour provides human effort and skills, land provides natural resources, capital provides machinery, equipment, and financial backing, while enterprise organises all of these inputs into a coherent process.

When economists analyse production decisions, they distinguish between two time horizons: the short run and the long run.

The short run is defined as the period of time in which at least one factor of production is fixed in supply. This means that although some inputs can be varied to increase output, at least one remains constant. Typically, the fixed factor in the short run is capital, which includes machinery, buildings, and equipment. These cannot be adjusted instantly, so firms face limitations in how much they can expand or contract production in the short run. For example, a restaurant may be able to hire more waiting staff and buy more raw ingredients if demand suddenly rises, but it cannot immediately enlarge the size of its kitchen or dining area. The fixed space and fixed equipment impose limits on how much extra output can be produced.

The long run is defined as the period of time in which all factors of production can be varied. In the long run, there are no fixed factors. A firm has the ability to change the scale of its operations entirely by investing in new buildings, purchasing additional machinery, or entering new markets. The long run therefore provides firms with complete flexibility. If a factory finds itself with sustained higher demand, in the long run it can build new production facilities, install new equipment, and hire more permanent staff. The long run is about strategic decisions that alter the capacity of the firm.

This distinction between the short run and the long run is central to understanding how firms face costs. In the short run, output is constrained by the presence of fixed inputs. A firm may increase its variable inputs, such as labour, but it cannot expand capital without delay. In the long run, however, the firm is free to alter both fixed and variable inputs. This freedom makes long-run decision-making crucial when analysing how economies of scale and diseconomies of scale arise.

To see why the distinction matters, imagine a small bakery. In the short run, it can employ more bakers and buy more flour to increase the number of loaves produced, but it cannot immediately increase the size of its ovens or bakery floor space. That means that sooner or later, additional workers will be competing for limited oven space, leading to diminishing productivity of labour. In the long run, however, the bakery could move into larger premises or purchase more ovens, meaning all inputs are variable and output can expand without the same constraint.

In analysing costs and output, economists often model a simple production process that uses only two factors: labour and capital. Labour is typically treated as the variable factor in the short run, while capital is treated as the fixed factor. This simplification allows us to understand the principles of cost behaviour without getting lost in the complexity of multiple inputs. The central message is that in the short run, firms must operate under constraints because at least one factor is fixed, whereas in the long run all factors are flexible and the scale of production itself can be changed.

The importance of distinguishing the short run from the long run becomes clear when considering how costs behave and how firms respond to increases in demand. In the short run, expansion of output usually means employing more variable factors alongside fixed factors, which leads to the law of diminishing returns. In the long run, expansion means increasing the scale of all inputs, which brings in the concept of economies of scale. Both of these ideas build on the short run–long run framework introduced here.

The Law of Diminishing Returns

The way in which output varies as inputs are increased depends on the period under consideration. In the short run, when at least one factor of production is fixed, the expansion of variable inputs eventually encounters a constraint. This effect is captured in the principle known as the law of diminishing returns.

The law of diminishing returns states that if a firm increases the quantity of one factor of production while holding all other factors constant, the extra output produced by each additional unit of the variable factor will eventually decline. In other words, beyond a certain point, adding more of a variable factor to fixed inputs will yield progressively smaller increases in output.

This law is one of the fundamental ‘laws’ of economics because it reflects the reality of production processes when resources are not all variable. It is not about inefficiency or poor management but about the physical limits imposed when fixed and variable factors are combined. Since the short run is defined by the existence of fixed inputs, diminishing returns is a short-run phenomenon.

To see why this occurs, consider a simplified example. Imagine an office equipped with ten computers, which represents the fixed factor. Suppose workers are hired one by one to use these computers. The first worker may make full use of one computer and produce a certain level of output. The second worker, also assigned a computer, adds a similar level of output. The process continues, and as long as each worker has a computer, total output rises significantly with each additional worker. However, once the number of workers exceeds the number of computers, additional workers no longer have their own computer. They must share, wait their turn, or perform less productive tasks. At this point, although output may still increase, it does so by a smaller amount with each new worker. Eventually, additional workers add so little to output that their marginal contribution becomes very low or even zero.

This example illustrates the causal mechanism of diminishing returns. When the fixed factor, such as capital equipment, becomes a bottleneck, the productivity of the variable factor, labour, begins to fall. Workers still contribute, but because they must share the limited fixed input, each additional unit of labour adds less to total output than the previous one.

Economists measure this effect using the concept of marginal physical product of labour. The marginal physical product (MPP) is defined as the additional quantity of output produced by an additional unit of labour input, holding all other inputs constant. As long as MPP is rising, each new worker is adding more to output than the one before. However, once diminishing returns set in, MPP begins to decline, indicating that the productivity of extra labour is falling.

This can be represented with a diagram that plots the MPP of labour against the quantity of labour employed. At first, as labour increases, MPP rises because workers can specialise and make better use of the fixed capital. This is sometimes called increasing returns to labour. However, after a certain point, labelled L* on the horizontal axis, diminishing returns set in. Beyond this level of labour, the MPP curve slopes downward, showing that each additional unit of labour contributes less additional output.

The logic of this process can also be expressed step by step. Initially, when few workers are employed relative to fixed capital, adding extra workers increases output more than proportionately. Workers can divide tasks, make better use of machinery, and reduce idle time. This is why MPP rises in the early stages. As more workers are added, the benefits of division of labour and specialisation reach their limit, and the fixed factor becomes binding. The extra output from each new worker is still positive but smaller than before, which is the essence of diminishing returns.

Eventually, if too many workers are employed relative to the fixed factor, MPP may fall to zero or even become negative. This would mean that hiring additional workers actually reduces total output, perhaps because of overcrowding or inefficiency. While extreme, this possibility underlines the fact that fixed capacity constrains variable inputs.

The law of diminishing returns is not confined to labour. It applies to any situation in which one factor of production is increased while another remains fixed. In agriculture, for example, if the area of land is fixed but more fertiliser is added, the additional increase in crop yield eventually diminishes. Similarly, in manufacturing, if factory size is fixed but more raw materials are processed, inefficiencies arise once the physical capacity is overstretched.

Understanding diminishing returns is essential because it explains why short-run cost curves take the shapes they do. When MPP falls, the cost of producing additional units of output rises, since more units of the variable factor are required to produce each extra unit of output. This relationship between productivity and cost will be explored in the next section on total, average, and marginal costs.

The critical point is that diminishing returns are a natural consequence of combining variable and fixed factors in the short run. They set a limit on how far output can expand using only variable inputs, and they form the basis for the rising part of the short-run marginal cost curve.

Total, Marginal and Average Costs

When examining the costs faced by a firm, it is important to be precise about what is being measured. Costs can be considered in total or on a per-unit basis, and they can also be considered in terms of how they change when output changes. To develop a clear understanding, economists distinguish between total costs, marginal costs, and average costs. Each of these measures captures a different aspect of how resources are used and how much it costs the firm to produce goods or services.

Total Cost

Total cost is defined as the sum of all costs incurred in producing a given level of output. It includes every expenditure required to bring that output to market, such as the cost of labour, raw materials, energy, and the fixed expenses of buildings and machinery. If a firm produces no output at all, it still incurs certain fixed costs, such as rent on premises or contractual commitments. As output increases, total cost rises because more inputs are required.

Mathematically, total cost is the sum of fixed costs and variable costs. Fixed costs are those that do not vary with the level of output. They include expenses like rent, salaries of permanent staff, or the cost of long-term advertising contracts. These costs must be paid regardless of how much the firm produces. Variable costs are those that change with the level of output, such as wages of temporary workers, the cost of raw materials, and fuel or electricity directly linked to production. Thus, total cost can be expressed as:

Total cost = Fixed cost + Variable cost

This representation shows that even at zero output, total cost is not zero because fixed costs must still be paid. As output increases, variable costs rise, and therefore total cost rises as well.

Average Cost

While total cost is important, firms and economists also need to know the cost per unit of output, since this figure allows direct comparison with the market price. This is where average cost is used. Average cost is defined as total cost divided by the quantity of output. It tells us how much, on average, it costs to produce each unit of the good or service.

Average cost = Total cost ÷ Output

Average cost can also be divided into average fixed cost and average variable cost. Average fixed cost is total fixed cost divided by output, while average variable cost is total variable cost divided by output. Since fixed cost does not change as output rises, average fixed cost declines steadily as output expands. This is often called the spreading effect of fixed costs. For example, if a firm has fixed costs of £100 and produces one unit, average fixed cost is £100 per unit. If it produces ten units, average fixed cost falls to £10 per unit. The more units produced, the lower the fixed cost per unit.

By contrast, average variable cost depends on how variable inputs behave as output increases. Initially, average variable cost may fall as workers specialise and resources are used more efficiently. However, because of the law of diminishing returns, average variable cost eventually begins to rise as more of the variable factor is employed relative to fixed inputs.

The shape of the average cost curve reflects both of these influences. At first, average cost falls as fixed costs are spread and variable inputs are used more productively. Then, as diminishing returns set in, average cost begins to rise. The result is a U-shaped average cost curve.

Marginal Cost

Another key measure is marginal cost. Marginal cost is defined as the additional cost incurred by producing one more unit of output. It shows how total cost changes when output increases by a very small amount. Formally, marginal cost is the change in total cost divided by the change in output:

Marginal cost = Change in total cost ÷ Change in output

Marginal cost is directly linked to the productivity of variable factors. When the marginal physical product of labour is rising, each additional worker contributes more output, and the marginal cost of producing that output falls. When the marginal physical product falls due to diminishing returns, more labour is needed to produce extra output, and marginal cost rises. Hence, marginal cost curves typically fall at first, reach a minimum point, and then rise sharply.

The relationship between marginal cost and average cost is crucial. Whenever marginal cost lies below average cost, it pulls the average cost down. Whenever marginal cost lies above average cost, it pushes the average cost up. This is the same logic that applies in everyday life with averages. If a student has an average score of 70 and then scores 80 in the next test, the average rises. If the new score is 60, the average falls. The point of intersection between the marginal cost curve and the average cost curve is the minimum point of the average cost curve.

Sunk Costs

In addition to fixed and variable costs, economists sometimes refer to sunk costs. These are costs that have already been incurred and cannot be recovered if the firm exits the market. For example, money spent on a specialised machine that has no alternative use is a sunk cost. While fixed costs may be recovered in some cases if assets are sold, sunk costs represent an irretrievable expense. They are important because they should not affect forward-looking decisions, yet in practice firms often find it difficult to ignore them.

Costs in the Short Run

To bring these concepts together, consider how costs behave in the short run when labour is variable and capital is fixed. As the firm increases output, total variable cost rises because more labour and raw materials are required. Total cost also rises, since it is the sum of fixed and variable costs. Average cost initially falls because fixed costs are spread and variable inputs are used more productively. However, as diminishing returns set in, average variable cost and average total cost rise. Marginal cost falls at first, then increases sharply once diminishing returns dominate.

This pattern produces the well-known U-shaped average cost curve and the rising marginal cost curve. The behaviour of these curves is not arbitrary but stems directly from the law of diminishing returns and the interaction of fixed and variable costs.

Short Run and Long Run Cost Curves

Short Run Cost Curves

In the short run, at least one factor of production is fixed. For most firms, this fixed factor is capital in the form of machinery, plant, or factory size. Because capital is fixed, firms can only adjust output by varying the quantity of other inputs such as labour and raw materials. As output expands in the short run, costs change in predictable ways due to the law of diminishing returns.

As we saw earlier, the average cost curve in the short run takes a U-shape. At low levels of output, average cost falls because fixed costs are spread over more units and variable inputs are used more effectively. However, beyond a certain level of output, diminishing returns set in. As the fixed factor becomes a bottleneck, each additional unit of labour or variable input produces less extra output, so costs rise. This creates the upward-sloping part of the U-shaped curve.

The marginal cost curve also plays a central role in the short run. Marginal cost falls initially as efficiency improves, but once diminishing returns dominate, it rises sharply. The point at which the marginal cost curve intersects the average cost curve is the minimum of the average cost curve. This relationship holds because when marginal cost is lower than average cost it pulls the average down, and when it is higher it pushes the average up.

The short-run cost curves therefore embody the interaction of fixed and variable inputs. They demonstrate how efficiency is gained initially but lost later as output grows without expansion of fixed capacity.

Long Run Cost Curves

The long run is different because all factors of production are variable. No factor is fixed, so firms are free to change the scale of production. They can build larger factories, install more machinery, or expand to new locations. In the long run, therefore, the constraint of fixed inputs disappears, and firms can choose the most efficient scale of production for any level of output.

The long-run average cost curve (LRAC) represents the lowest possible average cost of production at each level of output when all inputs are variable. It is derived from a series of short-run average cost curves (SRACs), each of which corresponds to a different plant size or scale of operation.

To visualise this, imagine a firm that can operate a small, medium, or large factory. Each factory size has its own SRAC curve. The small factory has low fixed costs but quickly experiences rising average costs when output increases beyond its limited capacity. The medium factory allows more output at lower average cost, and the large factory permits even greater output before costs begin to rise. The LRAC is formed by taking the lowest cost available at each level of output across all possible SRACs. It therefore acts as an envelope curve, touching each SRAC at its lowest point.

The LRAC is also typically U-shaped, but the reasons for this shape are different from the short run. In the short run, the U-shape arises because of diminishing returns when variable inputs are combined with fixed inputs. In the long run, the U-shape arises because of economies of scale and diseconomies of scale. At low levels of output, firms enjoy falling average costs as they expand because they can spread fixed costs, specialise labour, and use capital more efficiently. However, beyond a certain point, further expansion brings rising average costs due to managerial complexity, communication difficulties, and other diseconomies of scale.

The LRAC therefore summarises the cost structure a firm faces when it can adjust all inputs. It is a guide to the most efficient scale of production in the long run. The minimum point of the LRAC represents the output at which the firm achieves its lowest possible average cost, known as the minimum efficient scale.

Linking Short Run and Long Run

The short run and long run cost curves are connected because the long run is essentially a series of short runs. In each short run, the firm is constrained by fixed inputs, but in the long run it can move from one SRAC to another by changing plant size or scale. As a result, the LRAC is shaped by the underlying SRACs.

For example, if a firm is currently producing at the minimum point of its small-scale SRAC but demand grows, in the short run it can expand output along the same SRAC. However, costs will eventually rise. To avoid this, in the long run the firm can move to a larger plant and a lower-cost SRAC. Thus, the LRAC traces the lowest cost option available as firms adjust scale over time.

This relationship illustrates why the long-run perspective is critical for strategic decision-making. A firm that only looks at short-run costs may mistakenly assume that rising costs are unavoidable, when in fact, by changing scale, it could lower its costs in the long run. The distinction between short-run and long-run cost curves allows us to separate temporary cost pressures from long-term cost efficiency.

Economies of Scale

When a firm increases the scale of all its factors of production in the long run, it may find that its average cost of producing each unit of output falls. This phenomenon is known as economies of scale. Economies of scale are defined as the cost advantages that a firm experiences as it increases the scale of its operations, leading to a fall in long-run average costs. They occur because larger-scale production allows resources to be used more efficiently, fixed costs to be spread more widely, and specialisation to be extended further.

Economies of scale explain the downward-sloping part of the long-run average cost (LRAC) curve. At low levels of output, the LRAC falls as the firm expands. This means that larger firms can often produce goods and services at lower average costs than smaller firms, giving them a competitive advantage in markets.

There are several main types of economies of scale that operate when firms grow in size.

Technical Economies of Scale

Technical economies arise from the more efficient use of capital and production techniques when operating on a larger scale. Many production processes involve indivisible units of capital equipment, meaning that certain machinery is only efficient when used at large volumes of output. For example, in car manufacturing, a large automated assembly line is costly to build, but once installed it can produce thousands of vehicles at a much lower average cost than would be possible with small-scale hand assembly.

In addition, larger plants can use more advanced technology that is not cost-effective for small firms. Large-scale production also reduces waste because inputs can be used more fully, and processes can be integrated in ways that are not viable at a smaller scale.

Managerial Economies of Scale

As firms grow, they can benefit from managerial economies by employing specialist managers for different functions. A small firm may require one person to oversee production, marketing, and finance, leading to less efficiency. A larger firm, however, can afford to employ managers who focus solely on one area, such as human resources or logistics. This specialisation in management increases efficiency and reduces average costs, since decisions are made with greater expertise and coordination.

Financial Economies of Scale

Large firms often face lower costs when raising finance. They have better access to capital markets and are considered less risky by banks and investors, which allows them to borrow at lower interest rates. They may also be able to issue shares or bonds to raise funds, which small firms cannot do. Lower financing costs reduce overall production costs and provide larger firms with an advantage in expanding operations.

Marketing Economies of Scale

Marketing is another area where scale matters. Advertising and distribution involve high fixed costs that can be spread over a larger volume of output in bigger firms. For example, if a national advertising campaign costs £1 million, a firm producing one million units spreads that cost at £1 per unit, while a firm producing ten million units spreads the cost at just 10 pence per unit. Larger firms can also negotiate better terms with distributors and retailers, further reducing average costs.

Purchasing Economies of Scale

Large firms usually buy raw materials and components in bulk. By ordering greater quantities, they can negotiate discounts and reduce the average cost of inputs. Suppliers are often willing to provide better prices to larger buyers because bulk orders reduce their own selling and transaction costs. This purchasing power is another reason why larger firms can achieve lower long-run average costs.

Risk-Bearing Economies of Scale

Finally, larger firms can spread risks across more products and markets. A small firm producing a single product is vulnerable to shifts in consumer demand, but a large diversified firm can offset losses in one product line with gains in another. Similarly, large firms may operate in several geographical markets, reducing their exposure to local downturns. This stability lowers overall risk and allows larger firms to make longer-term investments at lower cost.

Diagram of Economies of Scale

The combined effect of these factors is shown in the long-run average cost curve. As output increases, average costs fall due to the various economies of scale. The downward-sloping section of the LRAC represents this cost reduction.

Importance of Economies of Scale

Economies of scale are crucial in explaining why certain industries are dominated by large firms. In industries such as steel production, car manufacturing, and commercial aviation, the minimum efficient scale is very high, meaning that only firms operating at a very large output can achieve competitive average costs. Smaller firms are unable to compete because their average costs are significantly higher. By contrast, in industries where minimum efficient scale is low, small firms can survive and thrive.

Economies of scale also explain trends toward mergers and acquisitions. Firms often seek to grow larger so that they can reduce costs and gain an advantage over rivals. However, economies of scale do not continue indefinitely. Beyond a certain point, firms may experience rising average costs, a phenomenon known as diseconomies of scale. That subject will be examined in the next section.

Diseconomies of Scale

While economies of scale explain why average costs fall as firms grow, expansion cannot reduce costs forever. Beyond a certain scale, further increases in output may cause long-run average costs to rise. This effect is called diseconomies of scale. Diseconomies of scale occur when a firm becomes so large that the cost per unit of output begins to increase. They represent the upward-sloping section of the long-run average cost (LRAC) curve.

The reasons for diseconomies of scale are not physical limitations in the way that diminishing returns arise in the short run. Instead, diseconomies are the result of organisational and managerial challenges that arise when a firm operates at a very large scale. As firms grow, the complexity of managing, communicating, and coordinating their activities expands dramatically. These organisational difficulties generate inefficiencies that push up costs per unit.

Managerial Diseconomies

One major source of diseconomies of scale is managerial inefficiency. In a small or medium-sized firm, managers can directly supervise workers and maintain effective control over operations. As the firm expands, however, layers of management are added to cope with the complexity of larger operations. This creates problems of communication and decision-making. Information may become distorted as it passes through several layers of hierarchy, leading to slower or poorer-quality decisions. Workers may feel less motivated if they are distant from the decision-makers and see themselves as anonymous parts of a vast organisation. The result is lower productivity and rising costs.

Communication Problems

Closely linked to managerial diseconomies are communication problems. In a small firm, information flows quickly and informally, allowing problems to be solved rapidly. In a large multinational corporation, however, information must travel across departments, divisions, and even countries. Language barriers, cultural differences, and time zones can all contribute to delays and misunderstandings. Decisions take longer to implement, and the firm becomes less responsive to changes in market conditions. These inefficiencies add to the cost of running the firm.

Lack of Coordination

As firms grow, coordinating the different functions of production becomes increasingly difficult. Production, marketing, finance, logistics, and research may all need to work together, but ensuring smooth coordination across large numbers of people and departments can be problematic. Duplication of effort, delays in supply chains, and misallocation of resources can occur. For example, if the production department increases output without proper communication with marketing, the firm may be left with unsold inventories, adding to costs.

Motivation and Morale Issues

Large firms also face challenges in maintaining worker motivation. In a small firm, workers often feel directly connected to the success of the business. Their contribution is visible, and rewards are more immediate. In a vast corporation, by contrast, individual workers may feel insignificant and alienated. This can lead to reduced effort, lower productivity, and industrial disputes. To counteract this, firms may need to invest more in supervision, monitoring, and incentives, all of which raise costs.

External Diseconomies of Scale

So far, the diseconomies discussed have been internal to the firm, arising from its own size and complexity. However, diseconomies can also occur externally, at the level of the industry as a whole. External diseconomies of scale occur when the growth of an industry raises costs for all firms operating within it. For example, if a large number of firms cluster in a particular area, the increased demand for labour may push up wages, or congestion may raise transport costs. These external pressures mean that firms cannot achieve indefinitely falling average costs simply by growing larger.

The effect of diseconomies of scale is reflected in the upward-sloping section of the LRAC curve. At first, average costs fall as the firm expands and enjoys economies of scale. Beyond a certain output level, however, diseconomies begin to dominate. Average costs then rise, showing that the firm has exceeded the efficient scale of operation.

Importance of Diseconomies of Scale

Diseconomies of scale explain why firms do not simply expand indefinitely. Although large size can confer many advantages, there are limits to how efficiently a firm can be managed. When diseconomies set in, further growth increases costs, undermining competitiveness. This is why in many industries there is a range of firm sizes rather than a single gigantic producer dominating everything. The balance between economies and diseconomies of scale determines the optimal size of firms in the long run.

Diseconomies of scale also have implications for mergers and acquisitions. While firms often seek to expand in order to capture economies of scale, they must also consider the risk that expansion may lead to diseconomies that outweigh the benefits. A merger that creates a corporation too large to manage effectively may result in higher, not lower, costs.

Minimum Efficient Scale

The long-run average cost curve (LRAC) reflects the lowest possible cost of producing each level of output when all inputs are variable. At first, the LRAC slopes downward because of economies of scale. Beyond a certain level, diseconomies of scale cause it to slope upward. The point that lies at the bottom of the LRAC curve is known as the minimum efficient scale (MES).

Minimum efficient scale is defined as the level of output at which long-run average cost stops falling as output increases. At this output level, the firm has fully exploited all available internal economies of scale, but it has not yet reached the stage where diseconomies of scale dominate. Producing below this level means the firm has higher average costs because economies of scale are not fully utilised. Producing above this level means the firm experiences rising average costs due to diseconomies of scale.

The MES can be illustrated on a long-run average cost curve. The LRAC is U-shaped, and the lowest point on this curve indicates the minimum efficient scale. At this output level, labelled Qmes, the average cost is at its lowest possible level, labelled Cmin.

Significance of MES

The concept of minimum efficient scale is important for understanding the structure of industries and the number of firms that can operate within them. If the MES is very small relative to the total size of the market, many firms can achieve efficient scale and compete with each other. This is often the case in industries such as restaurants or small retail shops, where efficient operation can be achieved at a modest scale of output.

If, however, the MES is very large relative to the size of the market, only a few firms will be able to produce at or near the MES. In such industries, firms must operate on a large scale to be competitive, which creates high barriers to entry. This is typical in industries such as steel production, commercial aircraft manufacturing, or telecommunications infrastructure. Because average costs are only minimised at very high levels of output, smaller firms cannot survive in the long run since their average costs are too high.

The MES also explains why some industries tend naturally towards monopoly or oligopoly. If only one or a handful of firms can produce at the minimum efficient scale, competition is limited. By contrast, where MES is small, markets are more fragmented and competitive.

MES and Long-Run Profitability

For an individual firm, operating at or near the MES is crucial to long-run profitability. Firms that remain below the MES suffer higher average costs than rivals and may be forced out of the market. Firms that grow beyond the MES face diseconomies of scale, which also raise costs. The goal is therefore to identify and operate at the efficient scale that minimises costs and maximises competitiveness.

In addition, the MES affects pricing strategies. Firms operating at MES can produce at the lowest average cost and may use this advantage to charge lower prices than competitors, reinforcing their position in the market. Conversely, firms that cannot achieve MES face the risk of being undercut on price and losing market share.

MES and Industry Dynamics

Over time, technological change can alter the MES. Advances in production techniques, automation, or information systems may reduce the scale needed to achieve minimum average cost. This can open up industries to smaller firms by lowering barriers to entry. Conversely, in some industries, MES may rise if technology becomes increasingly capital-intensive, favouring larger firms.

The MES therefore plays a dynamic role in shaping not only the cost structures of individual firms but also the overall competitive environment of industries. It is the critical point at which the downward pull of economies of scale ends and the upward pressure of diseconomies of scale begins.

Revenue of Firms

While costs represent the expenditure incurred by a firm in the production process, revenue represents the income that the firm receives from selling its output. The comparison between costs and revenues determines the level of profit or loss a firm achieves. Just as there are different ways of analysing costs, revenue can be measured in several distinct but related ways: total revenue, average revenue, and marginal revenue. Each provides insight into how a firm’s income behaves as output changes.

Total Revenue

Total revenue is defined as the total income a firm receives from selling a given quantity of output. It is equal to the price of the product multiplied by the quantity sold.

Total revenue = Price × Quantity

If a firm sells 100 units of a product at a price of £10 each, its total revenue is £1,000. Total revenue is therefore directly affected by both the price the firm can charge and the amount it is able to sell.

A diagram can illustrate this by plotting output on the horizontal axis and total revenue on the vertical axis. If the price is constant, the total revenue curve is a straight line from the origin, since each additional unit sold adds the same amount to revenue.

Average Revenue

Average revenue is defined as total revenue divided by the quantity of output sold. It measures the revenue earned per unit of output, which in most cases is simply the price of the product.

Average revenue = Total revenue ÷ Quantity = Price

This means that the average revenue curve coincides with the firm’s demand curve. Each point on the demand curve shows the price at which a certain quantity can be sold, and this is identical to the average revenue the firm receives for that output level.

If the firm is a price taker in a perfectly competitive market, it must accept the ruling market price. In this case, the demand curve is perfectly elastic, and the average revenue curve is a horizontal straight line at the market price. If the firm has some market power, such as in monopoly or imperfect competition, it faces a downward-sloping demand curve. This means that to sell more output, it must reduce the price, and therefore average revenue declines as output increases.

Marginal Revenue

Marginal revenue is defined as the additional revenue a firm receives from selling one more unit of output. Formally, it is the change in total revenue divided by the change in output.

Marginal revenue = Change in total revenue ÷ Change in output

The shape of the marginal revenue curve depends on the nature of the firm’s demand curve. In perfect competition, marginal revenue is constant and equal to the market price, since every additional unit sold earns the same revenue. In imperfect competition, however, marginal revenue falls as output increases. This is because the firm must lower the price to sell more units, so each extra unit adds less to total revenue than the previous one. In fact, under a linear downward-sloping demand curve, the marginal revenue curve lies below the average revenue curve and has twice the slope.

For example, suppose a firm sells 10 units at £10 each, giving total revenue of £100. If it lowers the price to £9 to sell 11 units, total revenue becomes £99, so the marginal revenue of the 11th unit is negative (£−1). This shows that beyond a certain point, reducing price to expand output can actually lower total revenue.

Relationships Between TR, AR, and MR

The three revenue concepts are closely linked. Total revenue shows overall income, average revenue shows income per unit, and marginal revenue shows the extra income from an additional unit. Their relationships reveal important information about the firm’s market situation.

In perfect competition, total revenue rises proportionately with output, average revenue is constant and equal to price, and marginal revenue is also constant and equal to average revenue. In monopoly or imperfect competition, total revenue rises at first but eventually falls as output increases, because price reductions needed to sell more output outweigh the extra sales. Average revenue falls steadily with output, and marginal revenue falls even more steeply, turning negative once total revenue begins to decline.

These relationships are critical in determining output and pricing decisions. Since profit maximisation depends on the relationship between revenue and cost, understanding total, average, and marginal revenue provides the foundation for analysing profit behaviour.

Profit and Loss

Profit is the financial reward earned by entrepreneurs for bringing together the factors of production and taking the risks involved in producing goods and services. In economic analysis, profit is more than just a measure of income; it is a signal that resources are being used efficiently and that firms are successfully meeting consumer demand. Conversely, losses indicate that resources may need to be reallocated. To understand this more clearly, economists distinguish between different forms of profit and examine how profits are determined by the relationship between costs and revenues.

Total, Average, and Marginal Profit

Just as costs and revenues can be measured in total, average, and marginal terms, so too can profit.

Total profit is defined as the difference between total revenue and total cost.
Total profit = Total revenue − Total cost

If a firm’s total revenue exceeds its total cost, it makes a profit. If total revenue is less than total cost, the firm incurs a loss.

Average profit is total profit divided by output. It shows the profit earned per unit of output.

Marginal profit is the additional profit earned from selling one more unit of output. It equals marginal revenue minus marginal cost. If marginal revenue exceeds marginal cost, producing one more unit increases profit. If marginal revenue is less than marginal cost, producing more reduces profit.

Normal Profit

In economics, the concept of normal profit is important because it represents the minimum level of profit necessary to keep a firm in operation in the long run. Normal profit occurs when total revenue is exactly equal to total cost, where total cost includes both explicit and implicit costs. Explicit costs are direct payments such as wages, rent, and raw materials, while implicit costs represent the opportunity cost of resources supplied by the entrepreneur, such as their own time or capital invested in the business.

Normal profit is therefore not an economic surplus but a cost of production. It is the reward necessary to keep the entrepreneur in the industry. If a firm earns only normal profit, it has no incentive to leave the market, but neither does it earn more than the opportunity cost of its resources.

Supernormal Profit

Supernormal profit, also called abnormal profit or economic profit, arises when total revenue exceeds total cost, including both explicit and implicit costs. Supernormal profit represents a return above the minimum necessary to keep the firm in the industry.

In the short run, firms may earn supernormal profits if they face strong demand or if competitors are slow to enter the market. In the long run, however, the existence of supernormal profits in competitive markets attracts new entrants, which increases supply, reduces price, and erodes profits back to normal levels. This process is central to the theory of competitive markets.

Subnormal Profit and Losses

When total revenue is less than total cost, a firm makes a subnormal profit, also referred to simply as a loss. This indicates that the firm is not covering the full economic costs of production. In the short run, however, it may still be rational for the firm to continue operating if it can cover its variable costs.

The Shut-Down Condition

The decision of whether to continue operating when making losses depends on the relationship between revenue and costs. If a firm’s total revenue covers total variable cost, it can contribute something toward fixed costs, even if it does not cover them completely. In this case, it is rational to continue operating in the short run. However, if total revenue does not cover total variable cost, then the firm cannot even pay for the inputs directly tied to production. In this case, the firm is better off shutting down immediately to avoid further losses.

The shut-down condition is therefore defined as the situation in which price is less than average variable cost at the profit-maximising output. At this point, the firm cannot cover its variable costs, and production ceases.

Profit Maximisation

The objective of most firms is to maximise profit. Profit maximisation occurs at the output level where marginal revenue equals marginal cost (MR = MC). At this point, the firm is producing the last unit of output for which the additional revenue is equal to the additional cost. Producing more would add greater cost than revenue, while producing less would forgo revenue greater than cost.

The profit-maximising condition (MR = MC) applies regardless of whether the firm is in perfect competition or monopoly. What differs between market structures is the shape of the demand curve and therefore the level of price and output at which MR = MC is achieved.

Accounting Profit vs Economic Profit

It is also useful to distinguish between accounting profit and economic profit. Accounting profit is the difference between total revenue and explicit costs, as recorded in financial accounts. Economic profit, by contrast, subtracts both explicit and implicit costs. A firm may report positive accounting profit while making zero or even negative economic profit if its implicit opportunity costs are high. Economic profit is therefore the relevant measure for analysing resource allocation and long-run industry dynamics.