Revenue Curves

Economies and Diseconomies of Scale: Internal and External

Revenue curves and Optimum Size of a Firm

Compiled by Netra Lal Subedi, with the help of Advance d Saraswoti Publication, Kathmandu
 Economies and Diseconomies of Scale
Economies of scale
It is a decrease in the long-run average cost from the expansion of the production scale. The
economies of scale are the cost saving factors that arise both inside the firm and outside the firm
(but inside the industry). The former is known as internal economies where the latter is known as
external economies.
A. Internal Economies
The internal economies (cost saving factors) arise within the firm as a result of the expansion of
its own size or scale of production. They arise from the use of methods that small firms cannot
employ.
Technical Economies
Technical economies are those which arise to a firm from the use of better machines and
techniques of production. As a result, production increases and per unit cost of production falls.
Professor Carcass divides technical economies into following five points:
i. Economies of Increased Dimension: Economies arise with the installation of large machines.
The average cost of operating large machines is less than that of operating small machines.
For example, the manufacturer of the double – Decker bus is lower as compared to the
manufacture of two ordinary buses.
 Contd…
ii. Economies of Linked Processes: A large firm can reduce its per-unit cost of production by
linking the various production processes. For example, a dairy and fodder farm. Sugar factories
and sugar–cane farms, paper – making and pulp-making can be combined to reduce average
costs of production.
iii. Economies of the Use of By-Products: A large firm can utilize its waste materials as a by-
product. For example, the molasses left over after manufacturing sugar from sugarcane can be
used for producing spirits by installing a subsidiary plant.
iv. Economies of Superior Technique: A large firm can afford a costly machine with advance
technology. Such machines are more productive than small machines. For example, only a big
newspaper can use the rotary press.
v. Economies of Increased specialization: A large firm can enjoy the benefits of the division of
labor and increased specialization. For example, Henry Ford Company has divided the
manufacturer of a car into 84 subs-processes to employ super specialized factors.
Managerial Economies
In a small factory, a manager is a worker, foreman, and a manager all rolled in one. Much of his
time is wasted on those activities which have little economic significance. In a large firm, the
management is divided into specialized departments like the production department, sales
department which has its own specialized personnel manager.
 Contd…
Marketing Economies
A large firm also reaps the economies of buying and selling in bulk. Large businesses have beginning
advantages. They can get freight concessions from transport, cheap credit from bank, prompt
delivery and careful attention from all dealers. It can manage own sales agency and outlets for sales
promotion.
Financial Economies
A large firm is in a better position than a small firm to raise fund and to spread its risks. It can
produce a variety of products, and sell them in different areas. By the diversification of markets, it can
counter balance the loss of one product by the gain from other products. Furthermore, large firm has
better creditworthiness as it offers better security to the banks. Thus, it can secure loans from the
banks and other financial institutions at lower interest rates thereby lowering cost of fund.
Economies in Transport and Storage
Own transport and warehouse facilities
Research
Huge expenditure on R &D thereby finding cost reducing techniques.
Risk and Survival Economics : ability to face risks and uncertainties (Economic depression,
pandemics, supply shocks of raw materials
 Contd.
B. External Economies
External economies are those economies which arise due to the expansion of the industry. External
economies benefit all firms within the industry as the size of the industry expands. As the industry grows,
subsidiary and correlated firms may produce cheaper inputs and utilize waste materials.
1. Cheaper Inputs
Lower input price due to expansion of industry as a whole

2. Technological Economies
Discovery of new and improved techniques by market/industry

3. Supply of Skilled Labor

More skilled labor in the field which is developed and can absorb more labor

4. Growth of Ancillary Industries

Growth of subsidiary industries (Tire and car manufacturing industries)

5. Economies of Localization :
Concertation of firms in an area: special economic zone in Bhairahawa : all facilities

6. Constant Flow of Information.

Association: For eg. FNCCI in Nepal- Journal by it may provide insight to the individual firm.
 Diseconomies of Scale
It is the production scale. The diseconomies of scale are the cost raising factors, which arise both
inside the firm and outside the firm (but inside the industry). The former is known as internal
diseconomies where the latter is known as external diseconomies.
A. Internal diseconomies
They are exclusive and internal to a firm as they arise within the firm. Once the division of
labour and potentials are fully exploited, warehouses are used in full capacity, the optimum
level of the plant is used diseconomies begin although some economies may still be left.
Internal diseconomies arise because of two factors:
a. Managerial inefficiency: As expansion of scale of production the communication between
the owner and manager, manager and labour get reduced. With the expansion of the scale,
the number of key managerial personnel gets bigger and decision making becomes
complex and is delayed.
b. Labour inefficiency: expansion of scale leads to increase in overcrowding of labour and it
becomes difficult to control their productivity and accountability.
c. Technical Diseconomies: Beyond the optimum level, machines also works inefficiently.
B. External diseconomies
a. Rise in input prices :shortage of raw materials
b. Higher wages: more demand for labour
c. Costlier transport: transportation bottlenecks
 Concept of Revenue
1. Total Revenue (TR)
It is the total receipts earned from the sale of total output at a particular time. It is obtained by
multiplying price per unit by units of quantity sold. It is also the summation of Marginal Revenue.
TR = P × Q Or, TR = ∑MR
2. Average Revenue (AR)
It is the revenue per unit of output sold. It is obtained by dividing total revenue by units of
quantity sold. Thus,

3. Marginal Revenue (MR)

Marginal revenue is the change in total revenue from the sale of one more unit of output. In other
words, it is the addition made to the total revenue due to the one additional unit of quantity sold.
Thus,

Revenue Function
It is the functional relationship between the total revenue from the sale of output and the factors that
affect it. Given the price of the product, revenue depends upon the units of quantity sold. It can be
written as: R = f(P, Q)
Revenue Curves under perfect competition
Perfect competition is a market structure characterized by the production of
homogeneous goods, firm as a price taker, a large number of buyers and sellers. Since
the market price is determined by the forces of demand and supply, all the firms follow
that equilibrium price. Therefore, the price is constant under this market structure. The
following table shows the forms of revenues under the perfect competition.
Unit of output Price (P) TR (P × Q) TR
AR (TRQ) MR ( )
Q
0 10 0 – –
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10

In the above table, the price is constant at Rs. 10 per output. As the sales increase, TR also
increases but at a constant rate because of constant price, AR is constant and is equal to the
value of the price. It is also the demand curve faced by all the firms. MR is the change in TR
per change in output sold and because TR changes at a constant state of 10, MR is constant
with a value of 10. It can also be shown in the figure.
Revenue Curves under perfect competition
Y
TR
50

Revenue
40
30
20

10 AR=MR
X
O
1 2 3 4 5
Quantity Sold
In the figure , the output is measured along the X-axis and revenue along the Y-axis. As
the output sold increases, because of the constant price, TR also increases at a constant
rate. Thus, it is upward shopping at a constant at Rs. 10 for every unit of output sold.
AR is TR divided by quantity so it equals price
(i.e. Rs. 10) and is parallel to output axis. MR is the rate of change of TR per unit of
output sold and since TR increases at a constant rate or the rate of change of TR per unit
of output is constant, i.e. Rs. 10 MR is Rs. 10 at every change in TR. Since P = AR = MR
they all coincide with the AR or demand curve.
Revenue Curves under Imperfect Competition (Monopoly
and Monopolistic Market)

Monopoly market structure is characterized by the features like a single seller, no close
substitutes for the commodity, barriers to entry, firm is an industry so it is price maker.
Because of no close substitute, its demand curve slopes downward, given the taste and
preference of the consumers. The following table shows the different revenues under the
monopoly.
Quantity Price (P) TR (P × Q) TR
Sold (Q) AR (TRQ) MR ( )
Q
0 10 0 – –
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 5 0
6 5 30 5 0
7 4 28 4 –2

In the above table, as the quantity of output sold by a monopolist increases the price of
the product falls. In this process, TR increases at a decreasing rate up to 5 units of output
sold and reaches its maximum After 6 units of output sold TR Starts falling. AR is as
always equal to price and is falling.
Contd…
The relationship between these costs can be shown in the following figure.
Y

35

30

25
TR
Revenue

20
15

10
5
AR
0 X
1 2 3 4 5 6 7
MR
Quantity Sold

In the figure , the output sold is measured along the X-axis and revenue along the Y-axis.
In the figure, TR starts from the origin because if output sold is zero then TR is also zero.
As output sold starts increasing TR increases at a decreasing rate because in order to sell
more, price must be reduced TR increases at a decreasing rate up to 6 units of output,
reaches its maximum and starts falling.
Relationship between AR and MR Curves
Revenue curves depend upon the market structure. So the relationship between AR and
MR can be discussed on the basis of two basic market structures namely, perfect
competition and Monopoly.
Relationship between AR and MR under perfect competition
Under perfect competition the firms are price taker so they have to follow the market
determined price. Because of this constant price AR coincides with the MR. This is
shown in the following figure.
Y
Revenue

AR = MR

X
O Output
Contd…

Relationship between AR and MR under imperfect competition

1. When both AR and MR are straight line
In this case, the slope of MR is twice the slope of AR. MR bisects the perpendicular
line drawn from any point of AR to the revenue axis. It can be shown in the figure.

Y In the figure , AR and MR represents

Average Revenue and Marginal
Revenue respectively. A line drawn
from point C is drawn towards
revenue the axis at point A. MR
Revenue

A B C
bisects the AC line at point B or, AB =
BC
AR

MR
X
O Output
Contd…
2. When both AR and MR curves are convex to the origin.
In this case, MR cuts the perpendicular line drawn from AR to revenue axis
somewhere between the midpoint of that perpendiculars line and the point where
that perpendicular line touches the average revenue axis. It can be shown in the
following figure.
Y

AR and MR

C
A
B D
AR

MR
X
O Output

In the figure, the mid-point of the perpendicular line drawn from point 'C' to point 'A'
is point 'D' but MR interests the line at point B such that, AB < BC.
Contd…

3. When both AR and MR are concave to the organ.

In this case, the MR intersects the perpendicular line drawn from AR to the revenue
axis in between the point where that perpendicular line touches the average revenue
curve and the mid-point of that perpendicular line. It can be shown in the figure as:
Y

AR and MR B C
A
D

AR
MR

X
O Output

In the figure, the perpendicular to the revenue axis is drawn from point 'C' of AR
and MR intersect that line at point B but the midpoint of the perpendicular line is
point D. Here, AB > BC.
Relationship between Price Elasticity of Demand and Revenue
1. Relationship between price elasticity of demand, marginal revenue and total revenue
We
know
that
 Contd…
Form the above final equation following conclusion can be drawn.
1. If ep = 1, MR = o; it means TR remains constant with a change in price
2. If ep > 1, MR >o; it means TR increases when price decreases TR increases and vice-versa.
3. If ep < 1 MR <o; it means TR increases when price increases and vice - versa this relationship
can be shown in the following figure.
Y

In the figure, the quantity sold is measured along the X-axis

Total Revenue

TR and revenue under the Y-axis. TR is measured in figure A and

MR and AR in figure B. Following relation can be summed up
O X
between the three revenue curves:
1. When TR is increasing at decreasing rate MR is falling but
Q1
Y
EP = ∞

EP > 1 is positive and the AR or demand curve will have price

AR and MR

EP = 1 elasticity greater than 1.

EP < 1 2. When TR reaches its maximum MR reaches zero at output
EP = 0 Q1 and elasticity of demand is equal to 1.
AR
O
Q1 X 3. When TR starts falling, MR becomes negative in value and
MR the elasticity of demand is less than unity.
Quantity
Contd…

2. Relationship between price electricity of demand and average revenue

Since P = AR in market we replace P by AR in the equation
Optimum Size of the Firm and Its Determinants

Optimal firm size refers to the speed and extent of growth that is ideal for
a specific small business. Optimal firm size is dependent on a variety of
internal and external factors.
The Optimum Size of a business unit refers to a unit with all the factors of
production in an ideal proportion. It is the situation in which, the factors
of production are united in such a manner that maximum production is
achieved at minimum cost. In other words, the profit-earning capacity of
a business unit is directly affected by its size. Therefore, the size of a unit
should not be too big or too small. It should be of such a size that
maximum production can be achieved at minimum cost.
Optimum Size of the Firm and Its Determinants…

The six main factors responsible for determining the optimum

size of the firm are as follows:
1. Entrepreneurial/Organizational Skill
2. Managerial Ability
3. Availability of Finance
4. Technical Factor
5. Nature of Business
6. Extent of the Market.
Optimum Size of the Firm and Its Determinants…

1. Entrepreneurial/Organizational Skill:

An entrepreneur of outstanding ability will be able to procure as much

finance as he may need, hire the requisite labor force, and build up a huge
business. But an entrepreneur of moderate ability will run a business on a
moderate scale and a man of limited entrepreneurial skill will be content
with a small business
2. Managerial Ability:
For running the routine part of the business, managers are appointed. If a
firm is lucky enough to have a manager of great ability, the size of the firm
will grow to considerable dimensions. On the other hand, an average
performing manager will have a small-sized firm to manage
Optimum Size of the Firm and Its Determinants…

3. Availability of Finance:
It is finance which oils the wheels of business machine. If ample funds are
available, it will help the entrepreneur to make his business grow to a big
size. This requires a proper development, of the banking system so that
savings of the community can be effectively mobilized and utilized in the
development of trade and industry.
4. Technical Factor
Technical factors are concerned with methods of production. They may
include specialization, division of labor, mechanization and the like.
Production methods become economical when these steps are taken.
Technical forces decide the minimum and the maximum limits to size.
Optimum Size of the Firm and Its Determinants…

5. Nature of Business:
Much also depends on the nature of business. If the business obeys the
law of increasing returns, it will grow to a big size, otherwise, in the case
of diminishing returns it will remain stunted (inferior in size), and in the
case of constant returns it will remain stagnant.
6. Extent of the Market:
The size of the firm also depends on the extent of the market. If the
commodity in which the firm deals or which it-manufactures has a wide
market, naturally the business will assume a large scale. But if the
demand for the commodity is fitful or limited, the size of the firm will
continue to be small.
Optimum Size of the Firm and Its
Determinants…
Other factors are:
7. Marketing Factors
8. Availability of factor inputs: labor, raw materials
9. Factors of Risk and Fluctuation.
10. Government’s control
To sum up, if firms are realizing a higher degree of economies of scale
over diseconomies of scale, they have large size and if firms are realizing
a lower degree of economies of scale over diseconomies of scale, they
have smaller size.
  Numerical Illustrations
Example –
The short-run total cost is TC = 100 + 10Q – 0.05Q² + 0.001Q³, If Q = 5. Find
(i) TFC ii) AVC iii) AFCiv) MC
Solution:
Given,
TC = 100 + 10Q – 0.05Q² + 0.001Q³
(i) Fixed cost remains same irrespective of output so it is also the cost when output is zero. Thus,
When Q = 0
TC = 100 + 10 (0) – 0. 05 (0)² + 0. 001 (0)²
 TC = 100
 Total Fixed Cost (TFC) = 100
(ii) TVC = TC – TFC
= 100 + 10Q – 0.05Q² + 0. 001Q³ – 100
= 10Q – 0.05Q² + 0.001Q³
AVC = TVC/Q
Contd…
= 10 – 0.05Q + 0.001Q²
When Q = 5
AVC= 10 – 0.05 (5) + 0.001(5)²
= 10 – 0.25 + 0.025
= Rs.9.775
iii) Average fixed cost (AFC) =
= = Rs.20
iv) Marginal Cost (MC)
MC = (TC)
= (100 + 10Q – 0.05Q² + 0.001Q³
 MC = 10 – 0.1Q + 0.003Q2
When Q = 5
MC = 10 – 0.1 (5) + 0.003 (5)²
= 10 – 0.5 + 0.075
= Rs.9. 575
 Contd…
Example – 7
Consider the following cost schedule:
Output (Q) 0 1 2 3 4 5 6 7 8 9
TVC 0 10 18 24 32 50 80 124 180 260

a. Compute TC, AFC, AVC, AC and MC under fixed cost Rs. 100.
b. Prove that AC is influenced by the trend of AFC and AVC.
c. Prove that SMC is independent with fixed cost.
Solution:
a. Computation of TC, AFC, AVC, AC and MC under fixed cost Rs.100
Output (Q) TVC TFC TC AFC AVC AC MC
0 0 100 100 - - - -
1 10 100 110 100 10 110 10
2 18 100 118 50 9 59 8
3 24 100 124 33.3 8 41.3 6
4 32 100 132 25 8 33 8
5 50 100 150 20 10 30 18
6 80 100 180 16.7 13.3 30 30
7 124 100 224 14.3 17.7 32 44
8 180 100 280 12.5 22.5 35 56
9 260 100 360 11.1 28.9 40 80
 Contd…
b. Initially, at the output range of 1 to 3 units, AFC and AVC both are falling. Hence, AC is also falling.
At the output range of 4 and 5 units, the rate of fall in AFC is greater than the rise in AVC. Hence,
AC is falling.
At the output range of 5 and 6 units, the rate of fall in AFC is equal to the rate of rise in AVC. Hence,
AC remains constant where MC is the minimum.
At the output range of 6 to 9 units, the rate of fall in AFC is less than the rate of rise in AVC. Hence,
AC is rising.
Thus, it is proved that AC is influenced by the trend of AFC and AVC.
c. Short-run marginal cost (SMC) is the change in total cost due to the change in one unit of output in
the short-run. Total cost is the sum total of total fixed cost (TFC) and total variable cost (TVC). Hence,
change in total cost is due to the change in total variable cost and not influenced by total fixed cost. It
can be explained as follows:
We know that,
MCn = TCn – TCn – 1
= (TFC + TVCn) – (TFC + TVCn – 1)
= TFC + TVCn – TFC + TVCn – 1
= TVC – TVC
Contd…
Example – 3
Consider the following table:
Output TFC TVC TC AFC AVC AC MC
0 50 0 - - - - -
1 - 30 - - - - -
2 - 55 - - - - -
3 - 77 - - - - -
4 - 102 - - - - -
5 - 132 - - - - -
6 - 169 - - - - -
7 - 216 - - - - -
8 - 278 - - - - -

a. Define TFC and TVC.

b. Explain the relationship between AC and MC.
Solution:
a. Definition of Total Fixed Cost (TFC) and Total Variable Cost (TVC)
Total Fixed Cost (TFC)
TFC is the total cost of the fixed factors of production. It is independent of the level of output.
It means total fixed cost is not affected by the level of output. Whether the output is zero or
maximum total fixed cost remains constant.
 Contd…
Total Variable Cost (TVC)
Total variable cost is the cost of the variable factors of production. It depends on the level of output. When
output is zero, TVC is also zero (i.e. when Q = 0, TVC = 0). It goes on increasing with the increase in level
of output.
Completion of the given table
Output TFC TVC TC AFC AVC AC MC
0 50 0 50 - - - -
1 50 30 80 50 30 80 30
2 50 55 105 25 27.5 52.5 25
3 50 77 127 16.67 25.67 42.33 22
4 50 102 152 12.5 25.5 38 25
5 50 132 182 10 26.4 36.4 30
6 50 169 219 8.33 28.17 36.5 37
7 50 216 266 7.14 30.86 38 47
8 50 278 328 6.25 34.75 41 62

b. Relationship between AC and MC

1. Initially AC and MC both are declining.
2. The minimum point of MC occurs when the level of output is 3 units and the minimum point of
AC occurs when the level of output is 5 units.
3. AC is declining up to 5 units of output but is greater than MC.
4. AC rises after 5 units of output but is less than MC.`
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