Drawing and interpretation of average total cost (ATC) diagrams to illustrate economies and diseconomies of scale

Firms – Economies and Diseconomies of Scale (IGCSE / A‑Level)

Learning objective

Students will be able to draw and interpret an Average Total Cost (ATC) diagram, explain the presence of economies and diseconomies of scale, and relate cost curves to revenue, profit and firm objectives. They will also distinguish internal from external scale effects, understand factor‑demand implications and recognise how market structure influences the position of the ATC curve.

Key concepts

• Average Total Cost (ATC)
• Average Fixed Cost (AFC) and Average Variable Cost (AVC)
• Marginal Cost (MC) and Total Cost (TC)
• Total Revenue (TR) and Average Revenue (AR)
• Profit (π = TR – TC)
• Economies of scale – internal & external
• Diseconomies of scale – internal & external
• Minimum Efficient Scale (MES)
• Firm objectives (survival, profit‑maximisation, growth, social welfare)
• Factor demand, factor‑intensity, productivity and investment effects
• Market types (perfect competition vs monopoly) and their cost implications

1. Cost and revenue definitions

2. Firm objectives (Cambridge IGCSE 3.6)

• Survival: Produce at least enough to cover variable costs (P ≥ AVC) in the short run.
• Profit‑maximisation: Produce where marginal revenue (MR) = marginal cost (MC).
• Growth: Expand output to achieve economies of scale and increase market share.
• Social‑welfare / non‑profit objectives: Accept lower profit or even a loss to meet environmental, community or public‑service goals.

3. Drawing an ATC diagram

1. Axes: vertical – “Cost per unit (£)”; horizontal – “Quantity of output (Q)”.
2. ATC curve:

   • Starts high on the left (high AFC), falls as AFC spreads, reaches a minimum (MES), then rises as diseconomies appear.

3. MC curve:

   • U‑shaped.
   • Intersects ATC at its lowest point – the MES.

4. Labelled sections:

   • Left of MES – “Economies of scale”.
   • At MES – “Minimum Efficient Scale”.
   • Right of MES – “Diseconomies of scale”.

4. Interpreting the ATC diagram

• Economies of scale (left of MES) – ATC falls because:

  • AFC falls as fixed costs are spread over more units.
  • AVC falls when variable inputs are used more efficiently (specialisation, bulk buying, better utilisation of plant).

• Minimum Efficient Scale (MES) – Output level where ATC is at its minimum. In long‑run competitive equilibrium firms tend to operate at or near this point.
• Diseconomies of scale (right of MES) – ATC rises because:

  • Management becomes less efficient (bureaucracy, slower decision‑making).
  • Coordination and communication problems increase.
  • Plant congestion, equipment breakdowns, and declining worker morale.

5. Internal vs. external scale effects

6. Relationship between ATC, MC and TC

• TC curve – total cost at each output level; its slope is the MC curve.
• MC curve – shows the extra cost of producing one more unit; always cuts the ATC curve at its minimum (MES).
• When MC < ATC the ATC is falling (economies of scale).
  

  When MC > ATC the ATC is rising (diseconomies of scale).

7. Factor demand, factor‑intensity and investment effects (syllabus 3.5)

• Expanding output changes the firm’s demand for inputs:

  • Labour‑intensive firms see a relatively larger increase in labour demand.
  • Capital‑intensive firms increase demand for machinery and equipment.

• Higher factor demand can shift the AVC (and therefore ATC) curve:

  • More efficient use of capital – downward shift of AVC (internal economies).
  • Over‑crowding of labour – upward shift of AVC (diseconomies).

• Investment in new technology or better infrastructure produces external economies of scale that shift the whole ATC curve downwards for all firms in the industry.

8. Market‑type box (syllabus 3.7)

9. Worked example (IGCSE style)

Suppose a firm has:

• Fixed Cost (FC) = £12 000
• Variable Cost (VC) = £3 Q + 0.02 Q² (where Q is output in units)
• Market price (P) = £40 per unit (so AR = MR = £40)

Calculate the cost figures and profit for Q = 1 000 units.

1. Total Cost (TC)

   \[

   TC = FC + VC = 12\,000 + (3\times1\,000) + 0.02(1\,000)^2 = 12\,000 + 3\,000 + 20\,000 = £35\,000

   \]

2. Average Fixed Cost (AFC)

   \[

   AFC = \frac{FC}{Q}= \frac{12\,000}{1\,000}= £12\text{/unit}

   \]

3. Average Variable Cost (AVC)

   \[

   AVC = \frac{VC}{Q}= \frac{3\,000+20\,000}{1\,000}= £23\text{/unit}

   \]

4. Average Total Cost (ATC)

   \[

   ATC = AFC + AVC = 12 + 23 = £35\text{/unit}

   \]

5. Marginal Cost (MC) – derivative of VC:

   \[

   MC = \frac{dVC}{dQ}= 3 + 0.04Q = 3 + 0.04(1\,000)= £43\text{/unit}

   \]

6. Total Revenue (TR)

   \[

   TR = P \times Q = 40 \times 1\,000 = £40\,000

   \]

7. Profit (π)

   \[

   \pi = TR - TC = 40\,000 - 35\,000 = £5\,000\;(\text{positive})

   \]

Interpretation:

• Because MC (£43) > ATC (£35), the firm is on the diseconomies of scale side of the ATC curve.
• Since price (£40) > ATC (£35), the firm makes a profit of £5 000 and would, in the long run, consider expanding until it reaches the MES where MC = ATC.

10. Summary comparison

11. Links to other economic concepts

• Profit maximisation – In the short run the firm produces where MR = MC. The position of MC relative to ATC tells whether the firm makes a profit (P > ATC) or a loss (P < ATC).
• Market structures – In perfect competition long‑run equilibrium forces firms to operate at the MES, where ATC is minimised and economic profit is zero. In monopoly or monopolistic competition firms may operate above MES because of market power or product differentiation.
• Long‑run equilibrium – All costs become variable; the firm can adjust plant size. Competitive firms expand or contract until they reach the MES, achieving the lowest possible ATC and zero economic profit.
• Factor demand & investment – Expanding output alters the demand for labour and capital; technological investment can shift the ATC curve downward, representing external economies of scale.