Long-Run Costs and Economies of Scale

Long-run costs are big, “one-time”-ish costs. For you, that might be a car, a house, or a child. For a firm, it might be a factory and equipment. Long-run costs contrast with short-term costs, which are costs you pay on the reg. For you, that’s groceries and utilities. For firms, that’s employees wages and the inputs that turn into outputs, like raw materials.

Understanding long-run and short-run costs are necessary to really understand how economies of scale work. Economies of scale is the main reason that big companies are putting all of the little guys out of business. The reason Amazon, Walmart, and Costco are flourishing like daisies.

Economies of scale describes the phenomenon where, as output increases, the marginal cost (think: cost per thing made) go down. For instance, there’s economies of scale when you’re making cookies in your kitchen. You could get out the flour, the chocolate chips, etc. and make one cookie in a mug (yeah, you can do this)...or, you could just make an entire batch of cookies. Thinking purely in the cost of your time, it might take you 20 minutes to make one cookie in a mug, or 30 minutes to make two dozen cookies. That’s the magic of economies of scale.

Why does this happen? The average costs for a firm go down as more output is made. While short-run costs have to be paid on the reg, long-run costs were already paid for: the gift that keeps on giving. This makes the long-run average cost go down, down, down.

Drop that long-run average cost to the floor.