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Log in through your institution journal article Cost of Production and Market PriceThe Accounting Review Vol. 6, No. 3 (Sep., 1931) , pp. 161-164 (4 pages) Published By: American Accounting Association https://www.jstor.org/stable/238253 Read and download Log in through your school or library Subscribe to JPASS Unlimited reading + 10 downloads Journal Information The Accounting Review is the premier journal for publishing articles reporting the results of accounting research and explaining and illustrating related research methodology. The scope of acceptable articles embraces any research methodology and any accounting-related subject. The primary criterion for publication in The Accounting Review is the significance of the contribution an article makes to the literature. Publisher Information The American Accounting Association is the world's largest association of accounting and business educators, researchers, and interested practitioners. A worldwide organization, the AAA promotes education, research, service, and interaction between education and practice. Formed in 1916 as the American Association of University Instructors in Accounting, the association began publishing the first of its ten journals, The Accounting Review, in 1925. Ten years later, in 1935, the association changed its name to become the American Accounting Association. The AAA now extends far beyond accounting, with 14 Sections addressing such issues as Information Systems, Artificial Intelligence/Expert Systems, Public Interest, Auditing, taxation (the American Taxation Association is a Section of the AAA), International Accounting, and Teaching and Curriculum. About 30% of AAA members live and work outside the United States. Rights & Usage This item is part of a JSTOR Collection. Cost benefits from higher output levels What are Economies of Scale?Economies of scale refer to the cost advantage experienced by a firm when it increases its level of output. The advantage arises due to the inverse relationship between the per-unit fixed cost and the quantity produced. The greater the quantity of output produced, the lower the per-unit fixed cost. Economies of scale also result in a fall in average variable costs (average non-fixed costs) with an increase in output. This is brought about by operational efficiencies and synergies as a result of an increase in the scale of production. Economies of scale can be realized by a firm at any stage of the production process. In this case, production refers to the economic concept of production and involves all activities related to the commodity, not involving the final buyer. Thus, a business can decide to implement economies of scale in its marketing division by hiring a large number of marketing professionals. A business can also adopt the same in its input sourcing division by moving from human labor to machine labor. Key Highlights
Effects of Economies of Scale on Production Costs
Image: CFI’s Financial Analysis Courses The graph above plots the long-run average costs (LRAC) faced by a firm against its level of output. When the firm expands its output from Q1 to Q2, its average cost falls from C1 to C2. Thus, the firm can be said to experience economies of scale up to output level Q2. In economics, a key result that emerges from the analysis of the production process is that a profit-maximizing firm always produces that level of output which results in the lowest average cost per unit of output. Types of Economies of Scale1. Internal Economies of ScaleThis refers to economies that are unique to a firm. For instance, a firm may hold a patent over a mass production machine, which allows it to lower its average cost of production more than other firms in the industry. 2. External Economies of ScaleThese refer to economies of scale enjoyed by an entire industry. For instance, suppose the government wants to increase steel production. In order to do so, the government announces that all steel producers who employ more than 10,000 workers will be given a 20% tax break. Thus, firms employing less than 10,000 workers can potentially lower their average cost of production by employing more workers. This is an example of an external economy of scale – one that affects an entire industry or sector of the economy. Sources of Economies of Scale1. PurchasingFirms might be able to lower average costs by buying the inputs required for the production process in bulk or from special wholesalers. By negotiating with suppliers for volume discounts, the purchasing firm takes advantage of economies of scale. 2. ManagerialFirms might be able to lower average costs by improving the management structure within the firm. The firm might hire better skilled or more experienced managers. 3. TechnologicalA technological advancement might drastically change the production process. For instance, fracking completely changed the oil industry a few years ago. However, only large oil firms that could afford to invest in expensive fracking equipment could take advantage of the new technology. Diseconomies of ScaleImage: CFI’s Financial Analysis Courses Consider the graph shown above. Any increase in output beyond Q2 leads to a rise in average costs. This is an example of diseconomies of scale – a rise in average costs due to an increase in the scale of production. As firms get larger, they grow in complexity. Such firms need to balance the economies of scale against the diseconomies of scale. For instance, a firm might be able to implement certain economies of scale in its marketing division if it increased output. However, increasing output might result in diseconomies of scale in the firm’s management division. Frederick Herzberg, a distinguished professor of management, suggested a reason why companies should not blindly target economies of scale: “Numbers numb our feelings for what is being counted and lead to adoration of the economies of scale. Passion is in feeling the quality of experience, not in trying to measure it.” Video Explanation of Economies of ScaleWatch this short video to quickly understand the main concepts covered in this guide, including the definition of economies of scale, effects of EOS on production costs, and types of EOS. Additional ResourcesThank you for reading CFI’s guide on Economies of Scale. To keep learning and advancing your career, the following resources will be helpful:
What is the difference between price and cost?Cost is typically the expense incurred for making a product or service that is sold by a company. Price is the amount a customer is willing to pay for a product or service. The cost of producing a product has a direct impact on both the price of the product and the profit earned from its sale.
What is consumer surplus and producer surplus?The consumer surplus refers to the difference between what a consumer is willing to pay and what they paid for a product. The producer surplus is the difference between the market price and the lowest price a producer is willing to accept to produce a good.
Is the difference between the true value of a good and the amount the firm wants to receive?Producer surplus is the difference between how much a person would be willing to accept for a given quantity of a good versus how much they can receive by selling the good at the market price.
Is the difference between the actual price a producer receives and the minimum price a producer can accept for a product?The producer surplus is the difference between the actual price of a good or service–the market price–and the lowest price a producer would be willing to accept for a good. Economic surplus is calculated by combining the surplus benefit that is experienced by both consumers and producers in an economic transaction.
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