The firm is said to have Economies of Scale if its Average Cost falls as output increases. But if average cost rises with output, the firm is said to have diseconomies of scale. Finally, if average cost does not vary with output, the firm has constant returns to scale.

There are a lot of reasons to expect a firm’s average cost to decline as its output increases (at least initially). Two of them are the followings: One is that fixed costs do not vary with output. Secondly, as output rises, a firm can use its labor in more specialized tasks (more efficient).

As I mentioned, scale economies exist if average costs (AC) falls as output expands. This can happen only if average cost (AC) is above marginal cost (AC > MC). This relationship suggest that a natural measure of scale economies (S) is the ratio of average to marginal cost (S=AC/MC). So economies of Scale Exist if S>1, diseconomies of scale exist if S and constant returns to scale exist if S=1.