Question

Explain the construction of the long-run average cost curve. What do you mean by Economies
and diseconomies? What are the reasons of economies and diseconomies. 500 words answer

Answer 1

The long run average cost curve is built by many short run average cost curves.

Lets say, based on different levels of output, a firm can operate on these three short run curves, as shown below. each of these different SAC curves are for a particular level of production. In the short run, the fixed costs are also fixed in the short run.

For each of the given SACs, there is a lowest point which corresponds to the lowest cost of production for that production level. Based on output (OA, OC, OD etc), the firm will sit at the lowest point of these different SACs. Over time the firm finds out lowest possible cost SACs of all output levels, and combining them all gives us the LRAC.

If we think of the SACs as infinite small SAC curves, then their envolope will be the LRAC. This is shown below.

Long run average cost curve is drawn tangential to all SACs. In other words, every point on the long run average cost curve is a tangent point on some SAC. Hence, whenever a firm desires to produce a certain output, it operates on the corresponding SAC.

Economies of scale- In continuation of the discussion above, once a firm has determined the least costly production technology, it can consider the optimal scale of production, or quantity of output to produce. In economies of scale, as the quantity of output goes up, the cost per unit goes down. The economies of scale curve is a long-run average cost curve, because it allows all factors of production to change. This is the situation in the first half of the LRAC shown above.

Diseconomies of scale refers to a situation where as output increases, average costs increase also. This is the situation in the second half of the LRAC shown above. In diseconomies of scale, the average costs keep rising as the production increases. This is exactly opposite of economies of scale.

Economies of scale happen because of lower average fixed costs as production increases and also because of increase in productivity. Diseconomies of scale happen when production increases so much that variable costs start rising.