Question

In the long run, all costs are variable. Diagram and explain the long-run average cost curve and what it means to have (i) economies of scale, (ii) diseconomies of scale, and (iii) constants costs. What factors contribute to these economies and diseconomies?

Answer 1

The long run cost curve is derived from all the short run curves. In the long run, the firm will choose that plant size where the cost is minimum. If the number of plant sizes are infinite, the shape of the LAC curve will be a smooth curve with each point of LAC being connected with one plant size.The LAC curve contains all the SAC curves. Here, LAC is U-Shaped. There is initially Economies of scale, then Constant returns to scale and finally Decreasing Returns to scale i.e. there is non-proportional returns. During economies of scale, the Long run Average Cost (LAC) curve touches the falling arms of Short run Average Cost (SAC) curve and under diseconomies of scale, long run average cost curve touches the upward rising portion of Short run Average Cost curve.

(i) Economies of scale - During Increasing returns to scale, the percentage increase in output quantity is greater than the percentage increase in all factor quantities. Given the factor prices, the percentage increase in total cost is equal to the percentage increase in factor quantities. So, the percentage increase in output quantity is greater than the percentage increase in total cost. As a result, the average cost will fall with the increase in output quantity. Thus with Increasing Returns to Scale and given factor prices, the Long run Average Cost (LAC) curve is negatively sloped. This phenomenon is known as "internal economies of scale". "Economy" means cost reducing advantages. If a producer enjoys some cost reducing advantages with the expansion of scale, the average cost goes down with the increase in output. These are called "internal economies" because the cost-reducing advantages arise from the internal production condition and they are enjoyed exclusively by the producer himself. In this case, the successive SAC curves will shift down and the LAC curve will envelope the falling arms of the SAC curves.

(ii) Diseconomies of scale - When there are Decreasing Returns to Scale, the percentage increase in output quantity is less than the percentage increase in the employment of factors. Again given the factor prices, the percentage increase in total cost is greater than the percentage increase in output quantity. So, the LAC rises with the rise in output quantity. Thus, with DRS and given factor prices, the LAC curve is positively sloped. This is known as "internal diseconomies of scale". With the expansion of scale, the internal condition of production becomes more and more difficult and so the average cost goes up with the increase in output. In this case, the successive SAC curves will shift up and the LAC curve will envelope the rising arms of the SAC curves.

(iii) Constants costs - If there are Constant Returns to scale (CRS), the percentage increase in output quantity is equal to the percentage increase in the employment of factor. Then the total cost and the output quantity increase at the same rate. As a result, the Average Cost remains the same at all levels of output. Thus, with CRS and given factor prices,the LAC curve is horizontal. In this case, neither internal economies nor internal diseconomies are strong enough to produce downward or upward shifts of the successive SAC curves. The LAC curve thus passes through the minimum point of all SAC curves.

Now, if we have the non-proportional returns to scale, the LAC curve is U-shaped. With non-proportional returns there is one scale of production at which the average cost is the minimum. This scale is called the "optimum scale". In the figure given below, the optimum scale is reached with SAC^* at OQ^* output quantity.