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An S-shaped Curve
The shape of the long-run total cost curve is S-shaped, much like a short-run total cost
curve. For relatively small quantities of output, the slope begins to flatten. Then for larger
quantities the slope makes a turn-around and becomes steeper. This shape, however, is NOT
the result of increasing, then decreasing marginal returns that surface when a variable input is
added to a fixed input in the short run. The flattening portion of this long-run total cost curve
is attributable to economies of scale or increasing returns to scale. The steepening portion is
then largely due to diseconomies of scale or decreasing returns to scale. No fixed inputs
under the control of the firm are in operation.
A U-shaped Curve
Scale economies and returns to scale generally produce a U-shaped long-run average cost
curve. For relatively small quantities of output, the curve is negatively sloped. Then for large
quantities, the curve is positively sloped. While the shape of the long-run average cost curve
looks surprisingly like that of a short-run average cost curve, the underlying forces are
different. This U-shape is NOT the result of increasing, then decreasing marginal returns that
surface in the short run when a variable input is added to a fixed input.
The negatively-sloped portion of this long-run average cost curve reflects economies of scale
and increasing returns to scale. The positively-sloped portion reflects diseconomies of scale
or decreasing returns to scale.
The long run cost output relationship can be shown with the help of a long run cost curve.
The long run average cost curve (LRAC) is derived from short run average cost curves
(SRAC).
The long-run marginal cost (LRMC) is derived from the short-rum marginal cost (SRMC)
curves. LRMC is formed from points of intersection of the SRMC curves with vertical lines
drawn from the points of tangency of the corresponding SAC-curves and the LRA cost curve.
The LMC must be equal to the SMC for the output at which the corresponding SAC is
tangent to the LAC.
Scale economies and returns to scale generally produce a U-shaped long-run marginal cost
curve, such as the one displayed to the right. For relatively small quantities of output, the
curve is negatively sloped. Then for large quantities the curve is positively sloped. While the
shape of the long-run marginal cost curve looks surprisingly like that of a short-run marginal
cost curve, the underlying forces are different. This U-shape is NOT the result of increasing,
then decreasing marginal returns that surface in the short run when a variable input is added
to a fixed input.
The negatively-sloped portion of this long-run marginal cost curve reflects economies of
scale and increasing returns to scale. The positively-sloped portion reflects diseconomies of
scale or decreasing returns to scale. The long-run marginal cost curve is extremely important
to the long-run profit maximization of a firm. In the same way that a firm maximizes
economic profit in the short run by equating marginal revenue with (short-run) marginal cost,
a firm maximizes economic profit in the long run by equating marginal revenue with long-run
marginal cost. The key difference is that long-run marginal cost is not attributable to just one
or two variable inputs, but to all inputs.
In other words, a profit-maximizing firm equates marginal revenue with the incremental cost
of not just hiring more employees, but of building a larger factory, too. An extremely
important point of interest regarding long-run marginal cost is that it is equal to long-run
average cost at the minimum of the long-run average cost curve. This quantity of output that
achieves the minimum efficient scale (MES).
Economies and Diseconomies of Scale
The U-shaped LRAC curve is can explain the economies of scale and diseconomies of
scale. Economies and diseconomies of scale are concerned with behaviour of
average cost curve as the plant size is increased.
If Long-run Average Cost declines as output increases, then we say that the firm
enjoys economies of scale.
If, instead, the Long-run Average Cost increases as output increases, then we
have diseconomies of scale.
if Long-run Average Cost is constant as output increases, then we have constant
returns to scale implying we have neither economies of scale nor diseconomies
of scale.
Economies of scale explain the down sloping part of the Long-run Average Cost curve. As
the size of the plant increases, Long-run Average Cost typically declines over some range of
output for a number of reasons.
In simple terms:
Economies of Scale refers falling average costs due to expansion; increase in
efficiency of production as the number of goods being produced increases
Diseconomies of Scale refers rising average costs due to a firm expanding too large
Economies of Scope
While economies of scale lowers the per unit cost as more of the same output is
produced, economies of scope lowers the per unit cost as the range of products produced
increases. For example, if a restaurant that provides lunch and dinner began to offer
breakfast, the fixed costs of the kitchen equipment and the seating area could be spread out
over a larger number of meals served decreasing the overall cost per meal. Likewise a gas
station that already must have a service attendant and building can lower the per unit cost by
providing convenience store items such as drinks and snacks. Since the cost of producing or
providing these products are interdependent, providing both lowers the cost per unit.