Long-Run Costs (Cambridge International A-Level Economics)

Long-run average costs

• The long-run average cost (LRAC) curve shows the lowest possible average cost of production at each level of output when a firm can vary all factors of production

  • In the long run, firms can change plant size, adopt new technology and reorganise production
  • This flexibility allows firms to move to the most efficient scale of production

• The LRAC curve is typically U-shaped

  • At low levels of output, firms experience economies of scale, causing average costs to fall
  • At higher levels of output, diseconomies of scale cause average costs to rise

Shape of the long-run average cost curve (LRAC)

As a firm grows, economies of scale help it reach its minimum efficient scale, before diseconomies raise the cost/unit again

• The LRAC curve is derived from a series of short-run average cost (SRAC) curves

  • Each SRAC curve represents a different scale of operation
  • As output increases, the firm can move to a larger plant size
  • The LRAC curve therefore shows the lowest possible cost of production at each level of output

• The LRAC curve touches each SRAC curve at the point where production is most efficient for that plant size

Minimum efficient scale (MES)

• The minimum efficient scale (MES) is the lowest level of output at which the firm achieves the minimum point on the LRAC curve At this level:

  • The firm has fully exploited most economies of scale
  • Producing additional output will not significantly reduce average costs further

• MES varies between industries.

  • In industries with low fixed costs, MES occurs at relatively low output levels
  • In industries with high fixed costs, MES occurs at very large output levels

• For example:

  • A small café may reach its MES with one location
  • A car manufacturer must produce very large quantities of vehicles to achieve minimum costs

Exam Hint When explaining the shape of the long-run average cost curve, structure answers using three stages:

• At low levels of output, firms experience economies of scale, so long-run average costs fall
• As the firm continues to expand, it reaches the minimum efficient scale, where LRAC is at its lowest point
• At very high levels of output, diseconomies of scale occur, causing LRAC to rise

This explains why the LRAC curve is typically U-shaped.

You may also want to add one short exam-ready sentence, which examiners often reward:

The LRAC curve is U-shaped because economies of scale initially reduce average costs, but diseconomies of scale eventually cause costs to rise as firms become very large.

Economies of scale

• Economies of scale occur when average costs fall as output increases
• This happens because larger firms can operate more efficiently.

Examples of internal economies of scale

• These efficiencies allow firms to reduce long-run average costs as production expands

External economies of scale

• External economies of scale occur when firms benefit from cost reductions due to the growth of the industry as a whole, rather than from their own expansion

• These cost reductions occur outside the firm but within the industry

• As the industry grows, firms may benefit from:

  • Improved infrastructure
  • A larger pool of skilled labour
  • The development of specialist suppliers
  • Better transport and logistics networks

• These factors can reduce production costs for all firms in the industry

Examples of external economies of scale

• For example, the growth of the technology industry in Silicon Valley created a large pool of engineers, venture capital and specialised suppliers, reducing costs for firms operating there

Diseconomies of scale

• Diseconomies of scale occur when average costs increase as firms become very large
• This happens because managing a very large organisation becomes more complex

Causes of diseconomies of scale

• These problems can cause long-run average costs to rise as output expands further

Avoiding confusion: three different concepts

Economies of scale

• Occur in the long run
• Average costs fall as output increases
• Caused by factors such as specialisation, bulk purchasing and better technology
• Help explain the downward-sloping section of the LRAC curve

Diseconomies of scale

• Also occur in the long run
• Average costs rise as firms become very large
• Caused by management, communication and coordination problems
• Explain the upward-sloping section of the LRAC curve

Law of diminishing returns

• Occurs in the short run
• Happens when additional units of a variable factor are added to a fixed factor
• The marginal product of the variable factor eventually falls

Exam Hint Diminishing returns explain the shape of short-run cost curves

Economies and diseconomies of scale explain the shape of the LRAC curve