In Fig. 19.
7, we have drawn the long-run average cost curve as having an
approximately U-shape. It is generally believed by economists that the long-run average
cost curve is normally U shaped, that is, the long-run average cost curve first declines
as output is increased and then beyond a certain point it rises. Now, what is the proper
explanation of such behaviour of the long- run average cost curve?
We saw above that the U-shape of the short-run average cost curve is explained with
the law of variable proportions. But the shape of the long-run average cost curve
depends upon the returns to scale. Since in the long run all inputs including the capital
equipment can be altered, the relevant concept governing the shape of this long-run
average cost curve is that of returns to scale.
Returns to scale increase with the initial increases in output and after remaining
constant for a while, the returns to scale decrease. It is because of the increasing
returns to scale in the beginning that the long-run average cost of production falls as
output is increased and, likewise, it is because of the decreasing returns to scale that
the long-run average cost of production rises beyond a certain point.
Why does LAC fall in the beginning: Economies of Scale?
But the question is why we first get increasing returns to scale due to which long-run
average cost falls and why after a certain point we get decreasing returns to scale due
to which long-run average cost rises. In other words, what are the reasons that the firm
first enjoys internal economies of scale and then beyond a certain point it has to suffer
internal diseconomies of scale? Three main reasons have been given for the economies
of scale which add to the firm and due to which cost per unit falls in the beginning.
First, as the firm increases its scale of operations, it becomes possible to use more
specialized and efficient form of all factors, especially capital equipment and machinery.
For producing higher levels of output, there is generally available a more efficient
machinery which when employed to produce a large output yields a lower cost per unit
of output.
Secondly, when the scale of operations is increased and the amount of labour and other
factors becomes larger, introduction of a great degree of division of labour or
specialisation becomes possible and as a result the long-run cost per unit declines.
Long-Run Average Cost Curve in Case of Constant Returns to Scale:
If the production function is linear and homogeneous and also the prices of inputs
remain constant, then the long-run average cost will remain constant at all levels of
output.
Therefore, with the given prices of inputs, when returns to scale are constant, the cost
per unit of output remains the same. In this case, the long-run average cost curve will
be a horizontal straight line as depicted in Fig. 19.8.
It will be noticed from Fig. 19.8 that all short-run average cost curves such as
SAC1, SAC2, and SAC3 have the same minimum average cost of production. This means
whatever the size of the plant, the minimum average cost of production is the same.
It is useful to note that though all levels of output will be produced at the same minimum
cost of production the different sizes of plants will be used for producing different levels
of output. Thus, for producing output OA, the plant of SAC1 will be employed; for output
ob, the plant of SAC2 will be employed; and for output OC the plant of SAC 3 will be
employed and so on. This is because the production at the lowest possible cost for
output OA is possible with plant SAC1 for output ob with plant SAC2 and for output OC
with plant SAC3.
all internal economies of scale are due to the indivisibility of some factors. Therefore, if
perfect divisibility of factors is assumed, then it implies the absence of internal
economies of scale and therefore in such a case the long-run average cost curve will
still be a horizontal straight line.
As per the above 2 Figures Explained I Conclude that
What gives the long run average total cost curve its U shape are the
concepts of economies of scale, constant returns to scale, and
diseconomies of scale.
Constant returns to scale can occur when every additional unit of input
is identical to the last no real gains or losses in efficiency occur.
Diseconomies of scale occur when an equal percentage increase in all
factors of production results in a lower percent increase in output --
eg. 10% more workers and a 10% bigger factory results in 5% more
tacos being made.
