Long-Run Costs (Cambridge (CIE) A Level Economics): Revision Note

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)

• 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

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