Economies of Scale & Long-Run Average Cost (LRAC) Definitions:
- The LRAC is a a cost curve which shows the average cost per unit of production over varying amounts of output in the long-run, and can be calculated by total costs divided by total output.
- Economies of Scale is the condition where the firm is able to reduce average costs (LRAC) in the long run, when output of goods/services increases.
- Diseconomies of Scale is the condition where the firm’s average costs (LRAC) in the long run increases, when output of goods/services increases.
- The Minimum Efficient Scale is defined as the range of production outputs where the firm can produce at its lowest long-run average costs on the LRAC curve.
Economies of Scale & Long-Run Average Cost (LRAC) Explanation:
When businesses get bigger and produce more, they benefit from certain cost advantages, such as being able to negotiate bulk discounts from suppliers, or being able to afford more productive equipment. As a result, it is common for them to see their costs decrease, and experience Economies of Scale. For example, if you are a small Chinese takeaway during Covid, you may need to rely on Uber to make your deliveries, who take commission (fees) from you for each one. However, if you are a large Chinese restaurant with enough orders, you can hire your own driver, make your deliveries in one go and potentially reduce costs. As a result, the business experiences transport Economies of Scale. Similarly, this start-up connects restaurants with offices ordering in bulk to help reduce delivery costs.
However, note that expanding the restaurant kitchen, hiring and driver and getting a business vehicle takes time. This means it may not occur in the short-tun where fixed factors of production cannot be changed/increased. Hence, Economies of Scale is a long-run concept. Despite the cost savings from expanding, Diseconomies of Scale will eventually set-in for the restaurant when it gets too big and difficult to operate (imagine if you expanded from Chinese to other Asian cuisines and find it much costlier to manage the food quality and chefs). By that point, LRAC will start to increase again. Therefore, the LRAC Curve is U-shaped due to Economies/Diseconomies of Scale, whereas the short-run average cost (SRAC) curve & marginal cost (MC) curve is U-shaped due to diminishing marginal returns.
Economies of Scale & Long-Run Average Cost (LRAC) Notes with Diagrams/Graphs:
Want a closer look? Download these Economies of Scale & Long-Run Average Cost (LRAC) notes.
The left video explains Economies of Scale and Diseconomies of Scale, and the right video looks at the Long-Run Average Cost (LRAC) Curve).
Economies of Scale & Long-Run Average Cost (LRAC) Multiple Choice Questions
Want a closer look? Download these Economies of Scale & Long-Run Average Cost (LRAC) multiple-choice questions.