Question

Why is long term average cost U-shaped?

Answer 1

• Based on Economies and Diseconomies of Scale: Unlike the short-run average cost (which is U-shaped due to the law of variable proportions), the LAC curve is U-shaped due to economies and diseconomies of scale.
• Falling Part of LAC – Economies of Scale:
  • When a firm increases its scale of production, it initially experiences economies of scale.
  • These are benefits like specialization, better machinery, and lower per-unit costs.
  • As a result, the LAC falls.
• Rising Part of LAC – Diseconomies of Scale:
  • After a certain point, further expansion creates diseconomies of scale (like poor management or coordination problems).
  • These inefficiencies cause per-unit cost to rise, and thus, LAC starts rising.
• Types of Economies and Diseconomies:
  • Internal: Occur within the firm (e.g., better machines or labour).
  • External: Affect all firms in an industry (e.g., industry-wide growth).
  • Internal factors determine the U-shape of LAC.
  • External factors cause upward or downward shifts in the LAC curve.
• Optimum Point:
  • The lowest point on the LAC curve is where the firm is most efficient — this is called the optimum scale of production.