Question

Draw the long-run total cost and long-run average cost curves for a firm that experiences: a. Constant returns to scale over all output levels. b. Diseconomies of scale over low levels of output, constant returns to scale over intermediate levels of output, and economies of scale over high output levels. Does this pattern of costs make sense? Why or why not?

Short answer

a. Under constant returns to scale, draw both the LRTC and LRAC as straight lines with LRAC being horizontal to quantity axis. b. With varying levels of returns to scale, draw the LRTC to slope upwards initially, flatten then decrease while draw the LRAC as decreasing, flattening and further decreasing. The pattern makes sense if a firm initially faces inefficiencies at low production levels that disappear at higher production levels.

Step-by-step solution

Draw for Constant Returns to Scale

Since there are constant returns to scale over all output levels, the curves will be linear. Create a coordinate system. The x-axis represents the quantity of output and the y-axis represents cost. Draw the LRTC as a line that starts from the origin and extends diagonally upwards. The LRAC curve will also be a straight line parallel to the x-axis because constant returns to scale maintain a steady cost per unit of production. The LRAC will intersect the LRTC at its minimum point.

Draw for Variable Returns to Scale

Create a new coordinate system for the second set of conditions. Initially, draw the LRTC curve to slope upwards at an increasing rate due to diseconomies of scale (increasing cost per unit) for low levels of output. Then, flatten the curve where constant returns to scale occur (steady cost per unit) for intermediate levels of output. Lastly, curve it downwards for where economies of scale (decreasing cost per unit) happen at high output levels. The LRAC will initially slope downwards, flatten over the region of constant returns to scale, and continue sloping downwards over the region of economies of scale.

Analyze Cost Patterns

The pattern of costs can make sense for some types of businesses. Initially at lower production levels, costs may increase due to inefficiencies but can stabilize as the production process becomes efficient. At high output levels, costs can decrease due to the business enjoying economies of scale. However, this may not be applicable to all business types.

Key concepts

Constant Returns to Scale

In economics, when we talk about constant returns to scale, we refer to a situation where increasing the input levels by a certain percentage results in an increase in output by the same percentage. This implies that the cost of producing one additional unit of product remains steady regardless of the scale of production.

Imagine a factory that makes pencils: If it doubles the amount of wood and graphite it uses, it will exactly double its output of pencils without changing the cost per pencil. The key characteristic in this scenario is linearity - the long-run total cost (LRTC) curve starts from the origin and goes upwards in a straight line. Similarly, the long-run average cost (LRAC) remains unchanged as output increases, which is depicted as a horizontal line that touches the LRTC at its lowest point. This concept is essential to understand since it sets the baseline for analyzing other types of scale returns.

For businesses, constant returns to scale imply that there’s a balanced growth. Neither economies nor diseconomies of scale are present, so this could indicate a competitive market where businesses have optimized their scale of operation.

Diseconomies of Scale

Diseconomies of scale are a less desirable concept that businesses encounter when they grow. This occurs when increasing production leads to a rise in the average costs. Essentially, it's the opposite of what many expect: as a company expands, it becomes less efficient, which can happen for a multitude of reasons.

Consider a large corporation that has grown too quickly. The communication between departments may become cumbersome, leading to mismanaged resources, which then causes production delays or even errors. In the context of the LRAC and LRTC curves, at low levels of output, the curves slope upwards at an increasing rate indicating rising costs per unit of increase in output.

Internal and External Diseconomies

These diseconomies can be internal due to managerial inefficiencies, or external, often due to market conditions such as increased prices for raw materials as demand increases. A key point for students to note is that recognizing and managing diseconomies of scale is crucial for a business's long-term success.

Economies of Scale

Moving on to a more optimistic aspect, we encounter economies of scale. This term defines the cost advantage that arises with increased output of a product. As production scales up, the firm can spread out its fixed costs over a larger number of units, which reduces the cost per unit.

There are many ways a firm might achieve economies of scale. Bulk buying of materials, technological improvements, specialized workers, and optimized processes can all play a part. In the long-run average cost curve, economies of scale are represented by the downward sloping section where the cost per unit of production decreases as output increases.

How Economies of Scale Work

For instance, a factory that invests in a more efficient machine may see a decrease in costs over time as the machine produces more units. However, it's important for students to understand that economies of scale can also lead to diseconomies if the business becomes too large and difficult to manage effectively. The goal for a business is to find the right balance where it can maximize its cost advantages while avoiding the pitfalls of overexpansion.