Long run average cost is the cost per unit of output feasible when all factors of production are variable
Economies of Scale and Long Run Average Cost (LRAC)
In the long run all costs are variable and the scale of production can change (i.e. no fixed inputs)
Economies of scale are the cost advantages from expanding the scale of production in the long run. The effect is to reduce average costs over a range of output
These lower costs represent an improvement in productive efficiency and can give a business a competitive advantage in a market. They lead to lower prices and higher profits – this is called a positive sum game for producers and consumers (i.e. the welfare of both will improve)
We make no distinction between fixed and variable costs in the long run
As long as the long run average total cost curve (LRAC) is declining, then internal economies of scale are being exploited.
The table below shows a numerical example of falling LRAC
|Long Run Output (Units)||Total Costs (£s)||Long Run Average Cost (£ per unit)|
Returns to Scale and Costs in the Long Run
The table below shows how changes in the scale of production can, if increasing returns to scale are exploited, lead to lower average costs.
|Capital||Land||Labour||Output||Total Cost||Average Cost|
|Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200|
Because the % change in output exceeds the % change in factor inputs used, then, although total costs rise, the average cost per unit falls as the business expands from scale A to B to C
Examples of Increasing Returns to Scale
Much of the new thinking in economics focuses on the increasing returns available to growing businesses:
An example of this is the software and computer gaming industry.
Capacity Utilisation, Fixed Costs and Profits
Long Run Average Cost Curve