The relationship between short-run and long-run average cost curves

In the short run, businesses face constraints because at least one factor of production, such as factory size, remains fixed. In contrast, the long run allows all factors to be varied, enabling firms to optimise their production setup.

Short-run average cost (SRAC) curve

The SRAC curve represents the costs when at least one factor is fixed. As output increases, the firm adjusts variable factors like labour, moving along this curve.

Long-run average cost (LRAC) curve

The LRAC curve shows the lowest possible average cost for each output level when all factors can be changed.

Firms cannot achieve costs below the LRAC curve, though SRAC curves can touch it. To operate on the LRAC at a specific output, a business must select the ideal combination of all production factors. In the short run, fixed factors prevent reaching this minimum, but in the long run, adjustments allow costs to drop to the LRAC level.

How internal economies and diseconomies of scale shape the LRAC curve

The LRAC curve's shape reflects how average costs change with output scale, driven by internal factors within the firm. As production expands, costs per unit can decrease due to efficiencies, but eventually, they may rise if inefficiencies emerge.

Internal economies of scale

Internal economies of scale occur when average costs decrease as output rises, often in the downward-sloping part of the LRAC curve.

Internal diseconomies of scale

Internal diseconomies of scale arise when average costs increase with higher output, causing the LRAC curve to slope upwards.

At certain output levels, a firm might experience both economies and diseconomies simultaneously. The overall effect on the LRAC depends on which dominates—net economies lower costs, while net diseconomies raise them.

External factors that cause shifts in the LRAC curve

External economies and diseconomies of scale affect all firms in an industry or region, shifting the entire LRAC curve without changing its basic shape. These are influences outside a single firm's control.

External economies of scale

External economies of scale reduce average costs at every output level, shifting the LRAC curve downwards.

External diseconomies of scale

External diseconomies of scale increase average costs across all outputs, shifting the LRAC curve upwards.

Other external shifts include tax reductions lowering the curve or new efficient technologies, like advanced robotics, reducing costs for all firms.

The alternative view of an L-shaped LRAC curve

Some economists propose that the traditional U-shaped LRAC curve does not fully capture real-world cost behaviours, suggesting an L-shaped alternative instead.

Characteristics of the L-shaped LRAC curve

In this view, average costs drop sharply at low output levels due to strong initial economies of scale.

As output continues to grow:

• Costs either level off or decrease gradually, rather than rising.
• Internal diseconomies, such as managerial complexities, are present but outweighed by ongoing economies like technical improvements.
• The curve does not turn upwards, implying no inevitable cost increases from scale alone.

This perspective emphasises that firms can sustain low costs at high outputs by continually offsetting diseconomies through innovation and efficiency gains.