Lecture 12
AVERAGE COST AND RETURNS TO SCALE

• U-shaped average cost curve
• Average costs in the short run and long run
• Returns to scale

1. Why is the average cost (AC) curve U-shaped?

• For small levels of output, AC decreases with output:
  • Inputs may yield increasing marginal returns
  • Sharp fall in the average fixed cost (AFC)
• After a certain output level, AC increases. Why?
  • Diminishing marginal returns from inputs set in
  • Increase in administrative costs as the firm's size increases
    

2. Long-run and Short-run costs

• In the short run:
  Some inputs are fixed, eg., plant size
• In the long run:
  All inputs are variable, including plant size.

3. Long-run and Short-run AC curves

• Short-run average cost (SRAC) curve
  • Drawn for a particular plant size
  • Different SRAC curves for various plant sizes
• Long-run average cost (LRAC) curve
  • The SRAC will never be below the LRAC. Why?
  • The lower envelope of all the SRAC curves

4. Returns to scale

1. When the firm increases all its inputs by the same factor, by how much does the firm's output increase?
   • By more than the factor: Increasing returns to scale (IRTS)
   • By the same factor: Constant returns to scale (CRTS)
   • By less than the factor: Decreasing returns to scale (DRTS)
2. Returns to scale and average cost
   • If there are economies of scale in production (IRTS), AC falls as more output is produced by the firm