The long-run total cost curve looks similar to the short-run total cost curve, just at a larger scale. Every decision is made in the short run, with an existing short-run cost curve, but a decision to invest in greater capacity, such as a larger manufacturing plant, is a long-run decision. It is a decision that allows the firm to be on a lower short-run average total cost curve (including both fixed and variable costs) in the future.
The scale of production is the long-run efficiency of producing outputs from the inputs, characterized by choosing between the possible short-run average total cost curves. The process of expanding a business is called scaling up.
Scaling up may or may not be beneficial for a given company. The long-run production process could have increasing, decreasing, or constant returns to scale. Like the short-run average cost curve, the long-run average cost curve is U-shaped, with a minimum point. The output at which long-run average cost first reaches this minimum is called the minimum efficient scale (MES).
Increasing returns to scale means that when the business scales up, the production becomes more efficient. That means the long-run average total costs are decreasing. Economists call this economies of scale. On the U-shaped long-run average cost curve, the downward-sloping part shows economies of scale.
On the other hand, decreasing returns to scale means that when the business scales up, the production becomes less efficient. That means the long-run average total costs are increasing. Economists call this diseconomies of scale. On the U-shaped long-run average cost curve, the upward-sloping part shows diseconomies of scale.
Being able to operate at minimum efficient scale can allow a firm to stay in business even if demand falls and the price is lower than expected. It means being the lowest-cost producer in the market. A market is productively efficient when the most efficient producers are the ones producing the good. In other words, operating at a minimum efficient scale helps improve market efficiency.
Minimum efficient scale also helps keep the market competitive. In the long run, if there are sufficiently low barriers to entry, then only the firms that are able to operate at the most efficient scale will be able to survive. In that way, firms' decisions regarding long-term production costs help determine the market structure and the number of firms.
Key terms
- Economies of scale
- The cost advantages a firm gains as its scale of output grows, shown by falling long-run average cost.
- Diseconomies of scale
- The rise in long-run average cost when a firm grows beyond its most efficient size.
- Minimum efficient scale
- The lowest output at which long-run average cost reaches its minimum.