Derivation of the Long-Run Average Cost Curve
A firm’s long-run average cost curve is derived from its short-run average cost curves. For each short-run fixed plant size, we take the lowest or near-lowest costs for that size plant. These bottom portions of the different short-run cost curves make up the long-run average cost curve. Thus, a firm’s long-run average cost curve is the “envelope” of the bottom points of the firm’s short-run average cost curves.
In the long run, all inputs are variable, and the firm has the choice of operating at a variety of plant or facility sizes. A small operation (SRAC1) that produces 300 units faces average costs of $26. A larger one, which produces 700 units (SRAC3), can lower its average costs to $17. When the firm gets too large (SRAC6), average costs rise to $20.
Economies and Diseconomies of Scale
When a firm increases its output and observes decreasing average total costs (in the downward portion of the long-run average cost curve), it experiences economies of scale. When a firm increases its output and observes increasing average total costs (in the upward portion of the long-run average cost curve), it experiences diseconomies of scale. Economies and diseconomies of scale are related to increasing and decreasing returns to scale. We elaborate on this in the next section.
For a video explanation of the long-run average total cost curve, please watch: