Modern Theory Of Cost: Long Run

Economies and Diseconomies of Scale

The economies and dis-economies of scale explain why under the traditional theory of costs, the LAC curve is U-shaped and under modern theory, the LAC is L-shaped. Alfred Marshall classified Economies of scale into internal economies and external economies.

Internal economies are internal to a firm and are not shared by its competitors in the industry while external economies are those benefits of large-scale production which accrue from outside due to the growth of the whole industry.

Long Run Costs Under Modern Theory

The shape of the long-run cost curve is dependent on the returns to scale. The traditional theory assumes a ‘U’ shaped Long-run cost curve under the presumption that after the optimal level of output, the diseconomies of scale overtake the economies of scale.

The modern theory contends that the long-run average costs essentially comprised production and managerial costs, of which the average production costs continue to fall even at large scales while the managerial costs per unit of output may rise only gradually and at large scales of output. The long-run Average cost curve is ‘L-Shaped’ or inverse J-shaped under the modern theory of cost.

The long-run Average cost curve LAC can be derived from the short-run Average cost curves. Under the modern theory of costs, the falling portions of SAC curves are considered to obtain/ derive the LAC Curve. A firm is assumed to operate till its load factor and not full capacity is achieved. The load factor generally lies between two-thirds and three-fourths of the total capacity and corresponds to the falling portion of the short-run Average cost curve.

Thus, the long-run Average cost curve does not envelop the SACs but intersects them at the level of output defined by the load factor of each plant. The existence of economies of scale checks the increase in cost and decreasing returns under the modern theory of costs.

In Fig 1, we find that as the average costs of production fall continuously with the increase in the level of output, the LAC curve assumes an inverse J-shaped which signifies that there are no diseconomies of scale even at very large scales of output.

If the average costs of production continue to fall only till a certain optimal level ox1 and beyond that it becomes constant, then the LAC curve is roughly L-shaped, and this signifies that the economies and diseconomies of production balance out each other beyond the optimal level of output ox1.

In the case of an inverse J- shaped LAC curve, the LRMC will lie below the LAC curve at all output levels since the average costs of production can fall continuously if and only if the LRMC pulls them downwards by remaining below it.

If there is a minimum optimal scale of the plant. OX1, at which all possible scale economies are reaped, beyond that level of output, the LAC remains constant. In this case, the LRMC lies below the LAC curve until the minimum optimal scale is reached and coincides with the LAC beyond that level of output.

According to the modern theory of costs, the long-run average costs are essentially comprised of production and managerial costs, where the fall in production costs more than offsets the rise in managerial costs; thus, the LAC curve either falls continuously or remains constant at very large scales of output.

Different Shapes of Long-Run Average Cost (LAC) Curves Under Modern Theory of Costs

L-Shaped Long Run Average Cost (LAC) Curve

Inverse J-Shaped Long Run Average Cost (LAC) Curve

Measurement of Economies of Scale

Economies of scale are usually measured in terms of cost-output elasticity (Ec), where Ec is defined as the percentage change in the cost of production resulting from a 1- percent increase in output, Ec = (∆𝐶/𝐶) / (∆𝑄/𝑄), Ec relates to the traditional measures of cost and does not show this relationship; therefore we can rewrite this equation as Ec = (∆𝐶/∆𝑄) / (C/Q = MC/AC).

This equation can be used to measure Ec in different cases and also to know whether there are economies or diseconomies of scale. If Ec = 1, then the firm‘s economies of scale are equal to the dis-economies of scale. If Ec is less than one, then the firm enjoys economies of scale. Finally, if Ec is greater than one, the dis-economies of scale exceed the economies of scale.

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