What is the relationship between returns to scale and cost curves? Can you asses
ID: 1105859 • Letter: W
Question
What is the relationship between returns to scale and cost curves? Can you assess the shape of the long-run average cost curve for your organization? You do not need to estimate the cost function, merely, on the basis of your knowledge of your firm, what do you think the curve looks like and why? (For HP) What is the relationship between returns to scale and cost curves? Can you assess the shape of the long-run average cost curve for your organization? You do not need to estimate the cost function, merely, on the basis of your knowledge of your firm, what do you think the curve looks like and why? (For HP)Explanation / Answer
The distinction between long run and short run lies in the fact that long run is a time period that is long enough to change the units of all the factors. A firm can increase production by input mix since all the factors can be changed in the long run. In the short run, however, a firm is unable to change units of some factors so that it has to operate with a fixed quantity of fixed factors
When a firm has increasing returns, the costs are diminshing. When there are decreasing returns, the costs are increasing. This precisely suggests that the short run average total cost is enveloped by the long run average total costs. This is because SRATC > LRATC. This gives a U shaped long run average cost curve that entails short run average cost curve at different (plant) capacities.
A firm can take decisions related to what plant size it needs or what level of output it should produce by looking at its current location of the LATC and comparing it with the desirable plant size.
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