Figure 1: Long-Run Average Cost

Figure 1 shows the long-run average cost (LRAC) of a product. The “U” shape of LRAC is due to the economies and diseconomies of scale. Economies of scale in production refer to increase in efficiency of production or decrease in long-run average total costs as output increases. For instance, if producing 1 million units of iPhone costs Apple $800 million ($800 each), but producing 3 million units of iPhone costs the firm $1.8 billion ($600 each). Obviously, from 1 million to 3 million units, the production of iPhone demonstrates significant economies of scale where the cost of production has reduced from $800 to $600 per unit. Diseconomies of scale occur when LRAC increase as output increases. Diseconomies of scale are due to the following factors:

There are two types of economies of scale, internal and external economies of scale. Internal economies of scale measure how efficient a firm in producing the goods. The efficiency here refers to how the firm manages to lower down the cost (variable costs) as it increases the total output. In external economies of scale, the reduction in unit cost of production is due to external factors (all positive externalities) like fall in material costs, labor wages and transportation costs. Thus, external economies of scale will increase the productivity of whole industry.     

Figure 1: Long-Run Average Cost

Figure 1 shows the long-run average cost (LRAC) of a product. The “U” shape of LRAC is due to the economies and diseconomies of scale. Economies of scale in production refer to increase in efficiency of production or decrease in long-run average total costs as output increases. For instance, if producing 1 million units of iPhone costs Apple $800 million ($800 each), but producing 3 million units of iPhone costs the firm $1.8 billion ($600 each). Obviously, from 1 million to 3 million units, the production of iPhone demonstrates significant economies of scale where the cost of production has reduced from $800 to $600 per unit. Diseconomies of scale occur when LRAC increase as output increases. Diseconomies of scale are due to the following factors:

There are two types of economies of scale, internal and external economies of scale. Internal economies of scale measure how efficient a firm in producing the goods. The efficiency here refers to how the firm manages to lower down the cost (variable costs) as it increases the total output. In external economies of scale, the reduction in unit cost of production is due to external factors (all positive externalities) like fall in material costs, labor wages and transportation costs. Thus, external economies of scale will increase the productivity of whole industry.