In the long run a firm can change everything, including the size of its plant. The question shifts from "how much from this factory?" (How Marginal and Average Costs Relate) to "how big should the firm be?"
Key idea
The long-run average total cost (LRATC) curve shows the lowest average cost of each output when all inputs can vary. Where LRATC falls as output grows, there are economies of scale; where it is flat, constant returns to scale; where it rises, diseconomies of scale. The minimum efficient scale is the smallest output at which LRATC reaches its lowest level.
Why it works
Bigger firms can split work into specialized jobs, use large machines that only pay off at high volume, and buy inputs in bulk: average cost falls. Past some size, a firm gets hard to manage: more layers of bosses, slower decisions, workers far from the customers, so average cost can rise. The long-run curve is made from short-run curves: for each output, the firm picks the plant size with the lowest ATC, so LRATC is the lower edge of all the short-run ATC curves.
| Output | Long-run total cost | LRATC |
|---|---|---|
| 1,000 | \$10,000 | \$10 |
| 2,000 | \$16,000 | \$8 |
| 3,000 | \$18,000 | \$6 |
| 4,000 | \$24,000 | \$6 |
| 5,000 | \$35,000 | \$7 |
Worked example: Reading scale from a table
Using the table, where are there economies of scale, constant returns and diseconomies? What is the minimum efficient scale?
- LRATC = total cost ÷ output: \$10, \$8, \$6, \$6, \$7.
- From 1,000 to 3,000 it falls: economies of scale. From 3,000 to 4,000 it is flat: constant returns. From 4,000 to 5,000 it rises: diseconomies.
- The lowest LRATC, \$6, is first reached at 3,000: the minimum efficient scale.
Answer: Economies to 3,000, constant to 4,000, diseconomies after; MES = 3,000.
Worked example: Why it matters for market structure
A market buys about 4,000 units a year, and the minimum efficient scale is 3,000. About how many firms can produce at the lowest cost?
- Each low-cost firm needs to make at least 3,000.
- $4{,}000 \div 3{,}000$ is between 1 and 2: there is room for only one firm at minimum cost.
- That is the seed of a natural monopoly (Regulating a Natural Monopoly).
Answer: Only one.
Common mistake
Confusing diseconomies of scale with diminishing marginal returns. Diminishing returns is a short-run idea: adding workers to a fixed plant. Diseconomies of scale is a long-run idea: growing the whole firm, plant and all, and finding average cost rising. Check: ask whether any input is held fixed. If yes, it's diminishing returns.