Chapter 7: Problem 29

Why will firms in most markets be located at or close to the bottom of the long-run average cost curve?

Short Answer

Expert verified

Firms in most markets are located at or close to the bottom of the long-run average cost curve (LRAC) because this is where the minimum efficient scale (MES) is achieved. By operating at the MES, firms maximize profits and minimize long-run average costs, ensuring a competitive edge in the market. The competitive nature of most markets drives firms to locate near the bottom of the LRAC, as they strive to reduce production costs and compete more effectively with other industry players.

Step by step solution

Understanding the Long-Run Average Cost Curve

The long-run average cost curve (LRAC) represents the lowest possible average cost for a firm to produce various output levels, taking into account all possible combinations of inputs and allowing for changes in production capacity. The LRAC is typically U-shaped, reflecting economies of scale at lower output levels and diseconomies of scale at higher output levels. The bottom of the LRAC represents the minimum efficient scale (MES), which is the lowest cost per unit at which a firm can produce. Firms strive to achieve this scale in order to maximize profits and minimize long-run average costs.

Effect of Market Competition on Firm Location

In a competitive market, firms need to maximize profits and minimize costs to remain viable. As a result, they are driven to locate at or close to the bottom of the LRAC in order to take advantage of the lowest production costs. If a firm is not operating at the MES, it is likely to face higher per-unit costs than its competitors, relegating it to a less favorable position in the market.

Achieving Minimum Efficient Scale

Firms can move closer to the bottom of the LRAC by increasing efficiency, adjusting production processes, or taking advantage of economies of scale. By doing so, they reduce production costs and position themselves to compete more effectively with other firms in the market.

Barriers to Entry and Firm Location

Sometimes, barriers to entry may allow some firms to operate at a higher point on the LRAC curve without facing immediate competitive pressure. However, in most markets, these barriers eventually erode, and new firms enter the market. As competition intensifies, firms will be pressured to reduce costs and locate closer to the minimum efficient scale to remain competitive.

Conclusion

Firms in most markets are located at or close to the bottom of the long-run average cost curve because doing so provides the lowest production costs, maximizing profits and ensuring a competitive edge in the market. By achieving the minimum efficient scale, firms can compete more effectively with other players in the industry. The competitive nature of most markets naturally drives firms to locate near the bottom of the LRAC curve, even if they may face certain barriers to entry initially.