Question

A long-run cost function for a product exhibits economies of scale if

• A. average cost of production increases when the output increases.
• B. the production function has decreasing returns to scale.
• C. average cost of production falls as the output increases.
• D. average cost of production remains constant as the output increases.

Answer 1

The Correct Option is C

To understand under what conditions a long-run cost function for a product exhibits economies of scale, we need to clarify the concept of economies of scale:

**Economies of Scale**: This occurs when increasing the scale of production leads to a lower cost per unit of output. In other words, as the output increases, the average cost of production decreases. This is due to factors such as operational efficiencies, the spreading of fixed costs over a larger number of units, and other efficiencies that come into play with increased production.

Now, let's evaluate the given options:

• Option 1: Average cost of production increases when the output increases.
  This describes diseconomies of scale, not economies of scale. Diseconomies occur when the costs per unit increase as more output is produced. Thus, this option is incorrect.
• Option 2: The production function has decreasing returns to scale.
  Decreasing returns to scale imply that doubling inputs results in less than doubling of output. While related, this is more about the production function's input-output relationship rather than cost per unit. Thus, this option does not directly indicate economies of scale.
• Option 3: Average cost of production falls as the output increases.
  This is the ideal description of economies of scale. As output increases, spreading fixed costs over a larger quantity and achieving operational efficiencies result in a lower average cost per unit. This option is correct.
• Option 4: Average cost of production remains constant as the output increases.
  This scenario describes constant returns to scale, where increasing production does not change the average cost. Hence, this option is incorrect with respect to economies of scale.

From the analysis above, only Option 3 states that "average cost of production falls as the output increases," which is the hallmark of economies of scale. Thus, the correct answer is:

Average cost of production falls as the output increases.