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Shapes of the Long Run Cost Curves

It is argued that in a typical firm IRS is observed at the initial level of production. This is then followed by the CRS and then by the DRS. LRAC curve downward sloping part corresponds to IRS and upward rising part corresponds to DRS. At the minimum point of the LRAC curve, CRS is observed. For the first unit of output, both LRMC and LRAC are the same. Then, as output increases, LRAC initially falls, and then, after a certain point, it rises. As long as average cost is falling, marginal cost must be less than the average cost. When the average cost is rising, marginal cost must be greater than the average cost. LRMC curve cuts the LRAC curve from below at the minimum point of the LRAC.

At the final level of production, a typical firm observes _______.

Decreasing returns to scale

The correct answer is Option (3) → Decreasing returns to scale

At the final (large-scale) level of production, most firms experience decreasing returns to scale. This means that when all inputs are increased by a certain proportion, output increases by a smaller proportion. 

The production process for a typical firm in the long run moves through three stages of returns to scale:

• Initial Level: Increasing Returns to Scale (IRS), where output increases by a greater proportion than the increase in all inputs (due to economies of scale like specialization and better utilization of resources). This corresponds to the downward-sloping part of the Long-Run Average Cost (LRAC) curve.

• Intermediate/Optimal Level: Constant Returns to Scale (CRS), where output increases proportionally to the increase in inputs. This corresponds to the minimum point or the flat part of the LRAC curve.

• Final Level (beyond the optimal scale): Decreasing Returns to Scale (DRS), where output increases by a smaller proportion than the increase in all inputs (due to diseconomies of scale like management difficulties, coordination problems, and eventual resource limitations). This corresponds to the upward-sloping part of the LRAC curve.