A typical firm moves from increasing returns to scale (IRS) to constant returns to scale (CRS) and then to decreasing returns to scale (DRS) as its output grows. Which chain of effects is correct?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → IRS → LRAC falls and LRMC lies below it → CRS at the minimum of LRAC, where LRMC cuts LRAC from below → DRS → LRAC rises and LRMC lies above it
Returns to scale decide how LRAC moves, and LRAC decides where LRMC lies.
Under IRS, cost rises by less than output, so LRAC falls. A falling average needs a lower marginal, so LRMC is below LRAC.
At the minimum of LRAC, CRS holds and LRMC cuts LRAC from below.
Under DRS, LRAC rises, so LRMC is above it.
Option (1) IRS → LRAC falls and LRMC lies below it → CRS at the minimum of LRAC, where LRMC cuts LRAC from below → DRS → LRAC rises and LRMC lies above it — Correct. Each link follows from the steps above.
Option (2) IRS → LRAC rises and LRMC lies above it → CRS at the maximum of LRAC → DRS → LRAC falls and LRMC lies below it — Incorrect. Under IRS, LRAC falls; CRS is at the minimum of LRAC.
Option (3) IRS → LRAC falls and LRMC lies above it → CRS at the minimum of LRAC, where LRMC cuts LRAC from above → DRS → LRAC rises and LRMC lies below it — Incorrect. While LRAC falls, LRMC lies below it, and it cuts LRAC from below.
Option (4) IRS → LRAC falls and LRMC lies below it → CRS at the minimum of LRMC, where LRMC equals LRAC → DRS → LRAC rises and LRMC lies above it — Incorrect. CRS is at the minimum of LRAC, not of LRMC.
NCERT (2026-27): “Shapes of the Long Run Cost Curves … It must be the case that as long as IRS operates, average cost falls as the firm increases output. DRS implies that if we want to increase the output by a certain proportion, inputs need to be increased by more than that proportion. As a result, cost also increases by more than that proportion. So, as long as DRS operates, the average cost must be rising as the firm increases output. CRS implies a proportional increase in inputs resulting in a proportional increase in output. So the average cost remains constant as long as CRS operates. 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. Accordingly, the LRAC curve is a ‘U’-shaped curve. Its downward sloping part corresponds to IRS and upward rising part corresponds to DRS. At the minimum point of the LRAC curve, CRS is observed.” “Shapes of the Long Run Cost Curves … Let us check how the LRMC curve looks like. 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 is therefore a ‘U’-shaped curve. It cuts the LRAC curve from below at the minimum point of the LRAC.”
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