Unit - VI (Theory of Revenue & Cost)

1. Why short run average cost curve (SAC) is U shaped ?

Ans: The implication for SAC being U shaped is due to the logic of classical economists that there must be only one level of output in which production cost is minimum (i.e. SAC contains only one minimum point where optimum output at least average cost can be produced). Here are main reasons  of SAC curve being U shaped.

a. Nature of AFC and AVC:

Due to the nature of AFC and AVC short run average cost (SAC) curve is U shaped. Initially as increase in output AFC and AVC both declines continuously due to which SAC is downward sloping and it reaches to its minimum point. After the minimum point SAC starts rising as result. This is because of the fact that the rate of increase in AVC after minimum point is greater than that of fall in AFC so that SAC curve increases after its minimum point. Due to which SAC curve is U Shaped as shown by above figure.

b. Indivisibility:

Some factors like machines, equipments are indivisible. It is impossible to reduce machine or manager in order to produce less. That is why indivisible factors are utilized to their fullest capacity as output expands which makes downward sloping SAC curve in the initial state (i.e. SAC falls). But later on, there will be diminishing productivity of indivisible factors so that SAC increases, finally giving U shaped SAC curve.

c. Law of Variable Proportions:

The U shaped of SAC curve is attributed to the law of variable proportions as it states that SAC decreases in the initial stage of production due to increasing returns to the variable inputs and begins to increase when returns to the variable inputs begins to decrease.

d. Economies and Dis-economies of Scale

At the initial phase due to the economies of scale such as positive effect of division of labour, increase in efficiency of machineries, decrease in marketing costs, decrease in transportation costs, decrease in advertising costs and fuller utilization of managerial capacity SAC declines as output expands. After certain point due to the dis-economies of scale such as unionism, decrease in efficiency of capital, increase in marketing costs, increase in transportation costs increase in advertisement costs, limitation of managerial ability and etc. SAC starts to increase. As a result SAC curve is U shaped.