Long-run average cost and economies of scale

The LRAC curve, minimum efficient scale and why firms grow.

Tesco takes more than a quarter of all UK grocery spending.

Tesco is the UK’s largest grocer. In the 12 weeks to 2 November 2025 it took 28.2% of all grocery spending, against 15.7% for Sainsbury’s, 10.6% for Aldi and 8.2% for Lidl. It buys from its suppliers on a scale no corner shop can match.

Why might a bigger firm make or sell each unit more cheaply? And if bigger is cheaper, how do Aldi and Lidl compete on price at a third of Tesco’s size?

Source: Worldpanel by Numerator, reported by Retail Gazette (November 2025).

Think first

A supermarket chain doubles the number of shops it runs.

What is most likely to happen to the cost of each item it sells?

A bigger firm can buy in bulk, use bigger lorries and hire specialist managers, so its cost per unit falls: economies of scale. But past a certain size, the firm becomes hard to manage and costs per unit start to rise again: diseconomies of scale.

Step by step

1. Start with the assumptions. In the long run every factor of production can change: a firm can build bigger shops, buy more lorries, open new sites. The long-run average cost curve, LRAC, shows the lowest cost per unit of producing each output once the firm can choose its scale. Think of it as joining up many short-run average cost curves, one for each size of plant. Its shape comes from returns to scale: compare the percentage rise in output with the percentage rise in all inputs.

2. As the firm grows, LRAC falls: economies of scale. If output rises by a bigger percentage than inputs, there are increasing returns to scale, so cost per unit falls. Internal economies include buying in bulk (purchasing), bigger and better machines (technical), specialist managers (managerial), cheaper borrowing (financial), spreading advertising over more sales (marketing) and spreading risk across more products and markets (risk-bearing).

   Teacher tip: Economies of scale lower cost per unit, not total cost. Total cost still rises as output rises. Write “average cost falls”, never just “costs fall”.

   Check: Which of these describes economies of scale?

   Total cost almost always rises with output: economies of scale are about cost per unit. Costs falling over time from new technology is dynamic efficiency, a different idea.

3. Mark the minimum efficient scale, MES: the lowest output at which LRAC reaches its minimum. A firm smaller than MES has higher costs than it needs to. If MES is near the whole market’s output, as with water pipes, only one firm may fit: a natural monopoly.

   Check: Why does the minimum efficient scale matter for the structure of a market?

   If each firm must be very large to reach MES, the market only has room for a few of them, as in car making or energy. If MES is small, many firms can survive.

4. Beyond MES, LRAC may be flat for a range: constant returns to scale. Firms of different sizes can have the same cost per unit. That is one reason Aldi and Lidl can compete with Tesco on price at a fraction of its size.

5. At very large scale, LRAC rises: diseconomies of scale, or decreasing returns to scale. Managers struggle to control a huge workforce, communication slows, departments are hard to coordinate and motivation falls. Each cuts productivity, so total cost rises faster than output.

   Teacher tip: Diseconomies of scale come from the size of the whole firm, in the long run. Diminishing returns come from a fixed factor, in the short run. Mixing the two up is one of the most common errors on this topic.

   Check: Which of these is a cause of diseconomies of scale?

   Diseconomies come from the firm being too big to manage well. Diminishing returns is short run. A rise in raw material prices shifts cost curves up; it is not about scale.

6. Compare a small firm at Q1 with a large firm at Q2. The large firm’s cost per unit, AC2, is lower than the small firm’s, AC1. It can charge a lower price and still make a profit. That is a barrier to entry: a new firm that starts small has higher costs than the firms already there.

7. External economies of scale come from the growth of the whole industry, not one firm: a pool of skilled workers, specialist suppliers nearby, better transport links. They shift the whole LRAC curve down, from LRAC to LRAC2. Internal economies are a movement along LRAC.

   Check: Tech firms cluster around Cambridge, attracting specialist suppliers and skilled workers. For one tech firm there, this is:

   The benefit comes from the industry growing in one place, not from the firm itself growing, so it is external and lowers costs at every scale.

What your diagram must show

• LRAC falling at low output, labelled economies of scale
• MES marked on the output axis where LRAC first reaches its minimum
• LRAC rising at high output, labelled diseconomies of scale

A common mistake

They labelled the rising part of LRAC as economies of scale. Where LRAC rises, cost per unit goes up as the firm grows: diseconomies of scale. Economies of scale are where LRAC falls.

Exam question

Explain why a firm’s long-run average cost curve may fall and then rise as it grows.

Model answer

In the long run all factors of production are variable, so a firm can change the scale of its operations.

As it grows, it can benefit from internal economies of scale. It can buy inputs in bulk at a discount, use larger and more efficient machinery, employ specialist managers and borrow more cheaply. Total cost rises, but by proportionately less than output, so long-run average cost falls. LRAC reaches its lowest point at the minimum efficient scale.

Beyond a certain size, diseconomies of scale set in. Communication between layers of management slows, decisions take longer and are harder to coordinate, and staff may feel less involved and less motivated. Cost per unit then rises as the firm grows, so LRAC turns up. Between the two there may be a range of constant returns to scale, where LRAC is flat and firms of different sizes have the same cost per unit.