Explain why a firm’s short run average cost curve is always ‘U’-shaped whilst the shape of its long run average cost curve is an indeterminate.

The average cost (AC) is defined as the cost of producing a single unit of a good, the total cost divided by the quantity produced. In order to appreciate what the two different curves mean you need to understand the difference between short run and long run. The long run is the conceptual time period in which there are no fixed factors of production, so that there are no constraints preventing changing the output level by changing the capital stock or by entering or leaving an industry. The long run contrasts with the short run, in which some factors are variable and others are fixed, constraining entry or exit from an industry.

The short run average cost, as shown in the figure below, demonstrates how there is a fall in average costs as output rises initially due to increasing returns to the variable factors of production and average fixed costs fall continuously as output rises. There is a point on every SRAC curve which is when output is optimum, when average cost is equal to marginal cost. However, as output keeps on increasing the SRAC will eventually rise as diminishing returns set in. This is the decrease in the marginal output of a production process as the amount of a single factor of production is incrementally increased, while the amounts of all other factors of production stay constant.

After a second variable factor of production is altered, such is new technology causes an advancement in capital, there is another short run average cost curve created due to this new variable, but, there is now a long run average cost curve which is formed by marrying together all of the different short run average cost curves which then make the LRAC curve, which is indeterminate. This occurs due to economies of which