Association of Chartered Certified Accountants (ACCA) Certification Practice Test

What happens to the average cost as production increases in the long run?

1. It continues to increase indefinitely

2. It decreases to a minimum point before increasing

3. It remains constant

4. It decreases and levels off

The correct answer is: It decreases to a minimum point before increasing

In the long run, as production increases, the average cost typically decreases to a minimum point before potentially increasing. This behavior is illustrated by the concept of economies and diseconomies of scale. Initially, when production starts to ramp up, firms often benefit from economies of scale. This means that as production increases, the average cost of producing each unit tends to decrease. This reduction occurs because fixed costs, such as rent and salaries, are spread over a larger number of units, and operational efficiencies often improve. However, after reaching a certain level of production, a firm may experience diseconomies of scale, where the average costs begin to increase once again. This can occur due to factors like management inefficiencies, overextension of resources, or logistical issues that arise from operating at a larger scale. Thus, the correct answer reflects the microeconomic principle that average costs initially decline as production increases, reach a minimum point, and may then start to rise again if production continues to increase beyond an optimal level.