Explain why the long run average cost Curve of a firm is U-shaped
As production increases, there are two basic influences at work. 1) Economies of scale. 2) Diminishing marginal returns. Economies of scale causes average cost to decrease as production increases. Think of Henry Ford's assembly line, producing many cars quickly instead of just a few cars slowly. Diminishing marginal returns causes average cost to increase as production increases. Imagine trying to build and run a second (or third, or tenth) factory...the ideal land for the factory isn't available any more (you've already built there!), your best low-cost suppliers are already running at full volume and now you're buying from slightly higher-cost suppliers, and it's harder to find labor with skills as good as you were able to hire in the first factory. Economies of scale outweighs diminishing marginal returns at low volumes, but eventually diminishing marginal returns outweight economies of scale at high volumes.