Explain, using a diagram, the shape of a short run average cost curve.

The short run average cost curve initially falls. Firstly, there are increasing returns, meaning that as production increases, the cost per unit decreases because resources are being used more efficiently. Additionally, the benefits of specialisation play a role, where workers and processes become more focused and efficient, further reducing costs. Fixed costs are spread over a larger number of units, reducing the fixed cost per unit. During this phase, output rises faster than costs, causing the average cost to decrease. When the marginal cost (MC) is less than the average cost (AC), it pulls the average cost down. The lowest point on the curve represents the point of maximum efficiency, where costs are at their lowest per unit.

However, the curve begins to rise due to diminishing returns or the law of diminishing marginal returns. As production continues to increase, the benefits of specialization are eroded, and the fixed factor becomes overworked. In this phase, costs begin to rise faster than output, causing the average cost to increase. When the marginal cost (MC) exceeds the average cost (AC), it pushes the average cost up.