Lecture-16

Cost Analysis (LONG RUN COSTS)

Learning Objective: Long Run Average Cost, long run marginal cost curve
Long Run Average Cost (LRAC)
In the long run all the factors are assumed to become variable. The behavior of
long run costs curves is almost the same as that of short run, but for the flatness.
The long run average cost (LRAC) is derived from short run cost curves. Each
point on the Long run average cost curve corresponds to a point on short run cost
curve which is tangent to Long run average cost at that point.
Long run average cost curve is also called envelope curve, because it envelopes
all short run average cost curves (Fig. 13). In another words it envelops the short
run production points or the production levels. Since this long run cost curve
allows us to learn from the short run experiences, it is also called as the planning
curve in the sense that it is a guide to entrepreneur in his/her decisions to plan the
future expansion of the output.

Fig.13
The shape of Long run average cost reflects the law of returns to scale.
According to the law, the unit cost of production decreases as plant size
increases due to the economies of scale which large plant size make possible.

 The traditional theory assumes that economies of scale exist only up to a certain
size of plant, known as optimum plant size, because with this plant size all
possible economies of scale are exploited. Hence,
The Long Run Average Cost Curve is usually shown as U-shaped.
The downward sloping phase of the curve is described as economies of scale.
Economies of scale results from:
Full utilization of labour, machinery, buildings.
Ability to afford specialized labour and machinery and new
technology.
Price discounts for volume purchasing of inputs.
Price advantages when selling large amounts of output.
The upward sloping phase of the curve is described as diseconomies of scale.
Diseconomies of scale result from:
Lack of sufficient managerial skill.
Need to hire, train, supervise, and coordinate larger labour force.
Dispersion over a larger geographical area.
Disease control, waste disposal.
In practice economies of scale may not be exhausted until a large level of output
is achieved.
So the LRAC will be continuously downward sloping over that range of output.

LONG RUN AVERAGE COST: Other Possible Shapes

Fig.14

Fig.15

Long Run Marginal Cost (LRMC)

Long run marginal cost is derived from short run marginal cost curves, but does
not envelope them. The long run marginal cost is formed from points of
intersection of short run marginal cost curves with vertical lines (to the x-axis)
drawn from the point of tangency of the corresponding short run average cost
curves and long run average cost curve. The long run marginal cost must be equal
to short run marginal cost for the output at which the corresponding short run
average cost is tangent to long run average cost curve (Fig.16).

Fig.16
For levels of output to the left of tangency a the short run average cost is
greater than long run average cost. At the point of tangency SAC 1 = LRAC. As
we move from point b to a, we actually move from a position of inequality
of SAC1 and LRAC to a position of equality. Hence the change in total cost (i.e.
the MC) must be smaller for the short run curve than for the long run curve.
Thus LRMC > SMC1 to the left of a.

TYPICAL LONG RUN AVERAGE COST AND MARGINAL COST CURVES AND
THEIR ATTRIBUTES

Fig.17
LRAC curve is normally U-shaped.
The downward sloping phase of LRAC curve describes economies of scale,
whereas upward sloping phase describes diseconomies of scale.
LRMC lies below the LRAC, LRAC curve is falling and when LRMC lies above
the LRAC, long run average cost curve will be rising.
When LRMC equals LRAC, LRAC curve is at minimum.
PRODUCTION RULES FOR THE LONG-RUN
If selling price > ATC (or TR > TC):

Continue to produce.

Maximize profit by producing where

MR = MC

If selling price < ATC (or TR < TC):

There will be a continual loss.

Sell the fixed assets to eliminate fixed costs.

Reinvest money in a more profitable alternative.

Questions
1The downward sloping phase of the long run average cost curve shows
a) Diseconomies of scale
b) Economies of scale
c) Both a and b
d) All of the above
2. When LRMC lies below the LRAC, LRAC curve is
a) Falling
b) Rising
c) Constant
d) None of the above
3. When LRMC equals LRAC, LRAC curve is at
a) Maximum
b) Minimum
c) Constant
d) Zero
4 The shape of Long run average cost reflects the law of
a) Returns to scale
b) Returns to size
c) Both a and b
d) None of the above
5 Long run average cost curve is also called
a) Envelope curve
b) Planning curve
c) Both a and b
d) None of the above
Answers
1 b)
2 a)
3b)
4a)
5c)