Long Run Average Cost (LRAC)
•In the long run, all inputs are variable. There are no fixed costs.
•The total cost and the total variable cost coincide in the long run.
•Long run average cost (LRAC) is defined as cost per unit of output, i.e.
•LRAC = TC/q
Long run marginal cost (LRMC)
•Long run marginal cost (LRMC) is the change in total cost per unit of change in output.
•When output changes in discrete units, then, if we increase production from q1–1 to q1units of output, the marginal cost of producing q1th unit will be measured as
•LRMC = (TC at q1 units) – (TC at q1 – 1 units)
•The sum of all marginal costs up to some output level gives us the total cost at that level.
Constant returns to scale (CRS)
•CRS implies a proportional increase in inputs resulting in a proportional increase in output.
•So the average cost remains constant as long as CRS operates.
Increasing returns to scale (IRS)
•IRS implies that if we increase all the inputs by a certain proportion, output increases by more than that proportion.
•Hence, as long as IRS operates, average cost falls as the firm increases output.
Diminishing returns to scale (DRS)
•DRS implies that if we want to increase the output by a certain proportion, inputs need to be increased by more than that proportion.
•As a result, cost also increases by more than that proportion.
•So, as long as DRS operates, the average cost must be rising as the firm increases output.
Trend of Long Term Curves
•In a typical firm IRS is observed at the initial level of production.
•This is then followed by the CRS and then by the DRS.
•Accordingly, the LRAC curve is a ‘U’-shaped curve.
•Its downward sloping part corresponds to IRS and upward rising part corresponds to DRS.
•At the minimum point of the LRAC curve, CRS is observed.
Characteristics of Long run marginal cost and
average cost curves.
•For the first unit of output, both LRMC and LRAC are the same.
•Then, as output increases, LRAC initially falls, and then, after a certain point, it rises.
•As long as average cost is falling, marginal cost must be less than the average cost.
•When the average cost is rising, marginal cost must be greater than the average cost.
•LRMC curve is therefore a ‘U’-shaped curve.
•It cuts the LRAC curve from below at the minimum point of the LRAC.
•LRAC reaches its minimum at q1.
•To the left of q1, LRAC is falling and LRMC is less than the LRAC curve.
•To the right of q1, LRAC is rising and LRMC is higher than LRAC.