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Long- run and short- run cost curves

Article · January 2010

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Long-run and short-run cost curves

Cost curves form a staple part of the curriculum of undergraduate microeconomics. Their
presentation across textbooks is fairly uniform and has not varied much over the years
since Marshallian partial equilibrium analysis was first codified in a set of diagrams. The
uniformity and stability of the presentation of the curves belies their controversial
beginnings in the 1920s and 30s, as economists struggled to contain Marshall’s realistic
descriptive insights and biological analogies into a logically coherent static equilibrium
model. In the battle that played out between descriptive realism and neat formalisms, the
latter won out for center stage in textbook studies of cost.

Cost curves are drawn with the quantity of a specific product along the horizontal axis
and money cost on the vertical. They can represent the total cost of the quantity, the
average (per unit) cost, or the marginal cost. For the short-run, total and average costs
can be broken down into the portion reflecting the amount spent on factors of production
whose quantities can be varied, and the portion reflecting the sunk costs of the fixed
factors of production. Further, one can consider long-run cost curves drawn under the
assumption that the quantities of all factors can be varied. Drawn together on one
diagram, cost curves can appear daunting to students of economics, and even their
teachers can have difficulty disentangling them in a comprehensible way. Evidence of
the difficulty can be seen in three pedagogical articles on cost curves that have appeared
in the Journal of Economic Education in recent years. (Sexton, Graves and Lee (1993),
Boyd and Boyd (1994), Silberberg (1999))

The typical textbook presentation starts with the short-run and shows the average cost

curves (total, fixed and variable) along with the marginal cost. The curves are presented

in Figure 1.

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Figure 1. Short-run unit cost curves: marginal cost (MC), average total cost (ATC),
average variable cost (AVC) and average fixed cost (AFC).

The short-run cost curves are normally based on a production function with one variable
factor of production that displays first increasing and then decreasing marginal
productivity. Increasing marginal productivity is associated with the negatively sloped
portion of the marginal cost curve, while decreasing marginal productivity is associated
with the positively sloped portion. The average fixed cost (AFC) curve is the cost of the
fixed factor of production divided by the quantity of units of the output, while the average
variable cost (AVC) curve cost traces out the per unit cost of variable factor of
production. The U-shaped average total cost (ATC) curve is derived by adding the
average fixed and variable costs. The marginal cost (MC) intersects both the AVC and
ATC curves at their minimum points. Declining average total costs are explained as the
result of spreading the fixed costs over greater quantities and, at low quantities, the result
of the increasing marginal productivity, in addition. Increasing average costs occur when
the effect of declining marginal productivity overwhelms the effect of spreading the fixed
costs.

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The long-run cost curves, usually presented in a separate diagram, are also expressed
most commonly in their average, or per unit, form, represented here in Figure 2. The
long-run average cost (LRAC) curve is shown to be an envelope of the short-run average
cost (SRAC) curves, lying everywhere below or tangent to the short-run curves. The firm
is constrained in the short-run in selecting the optimal mix of factors of production and so
will never be able to find a cheaper mix than can be found in the long-run when there are
no constraints. If there are a discrete number of plant sizes available, the LRAC will be
the scalloped curve obtained by joining those parts of the SRAC curves that represent the
lowest cost of production for a given quantity.

Figure 2. The long-run average cost (LRAC) curve is an envelope curve of the short-run
average cost (SRAC) curves. Increasing, constant and decreasing returns to scale are
exhibited at points a, b and c, respectively.

In the case of constant returns to scale, the most common assumption for production
functions, the LRAC curve is horizontal. More generally, the LRAC curve can be drawn
as a U-shape displaying increasing returns at lower levels of output and decreasing
returns at higher levels. The long-run marginal cost curve is usually omitted in
introductory treatments. If it is included, it is drawn so that it lies above the short-run
marginal cost curve to the left of their intersection point, and below to the right.

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Understanding the relationship between the short-run and long-run marginal cost curves
can be challenging, and may require conjuring up additional diagrams. Sexton, Graves
and Lee (1993) couch their explanation using isocosts and isoquants; whereas Boyd and
Boyd (1994) show how the relationship can be explained using the total cost curves.

Keppler and Lallement (2006) trace the cost curve construction back to Enrico Barone’s
1908 Principi di economia politica. Barone presents a diagram that contains a total cost
curve with costs increasing at a decreasing and then increasing rate—equivalent to the
textbook U-shaped average cost curve. He represents the marginal cost of a particular
quantity as the slope of a tangent to the cost curve at that quantity, and the average cost of
a particular quantity as the slope of a ray from the origin to the relevant point of the cost
curve. Total revenue is represented on the diagram as a line with the slope equivalent to
the price. The construction allows him to identify the profit maximizing quantity as that
for which the price equals marginal cost, and the zero profit long-run equilibrium
quantity as that for which price equals both marginal cost and average total cost .

The first U-shaped cost curve, in which cost is expressed in per unit terms, uncovered by
Keppler and Lallement (2006) appears an article by Edgeworth (1913) on railway rates.
Since the discussion was of a monopoly firm the relationship between price, marginal
cost and average cost found in Barone’s 1908 work is not brought out. The first per unit
cost curve construction of a firm in perfect competition bearing a close resemblance to
contemporary textbook treatments, was presented in paper by Piero Sraffa published in
1925 in an Italian language journal (reproduced in Keppler and Lallement (2006)). Upon
reading the article in Italian, Edgeworth commissioned Sraffa to write a similar piece for
the Economic Journal--which appeared in 1926 but did not contain the diagram. A
virtually identical diagram, however, appears in a related article by Pigou (1928). It is
reasonable to suspect that Pigou derived it from Sraffa’s 1925 paper.

Roy Harrod (1931) and Jacob Viner (1931) contemporaneously published articles
containing diagrams showing the relationship between the LRAC curve and a set of
SRAC curves. In his now legendary 1931 Zeitschrift für Nationalökonomie article,
Viner had instructed his draughtsman, the mathematican Y. K. Wong, to draw the long-

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run average total cost curve so that it would run tangent to the bottoms of the short-run
U-shaped curves, be downward sloping, and nowhere lie above the short-run curves.
Wong insisted that it was impossible to satisfy all three requirements and produced a
diagram with the long-run curve lying, on one portion, above the short-run curve.

In a footnote, Viner (1931, p. 36n) admits that the diagram was in error in placing the
long-run curve above the short-run, but confesses that he did not understand Wong’s
mathematical reason for it being impossible to draw the long-run curve nowhere above
the short-run curves while running along the bottoms of the short-run curves: “I could not
persuade him to disregard his scruples as a craftsman and to follow my instructions,
absurd though they might be.” Harrod (1959, p. 262) recounts the experience, when
working on his 1931 paper at Oxford, of wandering outside with his curves on Tom Quad
in Christ Church in quest of a scientific colleague who could tell him the proper name for
the long-run curve. His quest was successful and allowed him in the 1930’s, unlike
Viner, to properly describe the LRAC curve as an envelope.

In Foundations of Economic Analysis, Paul Samuelson provides a proof of what he calls

the Wong-Viner envelop theorem showing the proper relationship between constrained
and unconstrained functions. Samuelson, who had been a student in Viner’s class in
1935 recalls how after admitting his error in class, Viner had told him privately after the
bell had rung, that he still thought it possible to draw a downward sloping LRAC curve
that would smoothly join the bottoms of a set of SRAC curves. In the same
reminiscence, Samuelson (1972, p. 9) reports that Schumpeter, as well, continued to be
confused about the matter: “He always insisted somewhere in the third dimension of the
parametrized surface of U-shaped cost curves, the envelope did go through Viner’s
bottom points.” Silberberg (1999), noting the opacity of Samuelson’s proof in the
Foundations, provides a clarifying explanation using the total cost curve diagram.

The confusion leading to the error may be related to the result from the theory of the
competitive firm that firms will produce at the minimum point on the average total cost
curve after entry and exit has driven economic profit to zero. If the price of the product

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(P) is such that the marginal cost (MC) for the representative firm intersects the
horizontal price line above the minimum point on the SRAC curve, the firm will be
earning economic profits and there will be entry and expansion. As more firms enter, and
as existing firms expand production, supply of the product will increase and the price will
fall. Long-run equilibrium is reached when P = MC = SRAC. If the price intersects the
marginal cost below the minimum point on the SRAC, the opposite process of exit and
contraction will reduce supply, increase the price and a new long-run equilibrium will be
established with the representative firm producing at the minimum point of the SRAC
curve.

At first sight, it seems reasonable to suppose that the points on the LRAC curve will
coincide with the minimum points on the SRAC curves, since they are the long-run
equilibrium points. The confusion is due to the conflation of two separate notions of the
long-run. In Marshall’s theory of the firm in perfect competition, the long-run, or long
period as he termed it, is the hypothetical state that is achieved after economic profits
have been driven to zero. The LRAC curve, on the other hand, is tracing out the unit
costs of different levels of output under the assumption that all factors of production can
be optimally adjusted. It does not refer to the long-run equilibrium of the firm and might
be better labeled the unconstrained average total cost curve. It may be a recognition of
the conflation of the two notions of the long-run that lead Schumpeter to believe that if an
additional dimension was added the LRAC curve would run through the minimum points.
In any event, the confusion surrounding the curves seems to bear out well Marshall’s
(1920, p. 461) warning about the limitations of the “statical theory of equilibrium” in
analyzing the progress of industries through time: “limitations …so constantly
overlooked, especially by those who approach it from an abstract point of view, that there
is a danger of throwing it into definite form at all.”

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 References

Boyd, L. A. and D. W. Boyd (1994), ‘The Short- and Long-Run Marginal Cost Curve:
An Alternative Explanation’, Journal of Economic Education, 25 (3), 261-265.

Edgeworth, F.Y. (1913), ‘Contributions to the Theory of Railway Rates.-IV’, The

Economic Journal, 23 (90), 206-26.

Harrod, R. (1931), ‘The Law of Decreasing Cost’, Economic Journal, 41 (164), 566-576.

----------- (1959), ‘Review of The Long and the Short’, Economica, New Series, 26 (103),
260-262.

Keppler, J. H. and J. Lallement (2006), ‘The Origins of the U-Shaped Average Cost
Curve: Understanding the Complexities of the Modern Theory’, History of Political
Economy, 38 (4), 733-774.

Marshall, A. (1920). Principles of Economics, 9th ed., New York: The Macmillan
Company.

Pigou, A. C. (1928), ‘An Analysis of Supply’, Economic Journal, 38 (150), 238-257.

Samuelson, P. A. (1972), ‘Jacob Viner, 1892-1970’, Journal of Political Economy, 80 (

1), 5-11

Sexton, R. L., P. E. Graves and D. R. Lee (1993), ‘The Short- and Long-Run Marginal
Cost Curve: A Pedagogical Note’, Journal of Economic Education, 24 (1), 34-37.

Silberberg, E. (1999), ‘The Viner-Wong Envelope Theorem’, Journal of Economic

Education, 30 (1), 75-79.

Viner, J. (1931), “Cost Curves and Supply Curves,” Zeitschrift für Nationalökonomie , 3,
23-46.

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