Assignment no.

Q. 1 Discuss the scope and methodology of microeconomics.

Ans

Microeconomics is the study of the economic actions of individuals and well-

defined groups of individuals. The micro model is built slowly on the individuals
and deals with interpersonal relations only.

The Scope of Microeconomics studies small, individual units. This is obvious

from the mentioned definitions. As mentioned by H. Craig Peterson and W. Cris
Lewis "Micro-economics focuses on the behavior of the individual actors on the
economic stage: firms and individuals and their interactions in markets."
Likewise, in the words of E.K. Browning and J.M. Browning "Micro-economics
is the branch of economics based on the economic behavior of 'small' economic
units: Consumers, workers, savers, business managers, firms, individual
industries and markets, and so on".

Scope of Microeconomics

The study of individual units or individual consumers, individual firms or their

small group form the scope of micro-economics. Broadly speaking, the scope of
microeconomics covers the following topic.
1. Theory of demand
2. Theory of production and costs

3. Theory of product pricing

4. Theory of factor pricing
5. Theory of economic welfare

Theory of demand

The goods are produced due to the consumer's demand. Hence in

microeconomics, at first the theory of demand or the theory of customer behavior
is studied. This includes the meaning, types law, and determinants of demand,
elasticity of demand, law of diminishing utility, law of equity-marginal utility,
indifference curve revealed preference theory and so on. Besides, the practical
importance of these theories is also included in micro-economics.

Theory of production and costs

One of the important branches of economics is production and cost theory. The
theory of production consists of the factors of production, concepts of different
types of product and the theories like the law of variable proportions, laws of
returns to scale, least-cost combinations of inputs and so on. Similarly, the theory
of costs consists of the different concepts of cost, nature of short-run and longrun
costs, etc. It also includes linear programming, a mathematical technique of cost-
minimization or output maximization.

Theory of product pricing

Since micro-economics studies the determination of prices of goods and services,

it is also known as price theory. The relative price of different goods is
determined under different market situations. The market situations may be
perfect competition, monopoly monopolistic competition, oligopoly and so on.
Micro-economics studies the process of pricing of goods in these markets. The
theory of factor pricing includes the study of the costs, revenue, profit, position
of loss and the behavior regarding profit maximization or cost minimization.
Hence, the theory of product pricing is also known as the theory of the firm.

Theory of factor pricing

The theory of factor pricing is another important branch of micro-economics. The

theory of factor pricing is also called the theory of distribution. The goods are
produced with the joint efforts of land, labor, capital, and entrepreneur. These are
called factors of production. The rewards of these factors are called rent, wages,
interest, and profit respectively. In factor pricing the determination of rents
wages, interest and profit is studied. There are different traditional and modern
theories regarding the determination of the rewards of factors of production.

Theory of economic welfare

The theory of economic welfare is also known as welfare economics. Welfare

economics is an important branch of micro- economics. The normative price
theory is called welfare economics. The subject matter of welfare economics
includes the potential measures of maintaining economic prosperity of men as
consumers and producers and to improve that prosperity or welfare. One of the
important functions of welfare economics is to define and analyze the law of
economic efficiency. The economy is said to be efficient when the number of
goods and services are produced so as to yield maximum satisfaction to the
consumers. The economic efficiency is the subject matter of economics. Welfare
economics is an important branch of micro economics. Hence, micro-economics
is intimately related to economic efficiency or welfare. A.P. Lerner has rightly
remarked, "In micro economics, we are more concerned with the avoidance or
elimination waste." Micro-economics identifies the conditions of efficiency a
suggests measures to avoid inefficiency. This helps to improve economic
condition of the people.

Microeconomics is a ‘bottom-up’ approach where patterns from everyday life are

pieced together to correlate demand and supply. The study examines how the
behaviors of individuals, households, and firms have an impact on the market.
Microeconomics is entirely contradictory to macroeconomics.

Microeconomics is the social science that studies the implications of incentives

and decisions, specifically about how those affect the utilization and distribution
of resources. Microeconomics shows how and why different goods have different
values, how individuals and businesses conduct and benefit from efficient
production and exchange, and how individuals best coordinate and cooperate
with one another. Generally speaking, microeconomics provides a more complete
and detailed understanding than macroeconomics.

Q.2 Explain the main characteristics of indifference curves and their

justifications.

Ans

Characteristics of Indifference Curves. 1. Indifference curves slop downward to

the right. 2. Every indifference curve to the right represents a higher level of
satisfaction. 3. Indifference curves cannot intersect each other. 4. Indifference
curve will not touch the axis.

Characteristics of Indifference Curves

The indifference curves have a number of attributes and interesting properties

which have come to be known as characteristic features or properties of
indifference curves. The following are some of the important features.
1. Indifference curves slop downward to the right

This is an important and obvious feature of indifference curves. The sloping

down indifference curve indicates that when the amount of one commodity in the
combination is increased, the amount of the other commodity is reduced. This
must be so if the level of satisfaction is to remain constant on the same
indifference curve.

Let us consider the logical inferences or conclusions if the indifference curve

does not slope downwards from left to right.

If the indifference curve is horizontal to X axis, the various points on the curve
A,B,C,D denoting various combinations of x commodity and y commodity may
not have equal significance. At point B, the consumer gets more of x than at point
A and at point C, the consumer gets still more of x while the quantity of y
remains constant.

As the consumer moves along the indifference curve he is getting a fixed quantity
of y but increasing quantities of x. So the consumer cannot be indifferent, as
having rational behavior, he would prefer D more than C, C more than B and B
more than A and the level of satisfaction is not the same. Each succeeding
combination is better than the previous one. Therefore an indifference curve
cannot be horizontal since different combinations on the curve differ in
significance.

Similarly, an indifference curve cannot be vertical as shown in the figure, as in

point D, the consumer gets more of y commodity than at point C, B or A while
the x commodity remains constant; so the consumer cannot be indifferent to
various combinations as they denote different satisfactions.

In the upward sloping curve too, the different points on the curve differ in
significance because as he moves from point A to B, he gets more of x and more
of y commodities. So, he cannot be indifferent to the combinations. Similarly
point C is better than point B and D is better than point C as the combinations
differ giving the consumer greater satisfaction.

Only in a downward sloping curve the loss in one is compensated by the gain in
another commodity so that the different points on the curve will be of equal
significance and satisfaction to the consumer and he may be indifferent to the
various combinations. So, a horizontal or vertical or sloping up curve is not
possible.

2. Every indifference curve to the right represents a higher level of satisfaction

Every indifference curve to the right of the preceding curve indicates higher level
of satisfaction and the curve to the left shows lesser satisfaction. This means that
the indifference curve at a higher level from the axes shows greater satisfaction
than an indifference curve at a lower level.

In the indifference curve IC1 at point P the consumer is having OM quantity of

Bananas and ON quantity of Biscuits. At point Q in the IC2, the consumer
though having the same quantity of Biscuits, the quantity of Bananas has
increased from OM to OM1, i.e., at point Q the consumer gets larger quantities
than at point P and naturally position Q is preferred by the consumer than
position P as in the former he gets larger satisfaction due to larger commodities.

An indifference curve on the right is preferred than the indifference curve on the
left. The consumer will always try to move up in the indifference map so that he
can occupy as much as possible the topmost curve, as higher curves give larger
satisfaction in the difference map.

3. Indifference curves cannot intersect each other

The indifference curves never cut each other as higher and lower curves show
different levels of satisfaction. Suppose two indifferent curves cut each other at
point K as shown in Figure 3. This means that points K and T which are on the
same indifference curve IC2 show equal satisfaction; similarly points K and S
which are on the same indifference curve IC1 show equal satisfaction.

K = T, K = S, therefore, S = T

Since K is common to both the curves, points S and T show equal satisfaction.
But this is contrary to our earlier assumption that points on a higher indifference
curve show greater satisfaction than points on lower indifference curves. In order,
therefore, to be consistent with our assumptions; different indifference curves
would not cut each other.
4. Indifference curve will not touch the axis

Another characteristic feature of indifference curve is that it will not touch the X
axis or Y axis. This is born out of our assumption that the consumer is
considering different combinations of two commodities.

If an indifference curve touches the Y axis at a point P as shown in the figure, it

means that the consumer is satisfied with OP units of y commodity and zero units
of x commodity. This is contrary to our assumption that the consumer wants both
commodities although in a smaller or larger quantities. Therefore the indifference
curve will not touch either the X axis or Y axis.

But as a special case it will touch the Y axis at point A if the combination is
between Money and Commodity as shown in the Figure 4. It would then mean
that the consumer either wants various combinations of money and commodity or
only OA units of money which gives him command over commodity X. At point
B in the figure the consumer has OM units of commodity X and OA1 units of
money and this gives him the same satisfaction of having only OA units of
money which means command over x and other commodities.

5. Indifference curves are convex to the origin

The very important feature of the indifference curves is that they are convex to
the origin and they cannot be concave to the origin. A normal indifference curve
will be convex to the origin and it cannot be concave. Only convex curves will
lend to the principles of Diminishing Marginal Rate of substitution. In the case of
concave curve, it will lead to increasing marginal rate of substitution which is
impossible.

In order to understand this more clearly we have to study the exact purport and
significance in passing from one point to another on an indifference curve which
is convex to the origin.

In the Figure 5, the indifference curve is convex to the origin. The consumer
passes from point A to B on the same curve to remain in the same level of
satisfaction. While moving from A to B the consumer gives up YY1 or AC units
of Y commodity in order to obtain XX1 units of X commodities, i.e., CB units of
X.
According to the figure, CB units of x give the same satisfaction or utility as AC
units of y. This means

CB units of x = AC units of y

1 unit of x = (AC / CB) units of y

This means that one unit of x gives the same satisfaction or utility as (AC/CB)
units of Y. In other words, the Marginal Significance of x = (AC/CB) units of y.
In the triangle ACB, AC/CB = Perpendicular/Base = the tangent of angle ABC.

Assumption:

The points A and B on the indifference curve are so close to each other that they
almost fall on the same straight line Tt which is touching the indifference curve.

In the figure, since angle ABC is equal to angle TtO, the marginal significance of
x in terms of y is given by the tangent of the angle TtO. As the points A and B
are assumed to lie so near, the same tangent can pass through both of them. The
marginal significance of x in terms of y is shown by the angle which the tangent
makes on the X axis. So, Marginal Significance of x = Tangent of the angle TtO.

As the consumer moves down an indifference curve taking more of x

commodities, the marginal significance of x declines in terms of y commodities.
As the marginal significance of x declines, the tangent of the angle TtO should
also decline as both are directly related in the figure. This is possible only if the
curve is convex.

In the Figure 6, the tangent at point A makes a bigger angle on the X axis than
the tangent at point B which makes a smaller angle. This shows that the marginal
significance of x in terms of y is declining as the consumer travels down an
indifference curve and has more units of x.

It is the declining significance of x and increasing significance of y as the

consumer travels down an indifference curve which makes its shape convex to
the origin and this forms the basis of Prof. Hick’s Diminishing marginal rate of
substitution. On the contrary we shall see what would be the result if the curve is
concave. the indifference curve is concave to the origin. At point A of the
indifference curve the consumer has ox units of x and oy units of y when the
marginal significance of x in terms of y is given by the tangent of the angle AKO.
Now the consumer travels down the indifference curve and comes to point B
where he has ox1 units of x and oy1 units of y. The marginal significance of x in
terms of y at this new point is given by the tangent of the angle BLO. Since angle
BLO is greater than the angle AKO, it follows that the marginal significance of x
is greater at point ‘B’ on the curve and the marginal significance of x is smaller at
point A on the curve.

This gives the conclusion that as the consumer travels down the indifference
curve, the marginal significance of x has become greater as the respective angles
of tangents are greater. This is wrong and against the fundamentals of economics
and consumption.

The marginal significance of x cannot be greater if the consumer travels dawn the
curve enabling him to possess more of x commodities. The marginal significance
of x should become smaller and smaller as he possesses larger and larger
quantities of x. Since a concave curve violates the fundamental principle of
economics, the indifference curve cannot be concave. Only convex curve is in
tune with the principles of economics. So, indifference curve is convex to the
origin.

Q.3 Differentiate between homogeneous and non-homogeneous production

function. Also show graphically returns to scale for homogeneous production
function.

Ans

Homogeneous are those which makes completely which cannot be separated also
and nonhomogeneous are those which cannot dissolve completely and cannot tell
separated easily

Homogeneous production functions consist of a broad array of functions with a

special characteristic. A production function is said to be homogeneous of degree
n if when each input is multiplied by some number t, output increases by the
factor tn.

A form of nonhomogeneous production function is utilized to compute marginal

productivities, various elasticities, optimum input ratios, and the like, for
different levels of inputs and outputs. Such comparisons are relevant for labor
negotiations, capital investment, and control by either a parent corporation or a
government regulatory agency.

a production function gives the technological relation between quantities of

physical inputs and quantities of output of goods. The production function is one
of the key concepts of mainstream neoclassical theories, used to define marginal
product and to distinguish allocative efficiency, a key focus of economics. One
important purpose of the production function is to address allocative efficiency in
the use of factor inputs in production and the resulting distribution of income to
those factors, while abstracting away from the technological problems of
achieving technical efficiency, as an engineer or professional manager might
understand it.

For modelling the case of many outputs and many inputs, researchers often use
the so-called Shephard's distance functions or, alternatively, directional distance
functions, which are generalizations of the simple production function in
economics.

In macroeconomics, aggregate production functions are estimated to create a

framework in which to distinguish how much of economic growth to attribute to
changes in factor allocation (e.g. the accumulation of physical capital) and how
much to attribute to advancing technology. Some non-mainstream economists,
however, reject the very concept of an aggregate production function.

A form of nonhomogeneous production function is utilized to compute marginal

productivities, various elasticities, optimum input ratios, and the like, for
different levels of inputs and outputs. Such comparisons are relevant for labor
negotiations, capital investment, and control by either a parent corporation or a
government regulatory agency. This form of production function can be fitted by
simple regression and allows variable returns to scale and variable elasticities of
substitution.

A production function which is homogeneous of degree 1 displays constant

returns to scale since a doubling all inputs will lead to an exact doubling of
output. So, this type of production function exhibits constant returns to scale over
the entire range of output. In general, if the production function Q = f (K, L) is
linearly homogeneous,
A function is said to be homogeneous of degree n if the multiplication of all the
independent variables by the same constant, say λ, results in the multiplication of
the dependent variable by λn. Thus, the function Y = X2 + Z2

is homogeneous of degree 2 since

(λX)2 + (λZ) 2 = λ2 (X2 + Y2) = λ2Y

A function which is homogeneous of degree 1 is said to be linearly

homogeneous, or to display linear homogeneity. A production function which is
homogeneous of degree 1 displays constant returns to scale since a doubling all
inputs will lead to an exact doubling of output. So, this type of production
function exhibits constant returns to scale over the entire range of output. In
general, if the production function Q = f (K, L) is linearly homogeneous, then

F (λK, λL) = λf (K ,L) = λQ

for any combination of labour and capital and for all values of λ. If λ equals 3,
then a tripling of the inputs will lead to a tripling of output.

The second example is known as the Cobb-Douglas production function. To see

that it is, indeed, homogeneous of degree one, suppose that the firm initially
produces Q0 with inputs K0 and L0 and then doubles its employment of capital
and labour.

The resulting output would equal:

This shows that the Cobb-Douglas production function is linearly homogeneous.

Properties:

There are various interesting properties of linearly homogeneous production

functions. First, we can express the function, Q = f (K,L) in either of two
alternative forms.
(1) Q = Kg (L/K) or,
(2) Q = Lh (K/L)
This property is often used to show that marginal products of labour and capital
are functions of only the capital-labour ratio.

In particular, the marginal products are as follows: MPk = g (L/K) – (L/K) g’

(L/K) and MPL = g’ (L/K) where g’ (L, K) denotes the derivative of g (L/K). The
significance of this is that the marginal products of the inputs do not change with
proportionate increases in both inputs. Since the marginal rate of technical
substitution equals the ratio of the marginal products, this means that the MRTS
does not change along a ray through the origin, which has a constant capital-
labour ratio. Since the MRTS is the slope of the isoquant, a linearly
homo¬geneous production function generates isoquants that are parallel along a
ray through the origin.

Expansion Path:

If a firm employs a linearly homogeneous production function, its expan¬sion

path will be a straight line. To verify this point, let us start from an initial point of
cost minimisation in Fig.12, with an output of 10 units and an employment
(usage) of 10 units of labour and 5 units of capital. Now, suppose, the firm wants
to expand its output to 15 units. Since input prices do not change, the slope of the
new iso¬quant must be equal to the slope of the original one.

But, the slope of the isoquant is the MRTS, which is constant along a ray from
the origin for linearly ho¬mogeneous production function. Consequently, the cost
minimising capital-labour ratio will remain constant. Since output has increased
by 50%, the inputs will also increase by 50% from 10 units of labour to 15 and
from 5 units of capital to 7.5. Thus, the expansion path is a straight line.

Production functions may take many specific forms. Typically economists and
researchers work with homogeneous production function. A function is said to be
homogeneous of degree n if the multiplication of all of the independent variables
by the same constant, say λ, results in the multiplication of the independent
variable by λn. Thus, the function: Q = K2 + L2

is homogeneous of degree 2 since

(λK)2 + (λ L)2 = λ2 (K2 + L2) = λ2Q

A function which is homogeneous of degree 1 is said to be linearly

homogeneous, or to display linear homogeneity. A production function which is
homogeneous of degree 1 displays constant returns to scale since a doubling all
inputs will lead to a doubling of output.

A production function is homogeneous of degree n if when inputs are multiplied

by some constant, say, α, the resulting output is a multiple of a2 times the
original output.

That is, for a production function:

Q = f (K, L) then if and only if

Q = f (αK, αL) = αnf (K, L)

is the function homogeneous. The exponent, n, denotes the degree of

homo¬geneity. If n=1 the production function is said to be homogeneous of
degree one or linearly homogeneous (this does not mean that the equation is
linear). A linearly homogeneous production function is of interest because it
exhib¬its CRS.

This is easily seen since the expression αn. f(K, L) when n=1 reduces to α. (K, L)
so that multiplying inputs by a constant simply increases output by the same
proportion. Examples of linearly homogeneous production functions are the
Cobb-Douglas production function and the constant elas¬ticity of substitution
(CES) production function. If n > 1, the production function exhibits IRS. If n< 1
DRS prevails.

Cobb-Douglas Production Function:

Economists have at different times examined many actual production func¬tions

and a famous production function is the Cobb-Douglas production function. Such
a function is an equation showing the relationship between the input of two
factors (K and L) into a production process, and the level of output (Q), in which
the elasticity of substitution between two factors is equal to one.

As applied to the manufacturing production, this production function, roughly

speaking, states that labour contributes about three-quar¬ters of the increases in
manufacturing production and capital the remaining one-quarter.

Suppose, the production function is of the following type:

Q = AKα Lβ

where Q is output, A is constant, K is capital input, L is labour input and a and (3

are the exponents of the production function. This is known as the Cobb-Douglas
production function. It has an important property.

The sum of the two exponents indicates the returns to scale:

(i) If α + β > 1, the production function exhibits increasing returns to scale,
(ii) If α + β = 1, there are constant returns to scale,
(iii) Finally, if α + β < 1, there are decreasing returns to scale.

Suppose, the production is of the following type:

Q = AK0.+75 L0.25

It exhibits constant return to scale because α = 0.75 and β = 0.25 and α + β = 1.

returns to scale describe what happens to long-run returns as the scale of

production increases, when all input levels including physical capital usage are
variable (able to be set by the firm). The concept of returns to scale arises in the
context of a firm's production function. It explains the long-run linkage of the
rate of increase in output (production) relative to associated increases in the
inputs (factors of production). In the long run, all factors of production are
variable and subject to change in response to a given increase in production scale.
While economies of scale show the effect of an increased output level on unit
costs, returns to scale focus only on the relation between input and output
quantities.

There are three possible types of returns to scale: increasing returns to scale,
constant returns to scale, and diminishing (or decreasing) returns to scale. If
output increases by the same proportional change as all inputs change then there
are constant returns to scale (CRS). If output increases by less than the
proportional change in all inputs, there are decreasing returns to scale (DRS). If
output increases by more than the proportional change in all inputs, there are
increasing returns to scale (IRS). A firm's production function could exhibit
different types of returns to scale in different ranges of output. Typically, there
could be increasing returns at relatively low output levels, decreasing returns at
relatively high output levels, and constant returns at some range of output levels
between those extremes.

In mainstream microeconomics, the returns to scale faced by a firm are purely

technologically imposed and are not influenced by economic decisions or by
market conditions (i.e., conclusions about returns to scale are derived from the
specific mathematical structure of the production function in isolation).

Q.4 There is a smooth isoquant and an isoquant with kinks, which one is better
approximation to a real production function and why?

Ans

Definition: An Iso-Quant curve is the geometrical representation of the different

combinations of input factors employed to produce the given level of output.

Types of Iso-quant Curves

The iso-quant curves can be classified on the basis of the substitutability of

factors of production. These are:
1. Linear Iso-quant Curve: This curve shows the perfect substitutability
between the factors of production. This means that any quantity can be produced
either employing only capital or only labor or through “n” number of
combinations between these two.

2. Right Angle Iso-quant Curve: This is one of the types of iso-quant curves,
where there is a strict complementarity with no substitution between the factors
of production. According to this, there is only one method of production to
produce any one commodity. This curve is also known as Leontief Iso-quant,
input-output isoquant and is a right angled curve.
3. Kinked iso-quant Curve: This curve assumes, that there is a limited
substitutability between the factors of production. This shows that substitution of
factors can be seen at the kinks since there are a few processes to produce any
one commodity. Kinked iso-quant curve is also known as activity analysis
programming iso-quant or linear programming iso-quant.

4. Convex Iso-quant Curve: In this types of iso-quant curves, the factors can
be substituted for each other but up to a certain extent. This curve is smooth and
convex to the origin.
Thus, the classification of the iso-quant curve can be done on the basis of the
number of labor units that can be substituted for capital and vice-versa, so as to
have the same level of production.

The production function shows the relationship between the out¬put of a good
and the inputs (factors of production) required to make that good.

It usually takes the following general form:

Q = f (K, L, t, etc.)

Where Q is output, K is capital input, L is labour input, t is ‘technology or the art

of production’ and the term ‘etc.’ indicates that other inputs may also be relevant
(such as land, or raw materials). The production function shows how output
changes are related to changes in inputs or factors of produc¬tion. It is also an
efficiency relation showing the maximum amount of output that can be obtained
from a fixed amount of resources.

Production functions may take a variety of forms. Economists often work with
homogeneous production functions. One example of such function is the famous
Cobb-Douglas production function.

Production Isoquants:

The long-run production function involving the usage of two factors (say, capital
and labour) is represented by isoquants or equal product curves (or production
indifference curves).
Definition:

An isoquant is a curve or locus of points showing all possible combinations of

inputs physically capable of producing a certain fixed level of output. An
isoquant which lies above another shows a higher level of output.

Fig. 1 shows two typical isoquants — capital use is measured on the vertical axis
and labour use on the horizontal. Isoquant Q1 shows the locus of combinations of
capital and labour yielding 100 units of output. The producer can produce 100
units of out-put by using 10 units of capital and 75 of labour or 50 units of capital
and 15 of labour, or by using any other combina¬tion of inputs on Q1 = 100.
Similarly, isoquant Q2 shows the various combi¬nations of capital and labour
that can produce 200 units of output.

Q.5 With the help of expansion path derive long run total cost curve.

Ans

Production expansion path and long-run total cost curve On an infinitely dense
map of isoquant curves, consider the different equilibrium isocost lines. In this
way, uniting the different production methods that are technically and
economically efficient, we would obtain the “expansion path of production”.

Long Run Cost Curves

The long run is different from the short run in the variability of factor inputs.
Accordingly, long-run cost curves are different from short-run cost curves. This
lesson introduces you to Long run Total, Marginal and Average costs. You will
learn the concepts, derivation of cost curves and graphical representation by way
of diagrams and solved examples.

The Concept of the Long Run

The long run refers to that time period for a firm where it can vary all the factors
of production. Thus, the long run consists of variable inputs only, and the concept
of fixed inputs does not arise. The firm can increase the size of the plant in the
long run. Thus, you can well imagine no difference between long-run variable
cost and long-run total cost, since fixed costs do not exist in the long run.
Long Run Total Costs

Long run total cost refers to the minimum cost of production. It is the least cost
of producing a given level of output. Thus, it can be less than or equal to the short
run average costs at different levels of output but never greater.

In graphically deriving the LTC curve, the minimum points of the STC curves at
different levels of output are joined. The locus of all these points gives us the
LTC curve.

Long Run Average Cost Curve

Long run average cost (LAC) can be defined as the average of the LTC curve or
the cost per unit of output in the long run. It can be calculated by the division of
LTC by the quantity of output. Graphically, LAC can be derived from the Short
run Average Cost (SAC) curves.

While the SAC curves correspond to a particular plant since the plant is fixed in
the short-run, the LAC curve depicts the scope for expansion of plant by
minimizing cost.

Derivation of the LAC Curve

Note in the figure, that each SAC curve corresponds to a particular plant size.
This size is fixed but what can vary is the variable input in the short-run. In the
long run, the firm will select that plant size which can minimize costs for a given
level of output.

You can see that till the OM1 level of output it is logical for the firm to operate at
the plat size represented by SAC2. If the firm operates at the cost represented by
SAC2 when producing an output level OM2, the cost would be more.

So in the long run, the firm will produce till OM1 on SAC2. However, till an
output level represented by OM3, the firm can produce at SAC2, after which it is
profitable to produce at SAC3 if the firm wishes to minimize costs.
 Thus, the choice, in the long run, is to produce at that plant size that can
minimize costs. Graphically, this gives us a LAC curve that joins the minimum
points of all possible SAC curves, as shown in the figure. Thus, the LAC curve is
also called an envelope curve or planning curve. The curve first falls, reaches a
minimum and then rises, giving it a U-shape.

We can use returns to scale to explain the shape of the LAC curve. Returns to
scale depict the change in output with respect to a change in inputs. During
Increasing Returns to Scale (IRS), the output doubles by using less than double
inputs. As a result, LTC increases less than the rise in output and LAC will fall.
• In Constant Returns to Scale (CRS), the output doubles by doubling the
inputs and the LTC increases proportionately with the rise in output. Thus,
LAC remains constant.
• In Decreasing Returns to Scale (DRS), the output doubles by using more
than double the inputs so the LTC increases more than proportionately to
the rise in output. Thus, LAC also rises. This gives LAC its U-shape.

Long Run Marginal Cost

Long run marginal cost is defined at the additional cost of producing an extra unit
of the output in the long-run i.e., when all inputs are variable. The LMC curve is
derived by the points of tangency between LAC and SAC.

Note an important relation between LMC and SAC here. When LMC lies below
LAC, LAC is falling, while when LMC is above LAC, LAC is rising. At the
point where LMC = LAC, LAC is constant and minimum.

Solved Example for You

Question: Why is the LAC also called the envelope curve?

Answer: The LAC curve suggests the long run optimization problem of the firm.
The firm can choose a plant size to operate at in the long-run where all inputs are
variable. Thus, the firm shall choose that plant at which it can minimize costs.

So, the LAC is derived by joining the minimum most points of all possible SAC
curves of the firm at different output levels. Since the LAC thus obtained almost
‘envelopes’ the SAC curves faced by the firm, it is called the envelope curve.