ALLAMA IQBAL OPEN UNIVERSITY ISLAMABAD

Course: Introduction to Microeconomics (801

(Department of Economics)
ASSIGNMENT NO: 1

CORSE CODE:
NAME:
ROLL NO:
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LEVEL: MSc Economics

SEMESTER: Spring 2022

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 micro-economics, 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 long-run 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.[1]

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 Q 0 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 homogeneous 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 expansion 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 isoquant 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 homogeneous 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 λ n.
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 homogeneity. 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 exhibits 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 elasticity 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 functions 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-quarters 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.

ADVERTISEMENTS:

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 output 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 production. 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 output by
using 10 units of capital and 75 of labour or 50 units of capital and 15 of labour, or by
using any other combination of inputs on Q1 = 100. Similarly, isoquant Q2 shows the
various combinations 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.
 (Source: test.blogspot)

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.