Long run Cost

The cost incurred by producer on labor and capital in the long run is called long
run cost. In the long run, all the cost is variable so that a producer can expand the
plant size by altering all the factors as required. That is to say, there will be no
fixed cost in the long run and so the producer can change the size or scale of plant
or can build a new plant as per the expected demand.

The ‘plant’ here is to be understood as combination of capital equipment,

machinery, land etc., in fact, it is a short run production unit. Though fixed in
short run, a producer can even change plant size in the long run. In other words,
long run is that time period which is sufficiently long enough to permit the
changes in plant, that is, in capital equipment, machinery, land etc. so as to expand
or output.

Long Run Total Cost (LTC)

Since all the factors of production are variable in the long run, the long run total
cost and long run variable cost are exactly the same.

The LTC refers to the total cost incurred by producer on labor and capital in the
long run. In other words, the LTC is defined as total amount of cost made by
producer on production of given amount of output in the long run, where all inputs
are considered to be variable and the scale of production is changeable.

Long Run Average Cost (LAC)

Q. Define and Derive LAC. Why LAC is less pronounced than SAC? (10 Marks)
Or, Why LAC is flatter than SAC?

Or, Derive LAC with the help of SACs. Why it is called a planning curve?

Why it is called envelop curve?

Why it is called a tangential curve?

Long -run average cost (LAC) is the per unit cost of production in the long run.
In other words, the cost made by producer on labor and capital for per unit output
in the long run is the long run average cost.

Long run average cost of production is the least possible average cost of
production for producing any given level of output in the long run, when all inputs
are variable including the plant size.

LAC is obtained by dividing the long run total cost by the number of outputs
produced.

𝐿𝑇𝐶
𝐿𝐴𝐶 =
𝑄

𝑊ℎ𝑒𝑟𝑒, 𝐿𝐴𝐶 = 𝑙𝑜𝑛𝑔 𝑟𝑢𝑛 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡

𝐿𝑇𝐶 = 𝑙𝑜𝑛𝑔 𝑟𝑢𝑛 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡

𝑎𝑛𝑑 𝑄 = 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑

LAC is derived by joining all the relevant points of the short-run average cost
curves when the firm can shift from one plant to another plant.

Let us consider there are three alternative plants with different production
capacities under given state of technology, out of which SAC1 represents small
plant size, SAC2 represents medium plant size and SAC3 represents large plant
size.
Figure 3.32: Various size of Plant in the Long Run

In the given figure, only there technically possible plant size are existing and non-
other plants are built. Given the size of plant or short run average cost curve, the
firm will increase or decrease its output by varying the amount of variable inputs
as per market demand. Since firm can choose any of the plants: SAC1, SAC2 and
SAC3, it will try to get optimum level of cost -output combination. That is to say,
firm will decide with which plant size it should operate to produce given level of
output at the minimum possible cost.

It is observed from the figure that up to the output level Q1 and Q2, firm chooses
SAC1 plant size and operate production but at Q3 level of plant, firm can either
continue to produce small scale plant i.e., SAC1 or it can install the medium size
plant i.e., SAC2 as the cost incurred from both plant size is equal for output Q3
level. So, decisions at this point depends not on costs but on the firm’s
expectations of its future demand. So, firm go on doing research on the future
market demand and makes decision: if market demand is expected to be constant,
then firm will continue with existing plant i.e, SAC1 but if market demand is
expected to increase beyond Q3 level, say Q4 (from Q3 to Q4) then, it will install
the medium sized new plant SAC2 thereby saving per unit cost equals to ‘cb’.
So, for Q3 to Q5 level of output firm will produce to the right of SAC1 and to the
left of SAC3 due to the lower cost of production. Similar will be the case of the
output for more than Q5 level. It is because, producer can save ‘fe’ level of per
unit cost by producing Q6 level of output from large plant size SAC3.

From the above analysis, we can conclude that producer will operate only on the
portions below the intersections of various SAC curves because all portions of
SAC curves above their intersection will not be chosen due to greater per unit
cost. As, there exist thousands of plants i.e., SAC curves with respective level of
outputs, the portions above intersection of SACs will be vanished thereby making
LAC curve smooth and continuous. Hence, LAC is the locus of points denoting
the least cost of producing the corresponding levels of output with plants of
different sizes.

SAC3 LAC
SAC1

SAC2
Cost

X
O Q1 Q2 Q3

Output

Figure 3.34: Derivation of LAC

LAC is derived by joining the tangential points, or the possible minimum cost
points of plants that can be brought under operation in short-run production. Such
tangential points represent the most efficient combination of inputs that
minimizes average costs for a particular level of output in the short run. Hence, it
is also called a tangential curve. In other words, it is the locus of points denoting
the least cost of producing the corresponding levels of output with plants of
different sizes.

It is also called the envelop curve because it encloses (or envelops) the whole
family of short-run cost curves and represents the minimum achievable average
cost for each level of output in the long run when the firm can freely adjust all its
inputs, including capital and technology.

It is also termed a decision-making curve because, on the basis of this curve, the
firm decides what plant to set up in order to produce the expected level of output
at minimum cost. Similarly, the firm makes a plan about plant size and level of
output with the help of LAC. Hence, it is called a planning curve.

(If more than three SACs, not needed to draw)

Why LAC is U-shaped?

the LAC is U-shaped due to the operation of the law of returns to scale in the long
run. Because,

- When increasing returns to scale operates, the average product increases

while the average cost decreases,
- When decreasing returns to scale operates, the average product
decreases whereas the average cost increases,
- Due to constant returns to scale, the average product becomes constant
and maximum while the average cost becomes minimum and constant.

Thus, LAC is U-shaped due to the operation of returns to scale.

Why LAC is flatter (Less pronounced) than SAC?

In Traditional cost theory, the long-run average cost (LRAC) curve is flatter or
less pronounced than SAC due to the presence of economies and diseconomies
of scale in the production. To be more specific, the LAC is flatter because:

- The degree of economies of scale, in the long run, is greater than the
degree of economies of scale in the short run,
- The degree of diseconomies of scale, in the long run, is less than the
degree of diseconomies of scale in the short run.

In fact, the firm has more flexibility in the production process in the long run than
that of short-run, as all the factors including capital equipment are variable which
ensures a gradual decrease as well as a gradual increase in LAC, thereby making
it flatter than SAC.
Figure: Shape of LAC
Why LAC is U shaped (Extra Answer, just for additional knowledge)

Why does LAC U Shaped?

Law of Returns to Scale

• Increasing Returns to Scale
• Decreasing Returns to Scale
• Constant Return to Scale
Economies of Scale
• Specialization
• Technological Factor
• Indivisibility
• Managerial Economies
• Commercial Economies
• Financial Economies
Diseconomies of Scale
• Managerial Inefficiency
• Labor Inefficiency
• Technical Difficulties
Long Run Marginal Cost (LMC)

Long run marginal cost is defined as the rate of change in long run total cost due
to the change in one unit of output production. In other words, the additional
amount of cost that has to incur by producer for producing each extra unit of
output in the long run is called long run marginal cost.

Mathematically, it is expressed as:

∆𝐿𝑇𝐶
𝐿𝑀𝐶 =
∆𝑄

𝑤ℎ𝑒𝑟𝑒, ∆𝐿𝑇𝐶 = 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐿𝑇𝐶

∆𝑄 = 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡

LMC curve is derived with the help of SMC curves and the perpendicular line
drawn from the tangential point between SAC and LAC to the output axis. So,
LMC curve is obtained by joining the intersection points between the SMC and
the perpendicular line to output axis from the tangential point of LAC and SAC,
which is depicted through the figure below:

Cost SMC3 LMC

SAC1 SAC3
SMC1 F LAC

A SAC2
SMC2
C

D
B

O X
Q1 Q2 Q3
Output

Figure 3.34: Derivation of LMC

In the given figure, SMC1 and LAC are tangent at point A from which AQ1
perpendicular line is drawn on output line that intersects SMC1 at point D, which
is a point of LMC. Similarly, SMC2 and LAC are tangent to each other at point B
from where the perpendicular line BQ2 is drawn on output axis and this line meets
SMC2 at the same point B forming another point of LMC. Likewise, the SMC3
and LAC are again tangent to each other at point C from where the perpendicular
line to output axis is drawn that intersect SMC3 at point F forming another point
for LMC.

Now if we join these three points: D, B and F points generated by the intersection
of SMCs and the perpendicular line drawn from the tangential point to output axis,
we get a roughly U-shaped curve which is LMC. Thus, it is observed that for
each level of output, SMC is equal to LMC and LMC always cut LAC at its
minimum point from below to up.

Relationship Between LAC and LMC

Long -run average cost (LAC) is the per unit cost of production in the long run.
In other words, the cost made by producer on labor and capital for per unit output
in the long run is the long run average cost.

Long run average cost of production is the least possible average cost of
production for producing any given level of output in the long run, when all inputs
are variable including the plant size.

LAC is obtained by dividing the long run total cost by the number of outputs
produced.

𝐿𝑇𝐶
𝐿𝐴𝐶 =
𝑄

𝑊ℎ𝑒𝑟𝑒, 𝐿𝐴𝐶 = 𝑙𝑜𝑛𝑔 𝑟𝑢𝑛 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡

𝐿𝑇𝐶 = 𝑙𝑜𝑛𝑔 𝑟𝑢𝑛 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡

 𝑎𝑛𝑑 𝑄 = 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑

Long run marginal cost is defined as the rate of change in long run total cost due
to the change in one unit of output production. In other words, the additional
amount of cost that has to incur by producer for producing each extra unit of
output in the long run is called long run marginal cost.

Mathematically, it is expressed as:

∆𝐿𝑇𝐶
𝐿𝑀𝐶 =
∆𝑄

𝑤ℎ𝑒𝑟𝑒, ∆𝐿𝑇𝐶 = 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐿𝑇𝐶

∆𝑄 = 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡

The relationship in between LAC and LMC can be explained by the following
figure:

Figure 6.17: Relationshp between LAC and LMC

In the diagram, LAC and LMC represent long run average curve and long run
marginal cost curves respectively. These vurves are U- shaped but flatter than
short run average curve and marginal curve. It is observed that minimum point of
LMC is ‘A’ which lies left to the minimum point of LAC that is ‘B’. The
relationship in between them can be listed as below:

1. LAC and LMC both are derived from LTC.

2. When LAC is falling, LAC > LMC.
3. When LAC is rising, LAC < LMC.
4. Whe LAC is constant and minimum at point ‘B’, LAC = LMC.
5. LMC becomes minimum earlier than LAC. It means, the minimium point
of LMC is left of inimum point of LAC.
6. LMC always cuts LAC at its minimum point from below to up.
7. When LMC is decreasing, it decreases faster than LAC and When LMC is
increasin, it increases faster than LAC.

**********************************
Additional diagram, not necessary to draw