This curve is used to determine the possible projections of cost and output for the long term. While a short-term curve does exist, the factors that go into determining a short-term curve are a mixture of fixed inputs and variable inputs. However, given the sheer unpredictability of the future, the long-run average cost curve is mostly constructed using variable inputs. The long-run average total cost curve is used to determine productivity and cost in the long run.
Derivation of Long-run Average Cost Curve
To understand the reasoning behind the derivation of a long-run average cost curve, it is preferable to start with three short-run average cost curves.
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As the term suggests, short term average cost curves can be used for any firm in the short run. The firm can modify the increase or decrease in output and cost by changing the variable inputs appropriately. However, planning for the long run involves a little more creativity and understanding.
After closely examining each SAC (also referred to as plants, there may be more than 3 for a single firm), the firm will need to determine the most optimal curve to maximize production and minimize cost. To this end, the firm will need to choose the most optimal SAC, which will then be projected into the long term. While one SAC might give the firm the required results, another SAC might give them greater returns. This is why it is essential to consider multiple variables and create multiple SACs to determine the best cost vs output scenario. SACs are the key to how to find the long-run average total cost curve.
Long Run Average Cost Curve Definition
To define the long-run average cost curve, consider an array of SACs that will vary only slightly to form a specific gradation. In such a case, the curve that is formed by connecting the lowest points of each SAC will form the long-run average cost curve. Given that this long-run curve is drawn tangentially to all the increasingly graded SAC, it showcases the points with the lowest cost and thus gives the firm an idea of what SAC it can use to achieve the desired output.
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So if any point on the LAC is what the goal the firm wishes to reach, then the firm will employ the corresponding SAC that is closest to the point along the tangent. Multiple SACs along the tangent will be able to sustain a specific output, but only one will be able to do it at the lowest cost. Using the wrong SAC or improperly grading the curve will result in increased cost for the same output or (in cases of a faulty LAC) result in a decreased output for the expected cost.
The long-run average cost curve is used to plan the desired output for a specific cost, granting it the title of the planning curve. This is because a firm can plan their cost and productivity by choosing the right plant along the long-run average cost curve.
FAQs on Long Run Average Cost Curve: Meaning and Importance
1. What is the Long Run Average Cost (LRAC) curve in economics?
The Long Run Average Cost (LRAC) curve illustrates the minimum possible per-unit cost for producing any given level of output, assuming that a firm can adjust all its factors of production. It is often called a planning curve or an envelope curve because it is formed by the tangent points of numerous Short Run Average Cost (SRAC) curves, each representing a different plant size or scale of operation.
2. What is the main importance of the LRAC curve for a firm?
The primary importance of the LRAC curve lies in its role as a strategic tool for long-term planning and decision-making. It helps a firm determine the most cost-effective way to produce a certain level of output in the long run. By analysing the curve, a firm can identify the optimum plant size and scale of operations to achieve the lowest production costs, thereby maximising potential profits.
3. Why is the Long Run Average Cost (LRAC) curve typically U-shaped?
The U-shape of the LRAC curve is explained by the laws of returns to scale. Initially, as a firm expands its scale of production, it experiences economies of scale, causing the average cost to fall. After reaching an optimal point of minimum cost, further expansion leads to diseconomies of scale, which cause the average cost to rise. The combination of these two phenomena gives the curve its characteristic 'U' shape.
4. What do the different sections of a U-shaped LRAC curve represent?
Each section of the U-shaped LRAC curve represents a different phase of production efficiency as the scale increases:
- The downward-sloping part represents increasing returns to scale, where the firm is benefiting from economies of scale (e.g., specialisation, bulk purchasing).
- The minimum point of the curve represents constant returns to scale, indicating the most efficient, or optimum, size for the firm.
- The upward-sloping part represents decreasing returns to scale, where the firm starts to suffer from diseconomies of scale (e.g., managerial inefficiencies, communication breakdowns).
5. How does the Long Run Average Cost (LRAC) curve differ from the Short Run Average Cost (SRAC) curve?
The main difference between the LRAC and SRAC curves lies in the flexibility of production factors. In the short run, at least one factor of production (like the factory size) is fixed, and the SRAC curve shows costs for that fixed setup. In the long run, all factors are variable. The LRAC curve is an 'envelope' that comprises the lowest points of many possible SRAC curves, representing the lowest cost achievable for any output level when the firm is free to choose its optimal plant size.
6. What is the relationship between the Long Run Average Cost (LRAC) and Long Run Marginal Cost (LRMC) curves?
The relationship between LRAC and LRMC is fundamental to cost theory:
- When the LRMC is below the LRAC, it pulls the average cost down, so the LRAC curve is downward sloping.
- When the LRMC is above the LRAC, it pulls the average cost up, so the LRAC curve is upward sloping.
- The LRMC curve intersects the LRAC curve at its absolute minimum point. This point signifies the optimum scale of production where average cost is lowest.
7. Why is the modern LRAC curve sometimes described as L-shaped instead of U-shaped?
In some modern industries, particularly those with significant technological progress, the LRAC curve may be L-shaped. This shape suggests that economies of scale are substantial and can be realized over a very large range of output. Due to factors like technological innovation, automation, and learning-by-doing, a firm can maintain low average costs even as production increases significantly. The diseconomies of scale that cause the 'U' shape are either avoided or only occur at extremely high output levels, resulting in a long, flat bottom section of the curve.
