Long-run Cost Curves

Long-Run Cost Functions

In the long run, all inputs are variable, and a firm can have a number of alternative plant sizes
and levels of output that it wants. There are no fixed cost functions (total or average) in the
long run, since no inputs are fixed. A useful way of looking at the long run is to consider it a
planning horizon. The long run cost curve is also called planning curve because it helps the
firm in future decision making process.

Introduction To Long-Run Costs

In the long run, when all inputs under the control of the firm are variable, there is no fixed
cost. As such, there is no need to distinguish between total cost, fixed cost, and variable
cost. In the long run, total cost is merely total cost. With no fixed inputs in the long run,
increasing and decreasing marginal returns, and especially the law of diminishing marginal
returns, are not relevant to long-run total cost. There are, however, two similar
influences, economies of scale (or increasing returns to scale) and diseconomies of
scale (or decreasing returns to scale). In the long run, all the factors of production used by
an organization vary. The existing size of the plant or building can be increased in case of
long run. There are no fixed inputs or costs in the long run. Long run is a period in which
all the costs change as all the factors of production are variable. There is no distinction
between the Long run Total Costs (LTC) and Long Run Variable Cost (LVC) as there
are no fixed costs. It should be noted that the ability of an organization of changing inputs
enables it to produce at lower cost in the long run.

1. Long Run Total Cost Curve (LTC)

Long run Total Cost (LTC) refers to the minimum cost at which given level of output can be
produced. According to Leibhafasky, “the long run total cost of production is the least
possible cost of producing any given level of output when all inputs are variable.” LTC
represents the least cost of different quantities of output. LTC is always less than or equal to
short run total cost, but it is never more than short run cost.
 Long-Run Total Cost Curve (An S-shaped Curve)

An S-shaped Curve
The shape of the long-run total cost curve is S-shaped, much like a short-run total cost
curve. For relatively small quantities of output, the slope begins to flatten. Then for larger
quantities the slope makes a turn-around and becomes steeper. This shape, however, is NOT
the result of increasing, then decreasing marginal returns that surface when a variable input is
added to a fixed input in the short run. The flattening portion of this long-run total cost curve
is attributable to economies of scale or increasing returns to scale. The steepening portion is
then largely due to diseconomies of scale or decreasing returns to scale. No fixed inputs
under the control of the firm are in operation.

Scale Economies in Long-Run Total Cost Curve

Long-run total cost is guided by scale economies and returns to scale.
 Economies of Scale: For relatively small levels of production, a firm tends to
experience economies of scale and increasing returns to scale. These result because an
increase in the scale of operations (a proportional increase in all inputs under the
control of the firm) affects the cost of production.
 Diseconomies of Scale: For relatively large levels of production, a firm tends to
experience diseconomies of scale and decreasing returns to scale. These result
because an increase in the scale of operations affects the cost of production.

Long-Run Average Cost

Long-run average cost is the per unit cost incurred by a firm in production when all
inputs are variable. In particular, it is the per unit cost that results as a firm increases in the
scale of operations by not only adding more workers to a given factory but also by building a
larger factory. In other words, long-run total cost divided by the quantity of output
produced. Long-run average cost is guided by returns to scale. In the long run, when all
inputs under the control of the firm are variable, there is no fixed cost and thus no average
fixed cost. As such, there is no need to distinguish between average total
cost and average variable cost. In the long run, average cost is merely average cost.

Long-Run Average Cost Curve

A U-shaped Curve
Scale economies and returns to scale generally produce a U-shaped long-run average cost
curve. For relatively small quantities of output, the curve is negatively sloped. Then for large
quantities, the curve is positively sloped. While the shape of the long-run average cost curve
looks surprisingly like that of a short-run average cost curve, the underlying forces are
different. This U-shape is NOT the result of increasing, then decreasing marginal returns that
surface in the short run when a variable input is added to a fixed input.
The negatively-sloped portion of this long-run average cost curve reflects economies of scale
and increasing returns to scale. The positively-sloped portion reflects diseconomies of scale
or decreasing returns to scale.

Minimum Efficient Scale

The long-run average cost curve is extremely important to the long-run
production efficiency of a firm. The main point of interest is the minimum of the long-run
average cost curve, achieved at the locus of the long-run average cost curve. The quantity of
output that achieves at the locus of the long-run average cost curve is termed
the minimum efficient scale (MES). This level of production achieves the lowest possible
average cost in the long run. It is not possible to produce this good in such a way that reduces
the opportunity cost of foregone production, of giving up any less value from other
production, than is achieved at the MES.

Planning Curve and Envelope Curve / Relationship Between the Long-run

Average Cost Curve and Short-run Average Cost Curve / Derivation of
Long-Run Average Cost Curve
Planning curve and envelope curve are the another term for the long-run average cost
curve (LRAC). The long run average costs curve is also called planning curve or
envelope curve as it helps in making organizational plans for expanding production and
achieving minimum cost. Using the name planning curve indicates that the long-run
average cost curve is used to "making plans" especially concerning the desired scale of
operations of a firm. That is, in the long run a firm will seek the plant size that maximizes
long-run profit by equating long-run marginal cost and marginal revenue. It will then pick out
the appropriate plant size off the long-run average cost with the minimum short-run
average total cost.
long-run average cost curve is a planning curve; because, on the basis of this curve the
firm decides what plant to set up in order to produce optimally. LAC curve is the locus of
points denoting the least cost of producing the corresponding output. Long-run average cost
is derived from short-run cost curves. Long-run cost curve is a planning curve because it is a
guide to the entrepreneur to plan his output
long-run average cost curve is also an envelop curve; because, the long-run average cost
curve is the envelope of an infinite number of short-run average total cost curves, with each
short-run average total cost curve tangent to, or just touching, the long-run average cost curve
at a single point corresponding to a single output quantity. The key to the derivation of the
long-run average cost curve is that each short-run average total cost curve is constructed
based on a given amount of the fixed input, usually capital. As such, when the quantity of the
fixed input changes, the short-run average total cost curve shifts to a new location.

The long run cost output relationship can be shown with the help of a long run cost curve.
The long run average cost curve (LRAC) is derived from short run average cost curves
(SRAC).

Long Run Marginal Cost

Long-run marginal cost is the incremental cost incurred by a firm in production when
all inputs are variable. In particular, it is the extra cost that results as a firm increases in the
scale of operations by not only adding more workers to a given factory but also by building a
larger factory. Long-run marginal cost is an increment of the corresponding total. It is the
change in long-run total cost divided by, or resulting from, a change in quantity. Long-run
marginal cost is guided by returns to scale rather than marginal returns. Long run
Marginal Cost (LMC) is defined as added cost of producing an additional unit of a
commodity when all inputs are variable. This cost is derived from short run marginal cost. On
the graph, the LMC is derived from the points of tangency between LAC and SAC.
 Long-Run Marginal Cost Curve

The long-run marginal cost (LRMC) is derived from the short-rum marginal cost (SRMC)
curves. LRMC is formed from points of intersection of the SRMC curves with vertical lines
drawn from the points of tangency of the corresponding SAC-curves and the LRA cost curve.
The LMC must be equal to the SMC for the output at which the corresponding SAC is
tangent to the LAC.
Scale economies and returns to scale generally produce a U-shaped long-run marginal cost
curve, such as the one displayed to the right. For relatively small quantities of output, the
curve is negatively sloped. Then for large quantities the curve is positively sloped. While the
shape of the long-run marginal cost curve looks surprisingly like that of a short-run marginal
cost curve, the underlying forces are different. This U-shape is NOT the result of increasing,
then decreasing marginal returns that surface in the short run when a variable input is added
to a fixed input.
The negatively-sloped portion of this long-run marginal cost curve reflects economies of
scale and increasing returns to scale. The positively-sloped portion reflects diseconomies of
scale or decreasing returns to scale. The long-run marginal cost curve is extremely important
to the long-run profit maximization of a firm. In the same way that a firm maximizes
economic profit in the short run by equating marginal revenue with (short-run) marginal cost,
a firm maximizes economic profit in the long run by equating marginal revenue with long-run
marginal cost. The key difference is that long-run marginal cost is not attributable to just one
or two variable inputs, but to all inputs.
In other words, a profit-maximizing firm equates marginal revenue with the incremental cost
of not just hiring more employees, but of building a larger factory, too. An extremely
important point of interest regarding long-run marginal cost is that it is equal to long-run
average cost at the minimum of the long-run average cost curve. This quantity of output that
achieves the minimum efficient scale (MES).
 Economies and Diseconomies of Scale
The U-shaped LRAC curve is can explain the economies of scale and diseconomies of
scale. Economies and diseconomies of scale are concerned with behaviour of
average cost curve as the plant size is increased.
 If Long-run Average Cost declines as output increases, then we say that the firm
enjoys economies of scale.
 If, instead, the Long-run Average Cost increases as output increases, then we
have diseconomies of scale.
 if Long-run Average Cost is constant as output increases, then we have constant
returns to scale implying we have neither economies of scale nor diseconomies
of scale.
Economies of scale explain the down sloping part of the Long-run Average Cost curve. As
the size of the plant increases, Long-run Average Cost typically declines over some range of
output for a number of reasons.
In simple terms:
 Economies of Scale refers falling average costs due to expansion; increase in
efficiency of production as the number of goods being produced increases
 Diseconomies of Scale refers rising average costs due to a firm expanding too large
Economies of Scope
While economies of scale lowers the per unit cost as more of the same output is
produced, economies of scope lowers the per unit cost as the range of products produced
increases. For example, if a restaurant that provides lunch and dinner began to offer
breakfast, the fixed costs of the kitchen equipment and the seating area could be spread out
over a larger number of meals served decreasing the overall cost per meal. Likewise a gas
station that already must have a service attendant and building can lower the per unit cost by
providing convenience store items such as drinks and snacks. Since the cost of producing or
providing these products are interdependent, providing both lowers the cost per unit.