Explain the shape of the longrun average cost curve How firm

Explain the shape of the long-run average cost curve. How firms use the long-run cost curve to make choices about production?

Solution

The shape of the long-run average cost curve is related to economies and diseconomies of scale. Economies of scale are some of the factors that cause its longrun average cost to contract as output expands. Example: use of larger equipmentsand the specialization of its manpower. Diseconomies of scale are factors that cause its long-run average cost to expand as output expands. Example: the difficulty of managing a large scale operation the communication and coordination between the employees become difficult.

In the long run, all inputs (factors of production) are variable and firms can enter or exit any industry or market. Consequently, a firm\'s output and costs are unconstrained in the sense that the firm can produce any output level it chooses by employing the needed quantities of inputs (such as labor and capital) and incurring the total costs of producing that output level.

The Long Run Average Cost, LRAC, curve of a firm shows the minimum or lowest average total cost at which a firm can produce any given level of output in the long run (when all inputs are variable).

In the long run, a firm will use the level of capital (or other inputs that are fixed in the short run) that can produce a given level of output at the lowest possible average cost. Consequently, the LRAC curve is the envelope of the short run average total cost (SR ATC) curves, where each SR ATC curve is defined by a specific quantity of capital (or other fixed input). LRAC is shown in following graph.

The long-run average cost curve can be derived by identifying the factory size (or quantity of capital) that can produce each quantity of output at the lowest short-run average total cost. For example, The a firm has one short-run average total cost curve corresponding to a 10,000 square foot factory, another short-run average total cost curve corresponding to a 10,001 square foot factory, another for a 10,002 square foot factory, etc. Each of these short-run average total cost curves incurs the lowest average total cost for the production of a given quantity of output. The long-run average cost curve is then the combination of all minimum short-run average total cost values.