Study notes

Long Run Average Cost (LRAC)

What is long run average cost?

Long run average cost is the cost per unit of output feasible when all factors of production are variable

Economies of Scale and Long Run Average Cost (LRAC)

  • In the long run all costs are variable and the scale of production can change (i.e. no fixed inputs)
  • Economies of scale are the cost advantages from expanding the scale of production in the long run. The effect is to reduce average costs over a range of output
  • These lower costs represent an improvement in productive efficiency and can give a business a competitive advantage in a market. They lead to lower prices and higher profits – this is called a positive sum game for producers and consumers (i.e. the welfare of both will improve)
  • We make no distinction between fixed and variable costs in the long run
  • As long as the long run average total cost curve (LRAC) is declining, then internal economies of scale are being exploited.

The table below shows a numerical example of falling LRAC

Long Run Output (Units) Total Costs (£s) Long Run Average Cost (£ per unit)
1000 12000 12
2000 20000 10
5000 45000 9
10000 80000 8
20000 144000 7.2
50000 330000 6.6
100000 640000 6.4
500000 3000000 6

Returns to Scale and Costs in the Long Run

The table below shows how changes in the scale of production can, if increasing returns to scale are exploited, lead to lower average costs.

Factor Inputs Production Costs
(K) (La) (L) (Q) (TC) (TC/Q)
Capital Land Labour Output Total Cost Average Cost
Scale A 5 3 4 100 3256 32.6
Scale B 10 6 8 300 6512 21.7
Scale C 15 9 12 500 9768 19.5
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200

Because the % change in output exceeds the % change in factor inputs used, then, although total costs rise, the average cost per unit falls as the business expands from scale A to B to C

Examples of Increasing Returns to Scale

Much of the new thinking in economics focuses on the increasing returns available to growing businesses:

An example of this is the software and computer gaming industry.

  1. The overhead costs of developing new software programs or computer games are huge - often running into hundreds of millions of dollars
  2. The marginal cost of one extra copy for sale is close to zero, perhaps just a few cents or pennies
  3. If a company can establish itself in the market, positive feedback from consumers will expand the installed customer base, raise demand and encourage the firm to increase production
  4. Because marginal cost is low, the extra output reduces average costs creating economies of scale

Capacity Utilisation, Fixed Costs and Profits

  • Lower costs normally mean higher profits and increasing financial returns for the shareholders. What is true for software developers is also important for telecoms companies, airlines, music distributors and cinema operators
  • We find across many different markets that, when a high percentage of costs are fixed the higher the level of production the lower will be the average cost of production
  • Strong demand means capacity utilization rates are high and this lowers the unit cost of supply
The long run average cost curve with economies and diseconomies of scale

Long Run Average Cost Curve

  • The long run average cost curve (LRAC) is known as the ‘envelope curve’ and is drawn on the assumption of their being an infinite number of plant sizes – hence its smooth appearance in the next diagram on the next page.
  • The points of tangency between LRAC and SRAC curves do not occur at the minimum points of the SRAC curves except at the point where the minimum efficient scale (MES) is achieved.
  • If LRAC is falling when output is increasing then the firm is experiencing economies of scale. For example a doubling of factor inputs might lead to a more than doubling of output.
  • Conversely, When LRAC eventually starts to rise then the firm experiences diseconomies of scale, and, If LRAC is constant, then the firm is experiencing constant returns to scale
  • The working assumption is that a business will choose the least-cost method of production in the long run. Moving down the LRAC means there are cost advantages from a bigger scale of supply

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