Page 133 - DECO405_MANAGERIAL_ECONOMICS

Managerial Economics

Notes and over 9 points off if one excludes the petroleum monopolies. How long can most of
these firms survive competition in such a state? Isn't it a crime not to take a decision one
way or the other? You decide.

Question
What is the reason of U-shaped average cost curve in this case?
Source: Business India, 97.

8.3.3 Costs in the Long Run

The long run is a period of time during which the firm can vary all its inputs. None of the factors
is fixed and all can be varied to expand output. Long run is a period of time sufficiently long to
permit changes in the plant, that is, in capital equipment, machinery, land, etc., in order to
expand or contract output. The long run cost of production is the least possible cost of production
of producing any given level of output when all inputs are variable including the size of the
plant. In the long run there is no fixed factor of production and hence there is no fixed cost.
If Q = f(L, K)
TC = L.P + K.P
L K
Given factor prices and a specific production function, one can draw an expansion path which
gives the least costs associated with various levels of output which in fact yields the long run
total cost schedule/curve. LTC is an increasing function of output. The rates of change in these
two variables are not known unless the qualitative relationship is quantified. If one recalls the
concept of returns to scale and assumes fixed factor prices, one could see three things:
1. When returns to scale are increasing, inputs are increasing less than in proportion to
increases in output. It follows that total cost also must be increasing less than in proportion
to output. This relationship is shown in Figure 8.3(a).
2. When returns to scale are decreasing, total cost increases at a faster rate than does output.
This relationship is shown in Figure 8.3(b).
3. When returns to scale are constant, total cost and output move in the same direction and
same proportion. This is also shown in Figure 8.3(c).
Thus, depending upon the nature of returns to scale, there will be a relationship between LTC
and output, given factor prices. It is generally found that most industries and firms reap increasing
returns to scale to start with which are followed by constant returns to scale which give place to
decreasing returns to scale eventually. In this case, the long run total cost function first would
increase at a decreasing rate and then increase at an increasing rate as shown in Figure 8.4. Such
a total cost function would be associated with a U-shaped long run average cost function.
From LTC curve we can derive the firm's long run average cost (LAC) curve. LAC is the long run
total cost (LTC) divided by the level of the output (Q). That is,
LTC
LAC=
Q
Similarly, from the LTC curve we can also derive the long run marginal cost (LMC) curve. This
measures the change in LTC per unit change in output and is given by the slope of the LTC curve.
That is,
TC d LTC
LMC= or
Q dQ

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