Managerial Economics

Cost Analysis: Long Run

Veena Pailwar
Professor
IMT Nagpur

Long Run Cost Functions

Scale

Total
Product

LRTC
(Rs)

LRMC
(Rs)

100

500

5.00

5.00

200

900

4.00

4.50

300

1200

3.00

4.00

400

1500

3.00

3.75

500

2000

5.00

4.00

600

2600

6.00

LRAC
(Rs)

Q
LRTP

IRTS

CRTS

All
Inputs

DRTS

TC
LRTC

4.33

IRTS: Increasing Returns to Scale

CRTS: Constant Returns to Scale
DRTS: Decreasing Returns to Scale

IRTS

CRTS

DRTS

The firms long-run output decision

The decision:

LMC
LAC
AC1
LMC = MR

MR
Q1

Output
(goods per week)

If the price is at or
above LAC1, the firm
produces Q1.
If the price is below
LAC1
the firm goes out of
business

NB: LMC always

passes through the
minimum point of LAC.

Irrelevance of Fixed Costs if you stay in

Business

Changes in Fixed costs don't alter profit

maximizing P and Q because fixed Costs
dont impact Marginal Costs.
Fixed Costs do impact profits, and may
cause firm to decide the leave industry.
Same with lump sum taxes.

Impact of Fixed Costs on Profit

AC2
MC

AC1

P*
Profits2
AC*
Profits1
AC**
D
q
*

MR

Long Run Scenario I

Q: Is this firm making profit?
Costs

Long Run Scenario I

MC

AC

10
8

Output

Long Run Scenario II

Q: Is this firm making profit?
Q: Should the firm remain in the market or
exit the market?
Costs

Long Run Scenario II

MC

AC

Output

Long Run Scenario III

Q: Is this firm making profit?
Q: Should the firm remain in the market or exit the
market?
Costs

Long Run Scenario III

MC

AC

8
7

Output

The firms output decisions

A summary
Shortrun
decision

Marginal condition Choose Whether to

Produce
Choose the
Produce this output
output level at
unless price lower
which MR =
than SRAVC. If it is,
SRMC
produce zero

Long-run Choose the

output level at
decision
which MR =
LRMC

Produce this output

unless price is lower
than LRAC. If
P<LRAC then exit
the market

Long Run Cost Functions:

Envelope of SRAC curves
Ave Cost

SRAC-small capital
SRAC-med. capital
SRAC-big capital

LRAC--Envelope
of SRAC curves
LRMC is FLATTER than SRMC curves

Long Run AC
LRAC

MC1 SRAC1
SRAC3
MC2 SRAC2

Q1

MC3

Economies of Scale
Rs
Falling
average cost
as output
expands

Economies
of Scale

Increasing
average cost
as output
expands

LRAC

Diseconomies
of Scale
Constant Returns
to Scale

Output
Economies of Scale is a cost related concept
Returns to scale is a production related concept

Economiststhinkthatthe
LRACisUshaped
Downward section due to: Economies of Scale
Productspecificeconomieswhichinclude
specializationandlearningcurveeffects.
Plantspecificeconomies,suchaseconomiesin
overhead,requiredreserves,investment,orinteractions
amongproducts(economiesofscope).
Firmspecificeconomieswhichareeconomiesin
distributionandtransportationofageographically
dispersedfirm,oreconomiesinmarketing,sales
promotion,orR&Dofmultiproductfirms.

 Flat section
Constant returns to scale
Upward rising section of LRAC is due to:
Diseconomie of Scale
Large enough operation may increase input
prices
Disproportionate rise in transportation costs
Management coordination problems
Labor specialization and repetitive work too
little stimulation, productivity suffers

Using LRAC as Decision-Making

Tool
Which plant size to choose?
Both production cost information and accurate
demand forecasts are necessary
The cost structure of the industry will determine
the competitive structure of the industry

Minimum Efficient Scale

A firm can not expect always to achieve
economies of scale when it expands: at some
point it is likely that the further increase in
size does not produce any reduction in the
average cost per unit
minimum efficient scale (MES)
$

MES is the smallest scale at which

minimum per unit costs are attained.

LRA
C
MES

Scale of firm