Long Run Average Cost.

In the long run firm can increase its scale of production which means it can increase quantity of all of
its factors of production. Quantity of all of its factor inputs has become variable and all costs therefore
are variable costs. In the long run therefore total cost is not classified into fixed and variable costs all
costs are just total costs and we have to deal with ATC in the long run referred as Long Run Average
Cost Curve (LRAC).

In the long run firm can reach its least cost combination of factor inputs because all inputs are variable
now. The inputs whose productivity is declining or price is rising there quantity can be reduced and
inputs whose productivity is increasing or price is falling can be increased. This was not possible in the
short run because in short run some inputs will remain fixed in quantity. To reach the least cost
combination of inputs firm will compare MPP of a factor input and its price with other factor input’s
MPP and price. Least cost combination will be reached when

A change in quality of factor inputs will cause a shift in the cost curve because quality will influence
productivity, therefore we assume that quality of inputs is variable in the longer run.

We also assume that the firm is a price taker in the market of factors of production and does not have
control over the prices of its input.

The above two conditions are necessary to be established because both of the above factors will
cause a shift in cost curve while for the time being in long run we just want to see the behavior of per
unit cost only due to changing of scale of production or output.
LRAC curve is a downward sloping line initially then upward sloping. Downward sloping part is
determined by Internal Economies of large scale production and upward sloping part is influenced by
Internal Diseconomies of scale.
Internal Economies are cost saving advantages which occur due to expansion of output on a large
scale. These economies are classified into Bulk buying, Managerial, Financial, Risk bearing, Marketing
and Technical economies of scale. Internal Diseconomies are the problems which a firm faces when it
produces on a larger scale and are classified into Managerial and Labour diseconomies.

External economies and diseconomies will also take place due to factors outside the firm and are
beyond the firm’s control. However external economies will cause a shift in the cost curve which for
the time being is out of question.

Internal economies in terms of production means that rate of increase of output is greater than rate
of increase of inputs referred as Increasing returns to scale. However when rate of increase of output
is smaller than rate of increase of inputs it is referred as Decreasing returns to scale. Increasing
returns are a reason of falling per unit cost and decreasing returns are a reason of rising per unit cost
in the long run.

LRAC is a tangent line drawn joining the lowest cost points (optimum points) of short run average cost
curves (SRACs). This can be seen in the above drawn middle diagram. There are five SRACs and the
LRAC we can see is just a tangent joining the optimum points of SRACs. LRAC shows how the ATC or
per unit cost is behaving when a firm is expanding its output.

Minimum Efficient Scale:

MES or Minimum Efficient Plant Size is that output on LRAC where economies have exhausted and
there is no further reduction in ATC. As a result LRAC beyond MES will either flatten out or will start to
rise. MES of a firm can give an indication about the potential of competition in a market. If MES is on a
small scale then per unit cost is not low enough to hinder the entry of new firms into the industry
while if MES is on large scale then per unit cost of the existing firm will be lower enough to deter the
entry of new firms in the industry. Natural Monopolies are those monopolies whose MES is on such a
large scale that their per unit cost is extremely low and it is almost impossible for new firms to start
this business with smaller market share because their price will be higher than monopoly’s price.

Derivation of LRAC:
To derive the LRAC curve technically we will have to use Isoquants and Isocosts.

Isoquant:
An isoquant is a line or curve which shows different combinations of two factor inputs which will
produce a certain level of output for the firm. Isoquant is actually a menu of choices out of which any
one combination can be chosen to produce a certain level of output. Let the two factor inputs be
Capital (K) and Labour (L).
Isocost:
An Isocost is a line or curve which shows different combinations of two factor inputs a firm can
employ, with its available financial outlay and given prices of the two factor inputs. Isocost shows the
affordability of the firm that what combinations two inputs a firm can acquire at current market prices
of the inputs.

Producer Equilibrium:
In order to find out which combination of capital and labour will the firm actually employ to produce a
certain level of output we will plot the Isocost of the firm on the Isoquant Map. By the term producer
equilibrium we mean the least cost combination of factors of production which a firm can achieve
only in the long run at a certain level of output.

See the diagram below where Isocost has been plotted on Isoquant Map. We can see that the Isocost
AB is making a tangent with isoquant 2 at combination (a). Combination (a) is actually the least cost
combination because at this combination firm is producing maximum possible output with the current
resources of the firm hence it is the least cost combination. We can see that combination (b) shows
underutilization of resources, (c) shows full utilization but a lower level of output being produced than
(a). Combination (d) shows same output as (a) but at a higher cost. Finally combination (e) shows an
absolutely unattainable combination.

When resources of the firm will increase over time its Isocost will shift outward and will make a
tangent with higher isoquant creating a new least cost combination of factor inputs. Every time
Isocost will shift a new equilibrium will develop. If we join all these least cost combinations (a, b and
C) with a line that line is actually the LRAC or Expansion Path of the firm. Recall here that LRAC is
actually a line which shows the lowest cost outputs of each short run so points a, b and c are actually
showing least cost points at different scales and at different times on the diagram.