Long Run Average Cost
Long Run Average Cost: The long run is the span of time during which a company may modify all of its inputs. In the long term, there are no set inputs; all inputs are changeable. As a result, there are no fixed expenses in the long term; all costs are changeable. As a result, a company may adjust its production size to meet its demands in the long term.
The size of a plant or the scale stays constant in the short term, but adjustments in plant size may be made in the long run. A company might relocate from one factory to another in the long term, resulting in differing cost connections. It may develop a large-scale plant or a small-scale plant depending on the scenario.
It is important to note that the long term is a “planning horizon” in the sense that it serves as a guide for the company in making future production decisions. We are aware that production occurs in the short term. In a nutshell, the ‘operational phase’ of a company is the short term. Every company seeks to produce goods at a later period and choose from a variety of short-run scenarios.
As a result, the LAC curves are derived from the SAC curves. The lowest probable average cost for generating different amounts of production is shown by LAC. To calculate the LAC curve, we suppose that a given industry has three distinct plant sizes: small, medium, and big. The three SAC curves—SAC1, SAC2, and SAC3, respectively—represent small, medium, and large-sized plants
Plant curves are another name for SAC curves. Because we’re looking at the long term, the company may pick whatever plant size it wants to operate in the future in order to generate a specified production level at the lowest potential cost.
If the company chooses to manufacture OQ1, it will select the SAC1 plant size. On SAC1, a lesser output (for example, OQ’1) may be generated at a larger cost. However, the same plant size, i.e. SAC1, allows a company to create a big amount of product at a reduced cost. If OQ2 is the most lucrative level of production, the company will choose SAC2, a medium-sized facility.
It will choose the SAC3 large-scale facility to manufacture OQ3 output. However, making such a selection is not as simple as it looks at first glance. Assume the company is operating at SAC1 and that demand for its product is steadily increasing. Of course, even on SAC1, it can make OQ1 at the lowest cost. Beyond OQ1, production will be more expensive.
If the business intends to generate OQ”1 , selecting a plant size becomes challenging since the expenses of both plant sizes—SAC1 and SAC2—are the same. Now, the appropriate plant size is determined by the firm’s projections or expectations for product demand in the future years. At this level of productivity, cost cannot be the deciding factor in plant size selection.
It’s only logical that the company anticipates more demand for the product in the future. As a result, the company is more than likely to install SAC2 rather than SAC1. Larger outputs are now possible at a cheaper cost. Similarly, although output OQ”2 may be generated by both SAC2 and SAC3 plant sizes, it is preferable to employ the SAC3 plant size since bigger output (OQ3) can be produced at a cheaper cost (OQ3).
Long Run Average Cost
Assume, for example, that the company is confronted with a vast variety of plant sizes, each represented by five SAC curves, as illustrated in Fig.2. The ‘planning curve,’ also known as the Long Run Average Cost curve, is a smooth and continuous curve generated by these curves.
The lowest potential cost for generating the matching amount of production is shown at each position on this curve. The LAC curve is a planning curve because it helps a company in determining which facility to build in order to deliver the highest level of production at the lowest cost.
The company chooses the short-run facility with the lowest cost of production for the expected output level. To create a certain output in the long run, the company must first choose a point on the Long Run Average Cost curve that corresponds to that output, then construct a short-run plant that operates on the matching SAC curve.
Assume the corporation believes that point A on SAC1 is the most lucrative for creating output OQ1. It will then construct a plant at the reduced cost indicated by the SAC1 curve. [The SAC1 curve is tangent to the LAC curve at point A.] However, the company may lower its costs by increasing production to the level corresponding with point B on the SAC1 curve, which is the lowest point.
However, the company believes that demand for its product will increase in the future. As a result, it will build a new plant, represented by the SAC2 curve, that will run at point D on the SAC2 curve, decreasing its unit cost, rather than the lowest point on the SAC2 curve [SAC2 is tangent to the curve LAC, corresponding to the output level OQ2].
For output OQ3, the company would build a SAC3 plant and run it at E, where unit costs are the lowest. [Once again, SAC3 is perpendicular to the LAC curve.] In the long term, the same would be true for all other outputs. The business would build plant size SAC4 for output OQ4 and operate at point F.
The SAC minimum point, however, is now to the left of the operational point, F. Similarly, the plant size SAC5 might yield OQ5 output.
The company should operate at point G on the SAC5 curve. As a result, each point of the LAC curve is tangent to the matching SAC curves. All of the tangency points are located on the LAC curve. As a result, the LAC curve is known as the ‘envelope curve,’ since it encompasses or supports a family of SAC curves.
It’s worth noting that the LAC curve is not tangential to any of the SAC curves’ minimum points along its length. When LAC falls, it is tangential to the SAC curves’ falling section, not to the SAC curves’ minimum point.
For example, rather of operating at point B on the SAC curve, where expenses are lowest, the company runs at point A, the decreasing section. To put it another way, since the slope of the LAC curve is negative up to point E, the slope of the SAC curves must be negative as well. This is because the SAC and LAC curves have the identical slopes at the tangency points. Only at point E is the LAC’s minimum point tangent to the SAC’s minimum point.
As Long Run Average Cost rises, it is tangent to the rising piece of SAC curves to the right at this point. SAC = LAC at the tangency points, while SAC > LAC to the right or left of the tangency point. However, below OQ3 output, the lowest points of SAC curves are to the right of the operational point. SAC’s minimum points are to the left of the operational point, beyond OQ3 output.
As a result, the Long Run Average Cost curve is U-shaped: it decreases at first, reaches a minimum, and then increases as production grows. However, the LAC curve’s U-shape is less apparent than the SAC curve’s U-shape.