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CONCEPT OF COST

IN LONG RUN AND


ENVELOPE CURVE
ECONOMIC CONCEPT OF
COST
• The economic concept of cost is based on
the opportunity cost concept.
• OPPORTUNITY COST: It captures cost
as the worth of the goods or services that
have been forgone in order to have any
good or service.
• NORMAL PROFITS is the opportunity
cost of the entrepreneur’s entrepreneurial
skills and is as much an item of cost as
wages or interest.


Long run costs

In the long run, all inputs to a firm’s production
may be changed. Hence,
 There are no fixed inputs.
 No fixed costs.

All costs of production are variable. There are
three concepts of costs in the long run
1.Long run Total Cost (LRTC)
2.Long run Average Cost (LRAC)
3.Long run Marginal Cost (LRMC)
Long run cost function
Costs are defined as dependent on level of output

and level & prices of inputs;


But in most situations the producer is not in a

position to influence the price of inputs instead


producer works with given prices
Hence, the sole determinant of cost turns out to

be the level of output.



C = f(Q)CC
• C = f(Q)
Expansion path
•It implies to Long run because:
 No input is fixed.
 Path starts from origin
indicating that if output is
zero costs are zero.
•Expansion path gives us the

level of output & one least


combination that can
produce this level of output.

Movement along the line gives
the costs at which output can
be expanded

So called Expansion Path.

Long run total cost
 MEANING: The opportunity costs incurred by all of
the factors of production used in the long run by a
firm to produce good or service, being all inputs
variable.

 Long run total cost is always less than or equal to


short run total cost but it is never more than short
run total cost.

Relationship between long run
cost & long run production


LONG RUN COST CURVE

LONG RUN TOTAL PRODUCTION

Inverse S shaped Curve
LONG RUN TOTAL PRODUCTION
•INCREASING RETURNS TO SCALE:
§ Given factors increase in a given proportion,
output increases in a greater proportion.
§ Many economies set in and increase in return is
more than increase in factors.

CONSTANT RETURNS TO SCALE:
§ Output increases in exactly same proportion with
the proportionate increase in factors.
§ Economies of scale are counter balanced by
diseconomies of scale.

DECREASING RETURNS TO SCALE:
§ Output increases in a smaller proportion.
§ Diseconomies outweigh economies of scale.
§

Long run total cost curve
•In relation to long run production function long run cost
change in a reciprocal fashion.

The curve is divided in three phases according to LRTP:
•IRTS: with increase in output,

• variable costs rise at a


• diminishing rate
•CRTS: continues to rise till


production reaches level of
• normal capacity.

DRTS: after level of normal
• Capacity costs begin to rise
• at an increasing

rate.
Possible causes for economies
 Specialization in the use of labor and capital.
 Indivisible nature of many types of capital
equipment.
 Management efficiencies of line and staff.
 Economies in maintaining inventory of
replacement parts and maintenance
personnel.
 Discounts from bulk purchases.
 Lower costs of raising capital funds
Possible causes for diseconomies
 Disproportionate rise in transportation costs.
 Input market imperfections e.g. wage rates
driven up.
 Management coordination and control
problems.
 Disproportionate rise in staff and indirect
labor.
Long run average cost

LRAC refers to minimum possible per unit cost
of producing different quantities of output of
a good in the long period.

Long run average cost curve
•Properties:
 U-shaped curve.

Based on assumption of unchanging technology.
 LRAC is flatter curve than the SRAC.

In economics ,we define long period

as that during which size & organization of the

can be altered to meet changed conditions.
•Normally;

• output average costs


•But in long run, size of the firm

•Can be increased therefore

•Variable costs are likely to rise less


sharply. Hence a flatter curve.


Relationship between lrac and srac
 It explains the derivation of ENVELOPE CURVE.

Envelope curve
•Since LRAC envelopes all short run curves, hence

Called ENVELOPE CURVE.
 LRAC can never cut SRAC but it will be tangential
to each SRAC at some point.
 Average cost can not be higher in the long run
than in the short run;
•Explanation;

1.Any adjustment which will reduce costs possible


to be made in the short run must also be
possible in the long run
2.It is not always possible in the short run to
produce a given output in the cheapest
possible way as all the factors are not
variable.
Long run marginal cost
 Change in the total cost due to production of
one more or one less unit of a commodity.
 Long run marginal cost curve shows the extra
cost incurred in producing one more unit of
output when all inputs can be changed.
Relationship between lrmc and
lrac
 Regardless of whether a short run or long run
time period is assumed;
Ø When the marginal is below, it brings the
average down- a sure sign of economies of
scale.
Ø When the marginal is above,

it pulls the average up
- signifying diseconomies
- of scale.
Modern approach for lrac
 Theprevious concept assumes no technology
progress.
 Empirical investigations do not agree with the
previous concept because in real technology
progresses.
 Hence we obtain L-shaped curve.
Application of the concept
 In the long run, a firm exercises its choice
with regard to the size of the plant and
scale of production, on the basis of long run
average cost.
 Selection of the optimal plant size according
to the expected demand.
 Avoid unnecessary costs due to inappropriate
plant size.
references
A text book of economic theory by-

Alfred Stonier & Douglas C Hague.
 Managerial economics- Philips
 Managerial economics- Suma Damodaran
 www.wikipedia.com