What is the relationship between the short run average cost curve and the long run average cost curve?

The supply of goods available when all inputs are variable

What is the Long-Run Supply?

The long-run supply is the supply of goods available when all inputs are variable. It means that in the long run, all property, plant, and equipment expenditure is variable. Furthermore, in the long run, the number of producers in the market is not fixed. Therefore, new firms will enter the market if there are economic profits, and some firms will leave the market if they are experiencing an economic loss.

In the long run, there are zero economic profits, meaning that firms will only earn an ordinary profit. It implies that the long-run supply curve will always be more elastic than the short-run supply curve because, in the long run, all firms make zero economic profit.

Summary

• The long-run supply is the supply of goods available when all inputs are variable.
• The long-run supply curve is always more elastic than the short-run supply curve.
• The long-run average cost curve envelopes the short-run average cost curves in a u-shaped curve.
• Returns to scale can be determined by assessing if the long-run average cost curve is downwards sloping, constant, or upwards sloping at the quantity output.

Relationship Between Short-Run and Long-Run Average Total Cost Curves

Short-run and long-run average total cost curves differ because, in the short run, fixed assets are held fixed, whereas, in the long run, all costs are variable. It implies that each point on the long-run average total cost curve would minimize the average total cost for reach level of output.

The graphical relationship between the short-run average total cost curves and the long-run average total cost curves demonstrates how the average total cost is minimized for each level of output in the long run. Such a condition holds true at the point of tangency between the short-run average cost curve and the long-run average cost curve.

Returns to Scale

Scale is a major factor in a firm’s long-run average total cost of production, and firms that operate scale find that their long-run average total costs vary substantially by the amount of output produced. There are three major types of scale to be considered:

1. Economies of Scale
2. Constant Returns to Scale
3. Diseconomies of Scale

Economies of Scale

Firms experience economies of scale, otherwise known as increasing returns to scale, when the firm’s long-run average total cost becomes smaller as output is increasing. Firms employ economies of scale to create larger profit margins on the output produced. They experience economies of scale (increasing returns to scale) when the long-run average cost curve is downwards sloping.

Economies of scale generally occur because of:

1. Specialization

A larger scale of operations allows individual workers to specialize in a few specific tasks and become highly skilled at them. It will allow firms to produce output more efficiently.

2. Large initial setup cost

If an industry requires large initial capital expenditure to operate, firms that can afford the capital expenditure will experience increasing returns to scale.

3. Network externalities

The network effect is the impact of an additional user of a good or service on the value of that good or service to others. For example, if a social media platform only lists a hundred users, likely, it will not be very valuable for a social media user. Whereas if a social media platform counts one billion users, the social media service is more valuable to its users.

Constant Returns to Scale

Firms experience constant returns to scale when its long-run average total cost increases proportionally to the increase in output. Therefore, scale does not impact the long-run average cost of the firm. Firms experience constant returns to scale when the long-run average cost curve is flat. The area of constant returns to scale is around the center of the curve.

Diseconomies of Scale

Firms experience diseconomies of scale, otherwise known as decreasing returns to scale, when long-run average total cost increases at a greater rate than output. Firms that experience diseconomies of scale create smaller profit margins on the output produced.

Diseconomies of scale occur in large firms when there are problems of coordination or communication. It is because as firms grow, communication across the firm becomes more expensive and costly. Diseconomies of scale (decreasing returns to scale) can be observed graphically when the long-run average cost curve is sloping upwards.

More Resources

CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Capital Expenditures
• Diseconomies of Scale
• Short-Run Supply
• Supply and Demand