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)CCC = f(Q)

EXPANSION PATHIt 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

Inverse S shaped CurveLONG RUN TOTAL

PRODUCTION

LONG RUN TOTAL PRODUCTIONINCREASING 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 rateCRTS: 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 COSTLRAC 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 periodas that during which size & organization of thecan be altered to meet changed conditions.Normally; output average costsBut in long run, size of the firm Can be increased thereforeVariable costs are likely to rise lesssharply. Hence a flatter curve.

RELATIONSHIP BETWEEN LRAC AND SRAC

It explains the derivation of ENVELOPE CURVE.

ENVELOPE CURVESince LRAC envelopes all short run curves, henceCalled 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;

When the marginal is below, it brings the average down- a sure sign of economies of scale.

When the marginal is above, it pulls the average up- signifying diseconomies- of scale.

MODERN APPROACH FOR LRAC

The previous 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