Long Run Costs: Meaning and Derivation

Derivation of Long Run Marginal Cost Curve ( LMC )

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LMC is derived from short-run marginal cost curves. Similarly, we have to consider the points of tangency of the corresponding short-run average cost curves and long run average cost curve, i.e. points a, b and c respectively. LMC must be equal to SMC for the output at which the corresponding SAC is tangent to the LAC. These tangency points help to determine the level of output and different levels of plant’s capacity. For example; if we draw vertical lines from these points a, b and c to the X-axis, the corresponding output levels will be Q1, Q2, and Q3. The vertical line intersects SMC, at point d, where LMC is dQ1. When output expands to Q2, the marginal cost will be bQ2 (where bQ2 vertical line tangents SMC2 at b point).

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Long run marginal cost

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Similarly, if the vertical line CQ3 is extended to SMC3, it tangents SMC3 at point 'e'. Thus, eQ3 is the LMC at output Q3. When we join the points where vertical lines intersect or are tangent, all short-run marginal cost curves, say, d, b and e point, we derive the LMC curve. It is also U-shaped. It is due to an operation of laws of returns to scale.
 

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Economies and diseconomies of scale

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While the U – shape of the short run average cost curve is explained in terms of a law of variable proportions, the U–shape of the long-run average cost curve is explained by the economies and diseconomies of scale. When the firms expand their size of production, i.e. scale, they get some advantages or economies of production. But, if the scale of production becomes excessively large, certain disadvantages or diseconomies accrue to the firm. Economy means saving in per unit cost as output increases. Diseconomy means dissaving in cost as output increases. The economies and diseconomies of large scale production are of two kinds: i) Internal economies and diseconomies, ii) external economies and diseconomies.

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Internal economies

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Internal economies are that type of economies which arise from the expansion of the plant size of the firm. They are internal in the sense that they accrue to the firm when its output or scale increase. They depend solely on the size of the firm and will be different for different firms. They are specific or particular to the individual firms and do not reach the entire industry.

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Following are the main internal economies:

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a. Technical economies:

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Technical economies arise from the use of better techniques of production and increase in the labour efficiency, etc, A large firm achieves technical economies in the following forms:

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2. Use of superior technique
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4. Greater specialization
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6. Use of by-products
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8. An economy of bigger dimension
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b. Managerial Economies:

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Managerial economies arise due to better and more elaborate management which a large size firm is able to provide. A large firm is able to enjoy the benefit of division of labour in the management of its concern.

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c. Marketing Economies

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Marketing economies arise from the large scale purchase of raw materials and other inputs and the large-scale of firm’s own products. A large firm is capable of buying raw materials and other inputs more cheaply than a small firm because it buys in bulk and regularly, and so is able to get discounts.

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d. Financial Economies 

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The large firm is in a favorable position while raising its finances. This is known as financial economies. It will be able to raise the necessary finances more easily and cheaply. It has better creditworthiness as it offers better security to the banks.

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e. Economies in Transport and Storage

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A large-sized firm may possess its own means of transport to carry raw material and finished products and thereby can reduce the transport cost and can prevent delays in production.

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f. Research 

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A large firm can set up its own laboratories and employ a large number of scientists and research workers.

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Internal Diseconomies

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An increase in the scale of production beyond the optimal level may give rise to diseconomies. Following are the main types of managerial diseconomies:

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1. Managerial diseconomies: Increase in scale beyond limit gives rise to problems and complexities of large-scale management. There may emerge managerial inefficiencies.

2. Labour inefficiency: Overcrowding of labour gives rise to trade union activities. All this leads to fall in efficiency and increase in the cost of production.

3. Technical diseconomies: If any equipment is used beyond its optimal level technical diseconomies will arise.

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External Economies

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External economies are those economies which arise as a result of an expansion of the whole industry and not because of increase in the output of individual firms.
Some of them are:

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2. Cheaper inputs
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4. Technological Economies
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6. Supply of skilled labour
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8. Growth of ancillary industries
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10. Constant flow of information
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12. Economies of localization
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External diseconomies

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External diseconomies are the disadvantages which is originated outside the firm such as the input markets.
Some of them are:

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2. Rise in input prices
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4. Higher wages
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6. Costlier transport
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The ‘L – Shaped’ Scale Curve

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We know that all costs are variable in the long run. They give rise to a long run average cost curve (LAC) which is roughly L – shaped. The costs may be distinguished into production costs and managerial costs.

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L-shaped curve

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Production costs fall steeply in the beginning and then gradually as the scale of production increases. The L-shape of production cost curve is explained by the technical economies of scale. Initially, these economies are substantial. If a particular firm continues to enjoy economies of scale then it would expand its output in such a manner that it would become a dominant part of the industry. But in practice, this does not happen. The important point is that the economies of scale are not unlimited. As soon as the firm reaches a point at which opportunities for economies of scale are exhausted, average cost ceases to fall further. When this happens the LAC become a horizontal line, as illustrated in the figure.

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The level of output beyond which production costs stop falling is the minimum efficient scale (MES) and is shown by the output. If new techniques are invented for larger scales of output, they must be cheaper to operate.

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Reference

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Koutosoyianis, A (1979), Modern Microeconomics, London Macmillan