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Understanding Long-Run Average Cost Curves in Intermediate Microeconomic Theory

This guide explores the shape and implications of long-run average cost (LAC) curves in microeconomic theory, focusing on increasing returns to scale (IRS), decreasing returns to scale (DRS), and constant returns to scale (CRS). It discusses how LAC curves can be U-shaped or L-shaped, indicating different industry structures and efficiencies. Coverage includes minimum efficient scale, cost minimization in production, and examples from various industries, illustrating how both small and large firms can coexist depending on production technologies and market demand.

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Understanding Long-Run Average Cost Curves in Intermediate Microeconomic Theory

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  1. Economics 202: Intermediate Microeconomic Theory • Any questions? I know, I know … what’s on the test? • Coverage for test …

  2. Shape of Long-run AC curves LAC ($/q) IRS DRS LAC LAC CRS Output • Many are “U-shaped”, but some are “L-shaped” • L-shape  IRS/economies of scale are quickly exhausted, & CRS exist over a wide range of output • Result: both small & large firms can exist in same industry • LAC of small hospitals is 29% more than for large ones  declining LAC • IndustryLACsm/LAClg hospitals 129% electric power 112 banking 102 airlines 100 trucking 95 • Result: small banks & big banks exist

  3. Market Structure & Long-run AC curves LAC ($/q) D industry LAC tech 1 LAC tech 2 30K .05Qtotal .5Qtotal Qtotal Output • Minimum Efficient Scale is the production scale at which AC is a minimum. • This will vary by industry because production technology differs and technology is in part responsible for declining LAC. • Key question: Where does LAC reach minimum compared to total demand? • If very low (.05Qtotal), then lots of firms in that industry. • If relatively high (.5Qtotal), then very few firms in that industry. • LAC tech 1: coffee shops, breweries LAC tech 2: cars, law firms, cola, planes

  4. Min cost of producing 4 widgets is $80 (assuming w = r = $10), using K = L = 4 (point a) In the Long-run, the min cost way to produce Q = 12 is $120, using K = L = 6 (point c) a and c can also be interpreted as the points of max output for cost outlays of $80 or $120 IRS, DRS, or CRS? However, in the Short-run K is fixed at 4 machines, so the min cost to make Q=12 is higher, $140. Point b is (L,K) = (10,4) LR costs < SR costs of production LR vs. SR Cost-Minimization K 14 12 8 c 6 b 4 Q=12 a Q=4 L 4 6 8 10 12 14 • MRTS at b < w/r  the rate at which K can be substituted for L in production < rate at which K can be substituted for L in the market

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