PRODUCTION, COST AND SUPPLY

Highlights
 Defining the Concept of Production
 Total, Marginal and Average Product Curves
 Short-run and Long-run Product Curves
 Total, Marginal Cost and Average Cost Curves
 Short-run and Long-run Cost Curves
 Laws of Returns
 
 
Lesson 1: Concepts Related to Production
Lesson Objectives
After studying this lesson, you should be able to:
 state the meaning of production in Economics;
 state the nature of short-run and long-run production functions;
 define equal product curve and state its characteristics;
 state how the least cost combination of factors is obtained; and
 show returns to scale with the help of equal product curves.
Meaning of Production
In popular language, the term production is used to mean creation of a new commodity or a
service. In Economics, production means creation of new utility. The law of indestructibility of
matters in physics states that human beings cannot create or destroy matters. She/he can only
change the shape of matters so that these transformed matters satisfy human wants. In other
words, a human being creates new utility by rendering her/his services. Suppose a person gets a
piece of wood, free of cost, from her/his friend. As long as the piece of wood lies unused in his
courtyard, it will not be a production activity. The person hires a carpenter who puts her/his
services on the piece of wood to change it to an item of furniture.
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The carpenter creates new utility by changing the piece of the wood to the shape of a furniture
item. Thus, the carpenter produces a commodity which satisfies human wants. There are four
factors of production - land, labor, capital, and entrepreneur. The owners of land, labor, and
capital and the entrepreneur get rent, wages, interest income and profit respectively as their
remunerations. The entrepreneur organizes the production activities. She/he buys a piece of land,
hires the workers and borrow the necessary capital from the financial institutions for investing in
her/his production firm. Her/his ultimate objective is to maximize her/his profit which can be
defined as the difference between total revenue and total cost. A production firm generally
consists of a few production plants; each production plant in turn consists of one production unit
with one big furnace, machinery and equipments. The collection of all firms producing one
commodity is called an industry. For example, the sugar industry in Bangladesh consists of all
production firms engaged in producing sugar.
Production Function
A production function is a technical relationship between the inputs of production and output of
the firm; the relationship is such that the level of output depends on the levels of inputs used, not
vice versa. A production function is traditionally expressed by the following equation:
Q = f(K,L)
where,
Q = the level of output
f = the symbol of relationship, which is determined by the production engineers.
K = the amount of capital
L = the amount of labor
A production function may be a short-run or a long-run production function depending on the
period of time. In a short-run production function, at least one input of production cannot be
changed. In a long-run production function, all inputs of production can be changed. Short-run
does not specify a specific period of time; it depends on the nature of the commodity in question.
It may be six months for one commodity and one year for another commodity, etc. The inputs of
production consist of raw materials that a particular firm buys to use in the production process
and the inputs may be the commodities produced by other firms.
The Short-run Production Function
In the case of short-run production function, at least one input cannot be changed. For example,
the firm owner increases her/his production level by hiring more labor and by buying more raw
materials if the demand for her/his commodity increases in the short-run. She/he cannot add a
new production plant in the short-run, because it takes some time to erect a new building, to buy
machinery and other fixed inputs in the short-run. Even if she/he can add another production
unit, she/he would not do so, because the increase in the demand for his commodity may be very
much transitory. Whatever be the cause, some factors of production would remain fixed in the
short-run.
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Symbolically, a short-run production function can be expressed as follows:
Y = f (K0, L)
Where,
K0 means fixed level of capital.
Suppose there are two factors of production, capital (K) and labor (L). Also suppose capital is
fixed in the short-run. We are interested to examine how total, average, and marginal product
curves would be affected if we keep increasing the level of labor input. The following diagram
shows the behavior of total, average, and marginal product curves in the short-run.
In Figure 5.1, we measure productivity along the vertical axis, and quantity of labor along the
horizontal axis. The TP curve in the diagram shows how total product behaves if we increase the
quantity of labor keeping the quantity of other factors fixed in the short-run. It is evident that
total product increases at an increasing rate initially. It starts increasing at a decreasing rate after
point L1 along the horizontal axis and after A1 along the TP curve. Total product becomes the
maximum when OL3 amount of labor is used. Then it starts diminishing. Marginal product
increases as long as total product increases at an increasing rate. Marginal product becomes the
maximum at the inflection point where total product starts increasing at a decreasing rate.
Marginal product becomes zero when total product is the maximum. Marginal product remains
negative as long as total product diminishes. Average product increases initially up to point L2
along the horizontal axis and up to point A2 along the TP curve. It begins to fall after OL2
amount of labor. It should be noted that average product can never be zero or negative.
Law of Variable Proportions
Depending on the nature of various product curves, the economists have divided the diagram in
Figure 5.1 into three parts on the basis of quantity of labor used in the production process. These
three regions are O- L2, L2- L3, L3 - infinite. The first region is called the region of increasing
returns, because marginal productivity of the variable input increases here. The producer will not
TPL
A3
A2
A1
APL
L
MPL
O
TPL
MPL
APL
L1 L2 L3
Figure 5.1: Total, average and marginal product curve in the short-run
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stop here. The second region, L2- L3, is known as the region of diminishing returns, because
marginal productivity diminishes in this region. The entrepreneurs find that increased doses of
labor applied to a fixed quantity of other inputs result in decreasing amount of marginal products.
Diminishing returns are frequently found in agricultural production functions. The second stage
is also called the economic stage, because the entrepreneur produces at some point in this stage.
The point of production, of course, depends on the prices of the two inputs, the variable input
and the fixed input. For example, the producer will produce at OL2 if the fixed input is free but
the variable input is not free. Similarly, the producer will produce at OL3 if the variable input is
free but the fixed input is not free. She/he will produce at some point in the second stage if both
the inputs are not free. The third stage is called the stage of negative returns. The producer will
not produce in this stage, because the marginal product of the variable input is negative here. In
this case, the producer can increase her/his total product by withdrawing labor from production
process. Some economists call this the stage of disguised unemployment. Labor used at this stage seems
to be employed but their employment decreases total output rather than increasing it. Total product in the
short-run is also called returns to variable proportions. The ratio of variable input to fixed inputs changes
when quantity of variable input increases with the quantity of other factors remaining the same.
The Long-run Production Function
In a long-run production function, all factors are variable. The factors, however, can be varied in
two ways. We can vary all factors of production proportionately so that the initial ratio of the two
inputs remains constant. Alternatively, the two inputs can be varied by changing the initial ratio
between them. Let us examine how total product changes when we increase all factors of
production at the same rate. Total product and the inputs may increase at the same rate. This is
the case of constant returns to scale. Total product may increase at a rate higher than the rate at
which the inputs increase. This is the case of increasing returns to scale. Finally, the rate of
increment of total output may be less than the rate of increment of inputs. That is the case of
decreasing returns to scale. The following table illustrates the three cases of returns to scale
clearly.
Step
Capital
K
Labor
L
Capital-Labor
ratio
K/L
Total output
1 10 20 10/20 = ½ 100
2 20 40 20/40 = ½ 300
3 40 80 40/80 = ½ 600
4 80 160 80/160 = ½ 1000
It is evident from the table that we change all factors of production keeping the ratio of capital
(K) to labor (L) always equal to half. From step 1 to step 2, we double both the factors, capital
and labor. Total product however, becomes more than double. It is a case of increasing returns to
scale. From step 2 to step 3, total output and the two inputs increase at the same rate - all double
in step 3. We have constant returns to scale here. From step 3 to step 4, total product becomes
less than double though the inputs double in step 4. The final case shows decreasing returns to
scale. It should be noted that production functions showing any kind of returns to scale are
known as homogeneous production functions. We must use equal product curves in order to
show returns to scale diagrammatically. At the end of this lesson returns to scale will be shown
by equal product curves.
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Equal Product Curves and Budget Lines
Equal Product Curve
An equal product curve is the locus of different combinations of two inputs that can produce a
give level of output. It should be noted that an equal product curve is very much similar to an
indifference curve. An indifference curve consists of different combinations of two commodities.
An indifference curve represents the same level of satisfaction at all points on it; an equal
product curve shows the same level of output at all points on it. There is one difference between
two: the given level of satisfaction cannot be quantified in the case of indifference curve whereas
the given level of output can be quantified in the case of an equal product curve. The following
figure shows an equal product curve.
In Figure 5.2, we measure quantity of capital (K) along the vertical axis and the quantity of labor
(L) along the horizontal axis. Q = 20 is an equal product curve showing the different
combinations of two inputs capable of producing 20 units of output. For example, both
combination A1 with OK1 units of capital and OL1 units of labor and combination A2 with OK2
units of capital and OL2 units of labor can produce 20 units of output. The other points on Q = 20
are also capable of producing 20 units of output.
Characteristics of Equal Product Curve
Equal product curves possess characteristics similar to those of indifference curves. These are
cited below:
 Equal product curves are downward sloping;
 Equal product curves are convex to the origin;
 Two equal product curves cannot intersect each other; and
 A higher level of equal product curve indicates higher level of output.
Let's now discuss the concept of budget line in production analysis.
Q = 20
0 L1 L2 L
A2
A1
K
Figure 5.2: Equal product curve
K1
K2
Labor
Capital
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Budget Line or Iso-Cost Line
A budget line in production analysis shows the different combinations of two inputs that a firm
owner can buy with a given amount of money and given prices of two inputs. Figure 5.3 shows a
budget line with capital measured along the vertical axis and labor along the horizontal axis.
The combination C with OK1 of capital of OL1 of labor costs as much as the combination D with
OK2 of capital and OL2 of labor. All other points on the budget line cause the firm owner to
spend the same amount of money.
Least Cost Combination of Factors
The ultimate objective of a firm owner is to maximize her/his profit. This can be done in two
steps. First, the entrepreneur minimizes the cost of producing a given level of output. Second,
she/he maximizes the total revenue by selling her/his product. The following analysis explains
how a producer minimizes the cost of producing a given level of output when the prices of two
inputs are given. Figure 5.4 illustrates the minimization problem.
The producer wants to minimize the costs of producing 20 units of output shown by the equal
product curve Q = 20. The producer can obtain 20 units of output by producing at points M,N, P,
and Q, because these points are located on her/his equal product curve Q = 20. The producer,
however, will not produce at M, N, P and Q, because these points lie on higher budget lines. A
higher budget line means higher level of cost. Her/his cost of producing 20 units of output will
be minimum at point E at which the budget line is tangent with the equal product curve. At point
E the entrepreneur uses the least cost combination of K* units of capital and L* units of labor.
0 L1 L2 L
D
C
K
Figure 5.3: Budget line or Iso-Cost Line
K1
K2
Labor
Capital
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Her/his minimum cost is given by the budget line CD. She/he would like to go to budget line
AB, but she/he cannot produce 20 units of output by going to budget line AB. Thus, geometric
condition for minimum cost is that at the least cost combination, the equal product curve must be
tangent with the budget line. We can formalize the necessary and sufficient conditions for cost
minimization as follows:
Necessary Condition
PL/PK = MPL/MPK
Where,
PL = Price of labor input
PK = Price of capital input
MPL = Marginal productivity of labor
MPK = Marginal productivity of capital
Sufficient Condition
At the least cost combination, the equal product curve must be convex to the origin.
Equal Product Curves and Returns to Scale
We can illustrate the concepts of returns to scale with the help of least cost combinations of
factors. Figure 5.5 explains three kinds of returns to scale.
O L* B D L
E
N
M
Q
P EQ = 20
K
C
A
K*
Labor
Figure 5.4: Least-cost combination of factors
Capital
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We measure capital along the vertical axis and labor, along the horizontal axis. In Figure 5.5, we
have four budget lines A1B1, A2B2, A3B3 and A4B4 which result from increased budgets of the
entrepreneur with prices of two inputs remaining the same. We also notice four least cost
combinations of factors in the diagram. These are E1, E2, E3 and E4. By joining the least cost
combinations, we get a curve like OT in Figure 5.5. This curve is called the expansion path,
because it shows the inputs utilization levels when an entrepreneur wants to expand its
production levels keeping the inputs ratio the same. It should be noted that the expansion path is
a straight line in the case of a homogeneous production function. It is evident from Figure 5.5
that the following distances have the same length in the diagram.
OE1 = E1E2 = E2E3 = E3E4
This implies that if the producer doubles both the inputs, she/he comes to the least cost
combination E2 from the earlier least cost combination E1. The level of output, however, more
than doubles at E2 because E2 is on the equal product curve Q2 showing 50 units of output. At E1,
the producer used to produce 20 units of output. In other words, the movement from E1 to E2
shows increasing returns to scale if the two inputs are doubled and as a result the increase in
output is the same as the initial output, the situation is called constant returns to scale. In Figure
5.5, movement from E2 to E3 indicates constant returns to scale to the producer. Similarly, if the
inputs are doubled and as a result the increase in total output is 1.5 times of the initial output, the
situation is called decreasing returns to scale, the movement from E3 to E4 in Figure 5.5 indicates
decreasing returns to scale.
E1
Q1 =20
E2
Q2 =50
E3
Q3 =75
E4
Q4 =100
T
L
O L1 L2 L3 L4
K
A4
A3
A2
A1
K1
K2
K3
K4
B1 B2 B3 B4
Labor
Capital
Figure 5.5: Returns to scale
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Review Questions
1. Explain the relationship between the average cost and marginal cost curves.
2. Explain the behavior of cost curves in short-run. Show the relationship between marginal
cost, average variable cost, average total cost.
3. Suppose a cost function is given as C = 135 + 75Q - 15Q2 + Q3. There are a cost schedule
showing total cost, marginal cost, marginal cost, average cost and average variable cost.
Draw the cost curves on the basis of cost data obtained from the cost function.
4. (a) What is production?
(b) In each of the following activities, identify what is being produced and the major
inputs:
(1) Baking a cake
(2) Attending college
(3) Eating
(4) Sleeping
5. (a) What is production function? Distinguish between short-run and long
run production functions.
(b) Write down the characteristics of equal product curves.
(c) What is budget line or iso-cost curve?
(d) Explain the least cost combination of factors.
6. What is expansion path? Explain it graphically.
7. What is marginal physical product of labor? In what units MPL is measured in production
of:
(a) Wheat
(b) Haircuts
(c) Houses
(d) Dental services
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Lesson 2: Short-run and Long-run Cost Curves
Lesson Objectives
After studying this lesson, you should be able to:
 derive the different short-run cost curves;
 state the nature of different short-run average cost curves;
 derive the different long-run cost curves; and
 state the nature of different long-run cost curves.
Derivation of Short-Run Cost Curves
A firm owner has to incur costs when she/he undertakes production activities. She/he has to pay
rent to the landowner, wages to the labor, and interest to the owner of capital. In other words,
she/he has to buy her/his raw materials to be used in the production process. The nature of cost
of production depends on two things, viz., (a) the physical conditions of production and the input
prices and (b) the period of time.
In the production analysis, we defined short-run as a period of time in which certain types of
inputs cannot be changed regardless of the level of output. At least one input must be fixed in the
short-run. The usage of the variable inputs, however, can be changed in the short-run. In the
long-run, on the other hand, all inputs can be varied to obtain the minimum cost of production.
The amount of money spent for fixed inputs are short-run fixed cost. The various fixed inputs
have unit prices. The fixed explicit cost is simply the sum of unit prices multiplied by the fixed
number of units used. In the short-run, implicit costs are also fixed. Thus, it is an element of
fixed cost. Total fixed cost (TFC) is the sum of the short-run explicit fixed cost and the implicit
cost incurred by an entrepreneur. Variable inputs in the short-run give rise to variable cost. The
entrepreneur has to increase the usage of the variable inputs if she/he wants to increase her/his
output level in the short-run. As a result, total variable cost (TVC) increases when output level
increases. If there is zero output, no units of the variable input need to be employed. Variable
cost is zero and total cost is equal to fixed cost at the zero level of output. Total variable cost is
the sum of the amounts spent for each of the variable inputs used. The short-run total cost (STC)
is the sum of total variable cost and total fixed cost. It is shown by the following equation:
STC = TFC + TVC
An explanation of different types of the short-run cost curves is given in Figure 5.6.
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In Figure 5.6, we measure output level along the horizontal axis and different types of cost along
the vertical axis. The horizontal line marked TFC shows that total fixed cost does not depend on
the level of output; it is fixed at all levels of output. The curve STC shows how short-run total
costs increase with the level of output. The gap between short-run total cost (STC) and total
fixed cost (TFC) measures the total variable cost (TVC) of production. It can easily be seen from
the figure that both STC and TVC increase at a decreasing rate initially when output level
increases, and then both increase at an ??? here that the shape of STC derives from the shape of
the short-run total product curve; the shape of STC is just the opposite of the shape of the shortrun
total product curve. We know that the short-run total product curve increases at an increasing
rate and then it increases at a decreasing rate.
If we divide short-run total cost (STC), total variable cost (TVC), and total fixed cost (TFC) by
the level of output, we obtain short-run average total cost SATC, short-run avarage variable cost
(SAVC) and short-run average fixed cost (SAFC) respectively. The relations are shown below:
SATC = STC/Q
SAVC = TVC/Q
SAFC = TFC/Q
SATC = STC/Q = (TVC+TFC)/Q = TVC/Q + TFC/Q = SAVC + SAFC
Short-run marginal cost is defined as the change in short-run total cost due to one unit change in
output.
SMC = STC/ Q = TVC/Q
Alternatively, the average cost curves can be derived geometrically from the STC and TFC
curves. First, we find the values of SAC, SAVC, SAFC, and SMC at a particular level of output
like Q1 along the horizontal axis. Then we find these values at all levels of output. Finally, by
plotting these values, we get the different types of average cost curves. For example, we are
interested in finding the values of SAC, SAVC, SAFC, and SMC at output level Q1 in Figure 5.6.
SATC at Q1 is found by dividing total cost, Q1A, by the level of output, Q1. SAFC is equal to
total fixed cost, Q1 E, divided by the level of output, Q1. Finally, SMC is calculated as the value
of the slope of the tangent at point A, which is equal to DC divided by BC.
O Q1
Q
E
BC
D
A
STC
TFC
Output
Figure 5.6: Different types of short-run cost curves
STC, TFC,TVC
TVC
Commented [H1]: See
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Nature of Short-run Average Cost Curves
Short-run average total cost SATC is the sum of short-run average fixed cost (SAFC) and shortrun
average variable cost (SAVC).
SATC = SAFC + SAVC
SAFC declines continuously when the level of output increases, because the quotient TFC/Q
falls continuously with increasing units of output. SAFC is a rectangular hyperbola approaching
both axes asymptotically. SAVC is normally U-shaped, falling initially as output level increases.
It reaches a minimum value at a certain level of output and starts rising after that.
Why is Short-run Average Variable Cost Curve (SAVC) U-shaped?
There are two explanations for the U-shape of SAVC:
First, SAVC is related to average productivity of the variable input in the short-run. We know
that SAVC is equal to TVC divided by Q:
SAVC = TVC/Q
But TVC is nothing but the of product price of the variable input and quantity of the variable
input. Assuming labor to be our variable input, we can write SAVC as follows:
SAVC = TVC/Q = PLL/Q = PL/(Q/L) = PL/APL
Where,
PL = Price of labor
L = Quantity of labor
Q = Output level
APL = Q/L = Average productivity of labor
SAVC is found to be the reciprocal of average productivity of labor if we assume that price of
labor does not depend on the level of employment. We know that the average productivity curve
is inverted U-shaped in the short-run. Hence the SAVC curve is U-shaped in the short-run.
Second, in the short-run certain inputs are fixed. Each fixed input needs a certain number of
labor force for its optimum utilization. We assume that the number of labor force applied to each
fixed input in the short-run increases gradually starting from zero. Initially, a small number of
labor input is applied to the fixed input. Average productivity is, therefore, low and short-run
average variable cost is high at the initial stage. Average productivity of labor starts rising as the
number of labor input increases. As a result, SAVC starts falling. As the number of variable
input, labor, keeps increasing, average productivity of labor becomes maximum when the fixed
inputs are put to optimum their utilization. Corresponding to this point of labor employment,
SAVC becomes the minimum. If we increase the number of labor force beyond the optimum
utilization point, average and marginal productivity of labor start falling due to mismanagement
and chaotic conditions prevailing in the firm. Consequently, SAVC starts rising after the
optimum utilization points of the fixed inputs. This ends the explanation of the U-shape of
SAVC.
Why Is Short-run Average Total Cost Curve (SATC) U-shaped?
The shape of short-run average total cost SATC curve depends on the shapes of SAFC and
SAVC. Initially SATC falls because both SAFC and SAVC fall initially. SATC continues to fall
even when SAVC starts rising after its minimum point. This happens, because the rate of fall of
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SAFC is greater than the rate of rise of SAVC. After some units of output, the rate of rise of
SAVC becomes greater than the rate of fall of SAFC.
From that point, rise in SAVC offsets the fall in SAFC. As a result, SATC starts rising with the
increase in the level of output.
The preceding discussion explains why SATC is also U-shaped. Like SATC, short-run marginal
cost (SMC) curve is also U-shaped. SMC derives its shape from the shape of short-run marginal
productivity curve. The following equation shows how SMC and marginal productivity (MPL)
are related to each other.
SMC = STC/ Q = (L.PL)/Q = PL/(Q/L) = PL/MPL
If we assume PL to be fixed regardless of the level of employment, we find SMC to be the
reciprocal of MPL. Since MPL curve is inverted U-shaped, SMC curve will be U-shaped.
Now let's explain how short-run marginal cost (SMC) curve is related to SAFC, SAVC and
SATC curves.
Relationship among Short-run Average Cost Curves
It should be noted that SMC has no relationship with TFC and hence with SAFC. SMC is less
than SAVC as long as SAVC continues to fall in the initial stage. SMC equals SAVC at the
minimum point of SAVC. SMC is greater than SAVC as long as SAVC continues to rise. Similar
relationship holds between SMC and SATC. SMC is less than SATC as long as SATC decreases,
the two become equal at the minimum point of SATC and SMC remains greater than SATC as
long as SATC increases. Figure 5.7 shows the different types of short-run average cost curves.
In the Figure 5.7, we measure different types of costs along the vertical axis and the level of
output along the horizontal axis. It is evident from the Figure 5.7 that SAFC declines
continuously and becomes asymptotic to the horizontal axis as the level of output increases.
SAFC is also measured by the gap between SATC and SAVC. The gap is very large initially and
narrows down as SAVC becomes asymptotic to SATC as Q increases. SAVC declines initially
and becomes minimum at Q2 level of output. It begins to rise after Q2. The SATC curve falls
initially to its minimum at output level Q3, and it starts rising after that. Both the SATC and
SAVC curves are U-shaped for reasons discussed earlier, The SMC curve is also U-shaped,
O Q1 Q2 Q3
SAFC
SAVC
SATC
SMC SMC
SATCS
AVC
SAFC
Q
Figure 5.7: Short-run average cost curves
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falling initially to Q1 level of output and then starts rising. The SMC curve cuts the SAVC and
SAC curves at their minimum points corresponding to Q2 and Q3 levels of output, respectively.
Derivation of Long-run Cost Curves
In the long-run, all inputs are variable. The firm can increase its output level by changing
production plants in the long-run. There is no fixed input and hence no fixed cost in the long-run.
Hence the long-run total cost curve starts from the origin indicating that total cost is zero when
output is zero. Moreover, it can be shown that the long-run total cost curve is an envelope of the
short-run total cost curves, the firm owner faces a new Short-run Total cost (STC) curve when
she/he changes production plant, she/he can reduce total cost of production by changing
production plants and STCs.
In Figure 5.8, we showed three STC curves for three plants. If the entrepreneur wants to produce
Q1 level of output, she/he can use one of the three production plants. Her/his total cost of
production is Q1U with plant-1, Q1 S with plant-2 and Q1 T with plant-3. Her/his minimum total
cost is Q1T1 with plant-3. By joining minimum cost points like T1 and T2, we obtain the long-run
total cost curve (LTC) which starts from the origin as shown in Figure 5.9. Like STC, LTC also
increases at a decreasing rate initially and then it increases at an increasing rate.
Derivation of Long-Run Average and Marginal Cost Curves
It can be shown that long-run average cost (LAC) curve is also an envelope of short-run average
cost (SAC) curves. It is true, because, the producer can lower the average cost of production by
changing production plants in the long- run. Figure-5.10 shows the derivation of LAC from a
number of SATC curves.
O Q1 Q2
STC
U
S
T1
T2
STC3 STC2 STC1
O
Q
LTC LTC
Q
Figure 5.8 Figure 5.9
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In Figure 5.10, we measure short-run costs along the vertical axis and level of output along the
horizontal axis. In this diagram, we show five short-run average total cost (SATC) curves, each
representing one production plant. The SATC curves have been numbered according to the
number of production plants. Suppose the producer produces Q1 level of output with production
plant-1. The producer wants to increase his production level to Q2, which he can produce using
his old plant-1 or using the new plant-2. Her/his average cost of production is Q2E2 in plant-1
and Q2E3 in plant-2. He/she will use plant-2 since his average cost of producing Q2 level of
output is lower in plant-2 (Q2E3 <Q2E2). Similarly, she/he will produce Q3 level of output using
plant-3. Her/his average cost of production of Q4 level of output will be lower if she/he uses
plant-4 instead using plant-3 (Q4E5 <Q4E6). She/he will use plant-5 for producing Q5 level of
output. By joining the points of minimum average cost like E1, E3, E4, E5, and E7, we get the
long-run average cost (LAC) curve. It is easily seen that the long-run average cost of production
will be minimum if the producer produces Q3 level of output using plant-3. The plant giving rise
to long-run minimum average cost is known as the optimum plant, which is plant-3 in Figure
5.10. We also notice that LAC is tangent to the SATC curves in their falling portions to the left
of the optimum plant. LAC is tangent to the SATC curves in their rising portions to the right of
the optimum plant. In the long-run minimum cost level of output Q3, the LAC curve is tangent to
the SATC curve at its minimum point. It should be noted here that like SATC, LAC curve is also
U-shaped, though it is flatter than the SATC curve. Unlike the LAC curve, the long-run marginal
cost curve is not the envelope of the short-run marginal cost (SMC) curves. We know that there
is a short-run marginal cost curve corresponding to each short-run average cost curve. We find
the short-run marginal cost of each level of output produced in the long- run. We obtain the longrun
marginal cost (LMC) curve by joining the points showing short-run marginal cost of
producing the different levels of output in the long- run. For example, the short-run marginal cost
is Q1E8 for Q1, Q2E9 for Q2, Q3E4 for Q3, Q4E10 for Q4 and Q5E11 for Q5 level of output. We
SMC1
SATC1
SMC2
SATC2
SMC3
SATC3
SMC4
SATC4
SMC5
SATC5
0 Q1 Q2 Q3 Q4 Q5
Q
SAC
SMC
LAC LAC
E1 E2
E8
E3
E9 E4 E5
E10
E7
E6
E11
Figure 5.10: Derivation of long-run average cost curve (LAC)
100
obtain the LMC curve by joining the points like E8, E9,E4, E10 and E11. In Figure 5.11, we show
both the LAC and LMC curves derived in Figure 5.10.
We observe that LMC is less than LAC as long as LAC continues to fall. LMC is equal to LAC at the
minimum point of LAC curve LMC is greater than LAC as long as LAC continues to rise.
LAC
LMC
0 Q3 Q
LAC
LMC
Figure 5.11: Long-run average and marginal cost curves