Cost Curve - Long-run Average Cost Curve (LRAC)

Long-run Average Cost Curve (LRAC)

The long-run average cost curve depicts the cost per unit of output in the long run—that is, when all productive inputs' usage levels can be varied. All points on the line represent least-cost factor combinations; points above the line are attainable but unwise, while points below are unattainable given present factors of production. The behavioral assumption underlying the curve is that the producer will select the combination of inputs that will produce a given output at the lowest possible cost. Given that LRAC is an average quantity, one must not confuse it with the long-run marginal cost curve, which is the cost of one more unit. The LRAC curve is created as an envelope of an infinite number of short-run average total cost curves, each based on a particular fixed level of capital usage. The typical LRAC curve is U-shaped, reflecting increasing returns of scale where negatively-sloped, constant returns to scale where horizontal and decreasing returns (due to increases in factor prices) where positively sloped. Contrary to Viner, the envelope is not created by the minimum point of each short-run average cost curve. This mistake is recognized as Viner's Error.

In a long-run perfectly competitive environment, the equilibrium level of output corresponds to the minimum efficient scale, marked as Q2 in the diagram. This is due to the zero-profit requirement of a perfectly competitive equilibrium. This result, which implies production is at a level corresponding to the lowest possible average cost, does not imply that production levels other than that at the minimum point are not efficient. All points along the LRAC are productively efficient, by definition, but not all are equilibrium points in a long-run perfectly competitive environment.

In some industries, the bottom of the LRAC curve is large in comparison to market size (that is to say, for all intents and purposes, it is always declining and economies of scale exist indefinitely). This means that the largest firm tends to have a cost advantage, and the industry tends naturally to become a monopoly, and hence is called a natural monopoly. Natural monopolies tend to exist in industries with high capital costs in relation to variable costs, such as water supply and electricity supply.