The difference between short-run and long-run average costs

Average costs represent the total cost of production divided by the quantity of output. They behave differently depending on whether a firm is operating in the short run or the long run, due to the flexibility in adjusting factors of production.

Short-run average costs

In the short run, at least one factor of production is fixed, such as capital equipment or factory size. This restricts the firm to operating on a specific short-run average cost (SRAC) curve, like SRAC_A.

As output increases in the short run, the firm can only adjust variable factors, such as labour or raw materials. This means the firm moves along its existing SRAC curve.

Long-run average costs

In the long run, all factors of production are variable, allowing the firm to adjust everything, including capital and technology. This enables the firm to switch to a new SRAC curve, such as SRAC_B, to optimise production.

Firms can scale up or down fully, choosing the most efficient combination of inputs for any output level.

The long-run average cost curve and its relationship to short-run curves

The long-run average cost (LRAC) curve shows the lowest possible average cost for producing each level of output when all factors can be varied. It acts as an envelope for multiple short-run average cost curves.

Features of the LRAC curve

• The LRAC curve is formed by connecting the minimum points of various SRAC curves.
• SRAC curves can touch the LRAC curve at their lowest points but cannot dip below it.
• At any given output, operating on the LRAC requires using the optimal mix of all factors of production.
• In the long run, firms can adjust all factors to reach this minimum cost level on the LRAC curve.
• There is typically one SRAC curve that touches the LRAC at the overall minimum point of both curves.

How internal economies and diseconomies of scale shape the LRAC

The shape of the LRAC curve is primarily influenced by internal economies and diseconomies of scale, which affect how average costs change as output expands.

Internal economies of scale

These occur when average costs decrease as output increases, causing the LRAC curve to slope downwards. Economies arise from factors within the firm, such as bulk purchasing discounts or specialised machinery that spreads fixed costs over more units.

Internal diseconomies of scale

These happen when average costs increase as output grows, making the LRAC curve slope upwards. Diseconomies stem from internal issues, like management challenges or communication breakdowns in very large organisations.

Net effect on the LRAC curve

• Firms can experience both economies and diseconomies at the same output level; the overall shape depends on which has the stronger impact.
• If economies dominate, average costs fall; if diseconomies prevail, costs rise.
• The typical LRAC curve is U-shaped: falling initially due to economies, reaching a minimum, then rising due to diseconomies.

External factors that shift the LRAC curve

External changes, beyond the firm's control, can shift the entire LRAC curve, affecting average costs at every output level.

External economies of scale

These reduce average costs across an industry or region, shifting the LRAC curve downwards. Examples include improved infrastructure, such as better transport networks, or access to a skilled labour pool in a specialised area.

External diseconomies of scale

These increase average costs, shifting the LRAC curve upwards. Causes might include congestion in a growing industry hub or rising resource prices due to high demand.

Other external influences on the LRAC curve