The relationship between short run and long run average cost curves

Average cost curves help businesses understand how costs change with different levels of output. Short run average cost (SRAC) curves apply when some factors of production are fixed, while long run average cost (LRAC) curves show costs when all factors can vary, providing a broader view of efficiency over time.

Short run average cost curves

In the short run, firms have at least one fixed factor of production, such as factory size, which locks them onto a specific SRAC curve. As output increases in the short run, firms adjust variable factors like labour or materials, moving along their current SRAC curve.

Long run average cost curves

The LRAC curve represents the minimum possible average cost for each level of output when all factors of production can be adjusted. It acts as an 'envelope' that encloses multiple SRAC curves, touching each at their lowest points but never allowing them to dip below it. Firms can only achieve the costs shown on the LRAC curve by using the optimal combination of all resources, which may not be possible in the short run due to fixed factors.

How firms move between short run average cost curves in the long run

In the long run, businesses have the flexibility to alter all aspects of production, allowing them to switch to more efficient cost structures as they scale up or down.

Process of shifting between cost curves

When a firm expands output beyond the efficient range of its current SRAC curve, it can invest in changes like larger facilities or more machinery, moving to a new SRAC curve with lower average costs. The LRAC curve guides this process by showing the ideal cost-minimising path; firms aim to operate along it by selecting the most suitable SRAC curve for their desired output level. At the overall minimum point of the LRAC curve, there is an SRAC curve that matches it exactly, representing the most efficient scale where average costs are lowest.

The shape of the long run average cost curve

The LRAC curve typically forms a shallow U-shape, reflecting how average costs change with output in the long run. This shape arises from the balance of cost-saving efficiencies and potential inefficiencies as a business grows.

Characteristics of the long run average cost curve shape

• Downward-sloping section - Average costs decrease as output rises, due to cost advantages from larger-scale operations.
• Upward-sloping section - Beyond a certain point, average costs start to increase, indicating inefficiencies from excessive size.
• Minimum point - The lowest point on the curve shows the optimal output level where average costs are minimised, often aligning with the bottom of a specific SRAC curve.

Internal economies and diseconomies of scale affecting costs

Internal factors within a firm directly influence the shape of its LRAC curve by altering average costs as output changes. These can lead to either savings or rising expenses, depending on the scale.

Internal economies of scale

These occur when average costs fall as output increases, due to efficiencies gained from growth:

• Technical economies - Larger firms can afford advanced machinery or production methods that reduce costs per unit.
• Purchasing economies - Buying materials in bulk often secures lower prices from suppliers.
• Managerial economies - Specialised staff can be hired for roles like finance or marketing, improving efficiency without proportional cost increases.

Internal diseconomies of scale

These arise when average costs rise with higher output, often from management challenges in large organisations:

• Communication issues - Larger firms may face delays or misunderstandings across departments, increasing operational costs.
• Coordination problems - Overseeing a vast workforce becomes harder, leading to inefficiencies and higher average costs.
• Motivational challenges - Employees in big firms might feel disconnected, reducing productivity and raising costs.

At any output level, a firm might experience both economies and diseconomies simultaneously; the net effect determines whether overall costs fall or rise.

External factors that shift the long run average cost curve

Changes outside a firm's control can affect average costs across all output levels, causing the entire LRAC curve to move up or down.

External economies of scale

These lower average costs for all firms in an industry or area:

• Improved infrastructure - Better roads or utilities in a region reduce transport costs for everyone.
• Skilled labour pools - Areas with specialised training centres provide access to qualified workers at lower recruitment costs.
• Supplier networks - Clustering of related businesses can lead to shared resources and reduced input prices.

External diseconomies of scale

These increase average costs industry-wide:

• Resource shortages - High demand for materials in a growing industry can drive up prices.
• Congestion effects - Overcrowded areas may lead to higher transport or labour costs due to competition.

Other external influences on the long run average cost curve

• Taxation changes - An increase in taxes, like higher fuel duty, shifts the LRAC curve upwards by raising costs at every output level.
• Technological advancements - Innovations, such as more efficient software, can shift the curve downwards by allowing better use of resources across all scales.