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A study of cost of production in this article shall complete our understanding of the supply side scenario. We have analyzed producer’s behaviour to understand how a producer will reach to the least cost factor-combinations based on efficient methods of production for a level of output. However, while doing so we only considered factors of production in physical terms since the production relations were considered in a purely technical form.
We will attempt to translate such technical input-output relationship into a financial one. In short, this article will discuss a relationship between output and the cost of inputs required to carry out the production in monetary terms. Such a discussion will ultimately help a firm in achieving profit maximization under different market conditions.
Conventionally speaking, cost includes all the direct and indirect expenses incurred by a firm to produce output of a product. Even the cost of selling the product is also a part of the basic concept of the cost.
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Just to illustrate, cost includes the items like payment for workers and management personnel, for raw materials, fuels, transportation and so on. It also includes interest paid by the firm for borrowed money, rent paid for building and, royalty for technology. From the view point of a business economist, even a normal amount of profit is also a part of cost.
Alternative Cost Concepts:
In simple terms, production cost is the total expenditure incurred by a firm on various factors of production and inputs it procures to undertake the production process. However, such a simplified notion is not enough to capture all the granular details. In the Price Theory, we use different cost concepts for different purposes. These concepts highlight different facets of the cost and they are important from different view point.
For example, opportunity cost is important from an economist’s view point while explicit cost and sunk cost are essential for an accountant. Similarly, social cost is important from the societal view point. Therefore, understanding alternative cost concepts is important for a clear and better understanding of the cost.
To be specific, the important cost concepts are as follows:
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1. Opportunity or Alternative cost
2. Private cost or Money cost
3. Social cost
4. Explicit cost, Implicit cost, Accounting cost, out-of-pocket cost and Economic cost
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5. Sunk cost
6. Historical and Replacement cost
7. Fixed vs. variable cost or supplementary vs. prime cost
1. Opportunity Cost or Alternative Cost:
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The cost associated with the opportunity lost in the economy due to scarcity of resources is known as opportunity or the alternative cost. The resources in any economy are limited and can be put to many alternative uses. That is, different goods and services can be produced from the available set of resources. In the backdrop of scarcity of resources, we have to take a decision in favour of a particular production opportunity at the cost of many other opportunities which have to be foregone. The cost associated with the next best opportunity, which has to be foregone, is known as opportunity cost or the alternative cost.
According to Gould and Lazear, the alternative or opportunity cost of producing one unit of commodity X is the amount of commodity Y that must be sacrificed in order to use resources to produce X rather than Y.
It can be illustrated with the help of an example. Assume that a person has two offers of job. He is offered Rs.50000 per month in one case while Rs.45000 per month in other. Other things remaining the same, he will opt for the first offer which provides him a higher salary. In this situation, he has to forego the second opportunity of earning Rs.45000 per month. Thus, the opportunity cost of his decision to join the first job would be Rs.45000 per month.
In a sense, it is a notional cost associated with the opportunity lost.
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2. Private Cost or Money Cost:
Private cost, which is also known as money cost, includes all heads of expenses which can be measured in the monetary form.
Broadly speaking, all the elements of the private cost can be placed under the following three heads:
1. An entrepreneur mobilizes various inputs from the market to carry out the production process. For example, he hires work force, borrows capital, procures technology etc. To all of them, he has to make direct payments, such as wages and salaries, interest, royalties etc. The firm will also purchase different raw materials and will pay for them as well. All these expenses are included in the private cost.
2. Secondly, the entrepreneur may also use his own resources in the production process. For example, he may invest his personal savings in the firm and/or invest time in managing the business. Imputed reward for such contributions to the production process is also accounted for in the private cost.
3. Lastly, all private production activities are motivated by profit earning and, hence, the private cost should also include normal profit as one of its components. In the absence of normal profit, the entrepreneur will have no interest in continuing the production activities.
To reiterate —
Private cost = Payments to procured factors + Imputed reward to entrepreneur owned factors + Normal profits
3. Social Cost:
Social cost is the total burden of producing a commodity on the society. It is the cost incurred by the entrepreneur for undertaking production (i.e. the private cost) as well as the liability borne by the society (i.e. the external cost). It may be clarified that the external cost is also associated with the production but not borne by the firm. Its burden falls on the society. As such, the social cost is summation of private cost and external cost.
Social Cost = Private Cost + External Cost
The implication of the external cost borne by the society can be understood by the following example:
Suppose there is a chemical plant located on the bank of a river. It disposes its untreated chemical waste in the river. This would, certainly, improve the profitability of the firm as the firm does not incur any expenditure on the treatment of the waste materials. However, this act of the firm will pollute the river. In due course of time, water of the river may become unusable for consumption. This will affect the society adversely in a number of ways, such as health problems for the nearby population and scarcity of drinking water. The larger such negative externalities the higher would be the external cost on the society. At some stage, the society may have to incur huge expenditure in cleaning the river. In the worst case, some of the damages may be irreversible.
4. Explicit Cost, Implicit Cost, Accounting Cost and Economic Cost:
i. Explicit Cost:
The explicit cost includes those expenses of the firm which are easily identifiable and can be accounted for. It represents clear and obvious cash payments or outflows from the firm’s accounts for the factors not owned by the owner.
For example, wages paid to the workers, salaries to the managers, rent for building and royalties for technological inputs are the components of the explicit cost. It also includes the payments made to the suppliers for various raw materials and intermediates. All these cost components involve transfer of money from the firm to the factor owners and suppliers and, hence, referred as the explicit cost. It is also called as outlay cost.
Accounting Cost or Out-of-Pocket Cost:
Since the concept of explicit cost is widely used by the accountants to prepare various financial statements, it is also referred as accounting cost or out-of-pocket cost. Therefore —
Explicit Cost = Accounting cost = Out-of-pocket cost
ii. Implicit Cost or Book Cost:
In contrast, implicit cost is the imputed opportunity cost of the resources for which the firm does not make any direct cash payment.
For example, an owner managing his own factory will not draw a salary directly from the factory accounts. However, if he would have worked in some other factory as a manager, he would have earned a salary. The amount of best expected salary from the alternative job is taken as implicit cost of the owner’s contribution in the production process. Similar examples of the implicit cost can be indicated when owner provides his own building or capital for the factory use.
In all such cases, imputed values are to be estimated and added up to determine the total implicit cost. Such elements of cost are also called as book cost.
To illustrate it, let us presume that an owner of a small production unit has set up his office in one of the rooms of his residence and, hence, does not charge any rent from the factory. However, had he rented the same to someone else he would have earned a rent of Rs.2000 per month. In this case, the imputed implicit cost for the firm would be Rs.2000 per month for the office building.
iii. Economic Cost:
From the view point of economic decision making, both the explicit and implicit costs are important. Therefore, the economic cost is defined as a summation of the two, i.e.,
Economic Cost = Explicit Cost + Implicit Cost
5. Sunk Cost:
Sunk cost is the expenditure incurred in the past but becomes unusable due to some reason and, hence, is treated as lost or sunk completely. It can neither be recovered nor be put into any alternative use. Being unusable, it has no implications for future economic decisions and, hence, an economist ignores it. In contrast, an accountant has to book a capital loss in balance sheet against the sunk cost.
It can be illustrated from the following example:
Suppose a country has set up an electricity generating plant based on nuclear source. However, it could not make the plant operational because the required heavy water could not be arranged for some reason. Further, there is no other alternative for getting the heavy water. As the plant has no alternative use, investment has to be written off and to be considered as sunk expenditure. Such investment constitutes sunk cost.
Sunk Cost and Fixed Cost:
One should be clear that the sunk cost is different from the fixed cost. While the sunk cost is completely lost and non-recoverable as it has no alternative use, the fixed cost components are recoverable to an extent. For example, the fixed cost incurred as salary to permanent employees will cease to burden the firm once production is stopped and employees are relieved from the job.
Likewise, if a firm decides to go out of business, some recovery is possible from the machinery and equipment installed as well. The firm can dispose them off to some other producer, as it has alternative uses. Therefore, both the sunk cost and the fixed cost should be treated separately.
6. Historical and Replacement Cost:
Historical cost is the cost which a producer has incurred to create an asset. The sum spent by a producer, say, for setting up plant and machinery or for purchasing a piece of land or a building is the historical cost. On the other hand, replacement cost is one which is required in a current period to replace the asset.
For example, suppose a firm has purchased an office accommodation for Rs.20 lakhs in 2005. The same accommodation is now priced at Rs.90 lakhs in 2013. In this case, the historical cost will be Rs.20 lakhs while its replacement cost will be Rs.90 lakhs.
7. Fixed Vs. Variable Cost or Supplementary Vs. Prime Cost:
A distinction as fixed and variable cost is made in short run. Short run is a period in which quantum of some of the factors remain unchanged. Hence, the costs associated with such factors are known as fixed cost. They include the factors like building, plants, machinery & equipment and, technology.
They are treated as fixed because all of them are to be produced first before they can be deployed in the production process. As their production takes time, their contribution in the short run cannot be changed. It is also known as supplementary costs’ or overhead cost or indirect cost or unavoidable cost.
The factors whose quantum can be changed in short run are known as variable factors and the costs associated with them are termed as variable cost. Thus, output can be increased during the short period only by deploying more of the variable factor.
In a two factor production model, capital is treated as a fixed factor while labour as a variable one. It is also known as prime costs or direct cost or avoidable cost.
However, such a distinction will disappear in long run in which a firm enjoys a complete freedom to change the quantum of all the factors of production. Thus, cost of both capital and labour, in a two factor model, will be treated as variable cost. There will be no fixed cost in the long run.
Cost Behaviour of a Firm in Short Run:
Based on the above short run cost function, the following three basic cost concepts can be identified:
1. Total Fixed Cost
2. Total Variable Cost
3. Total Cost
Further, following cost curves can be derived from these three cost concepts:
1. Average Fixed Cost
2. Average Variable Cost
3. Average Cost
4. Marginal Cost
A brief discussion on each of them has been carried out in the following paragraphs:
Total fixed cost is associated with the fixed factors of production, which remains constant irrespective of the level of output. It means that the total fixed cost will remain same even if the firm produces no output or produces at full capacity during short run.
For example, suppose an entrepreneur invests Rs.5 lakhs on building, machinery and technology to establish a production capacity of 5000 units of soap bar per month. During first month, it produced no output while in the second and third month his output levels are 2000 & 5000 units respectively. Now the question is what will be his fixed cost in each of the three months? The obvious answer is a same Rs.5 lakhs, despite varying levels of output.
This is depicted in Figure-9.1 which shows the total fixed cost (Rs.5 Lakhs) as a straight line parallel to X-axis or the quantity axis indicating that whatsoever the level of output the total fixed cost remains the same (Rs.5 Lakhs).
The total variable cost is the cost associated with the variable factors of production. It depends upon the level of output. Higher the level of output higher will be the total variable cost. This cost will be zero if the firm stops production altogether. The TVC is graphically shown in Figure-9.2.
It is clear from the above figure that the TVC curve assumes a shape of inverse S, which can be explained as follows:
i. It starts from the point of origin which implies that at zero output level the TVC will be zero.
ii. As the output increases, the variable cost will increase but not proportionately. This happens because of the Law of variable proportions. According to it, as the output increases, initially the law of increasing return to the variable factor will enforce a proportionately smaller increase in cost due to a better utilization of fixed factors of production.
Such an output-cost relationship is represented by the OS segment of the TVC curve in the Figure-9.2. This segment of the TVC is tilted towards X-axis or the quantity axis indicating a proportionately smaller increase in cost than that of the output. This trend will gradually push the production to an optimal level at the point S.
iii. After point S, the production will enter into the law of diminishing return to the variable factor and the cost will increase faster than the output. This will be reflected in falling productivity of the variable factor. It is depicted as the SR portion of the TVC curve in the figure, which is tilted towards Y-axis or the cost axis indicating a proportionately higher increase in cost than that of the output.
iv. It short, it can be stated that as the output increases, the TVC initially increases at a diminishing rate and later on at an increasing rate. It provided an inverse S shape to the TVC curve.
The total cost of production in short run is simply a summation of total fixed cost and total variable cost at each level of output. That is, TC = TFC + TVC. Since the TC at each level of output is a vertical summation of total fixed and variable costs, the shape of TC curve depends upon the shapes of the TFC and TVC curves.
Figure-9.3, in this regard, shows that the TC curve assumes the same shape as that of TVC curve. The TFC does not affect its shape since it is same at all the levels of output. However, the TC curve is placed above the TVC curve at a vertical distance equal to the TFC. It means that the TC curve has the same slope as that of TVC curve while the vertical distance between the TC and TVC curves is equal to TFC.
Based on above, the total cost at output level OQ in Figure-9.3 can be estimated as follows —
TFC = PT, TVC = TQ and, TC = PQ
Thus, PQ = PT + TQ
Based on the above three cost curves in terms of total, we can derive three kinds of average cost curves and a marginal cost curve, which are explained below:
The AFC is the fixed cost per unit of output. It is calculated as the total fixed cost divided by the level of output. That is, AFC = TFC/Q.
Since the TFC remains same, the AFC will fall as the output increases. This implies that as the firm produces more output, the average fixed cost will be less and less. However, it will never be zero as a positive number divided by another positive number will always results into a positive number. As such, the AFC curve will never meet the X-axis or the quantity axis. Such behaviour of AFC will provide a rectangular hyperbola shape to the AFC curve, as shown in the following Figure-9.4.
2. Average Variable Cost (AVC):
The AVC curve can be defined as the variable cost per unit of output. It can be calculated by dividing the total variable cost by the level of output. That is, AVC = TVC/Q.
The shape of AVC curve is shown below in the Figure-9.5.
It can be observed from the figure that the AVC does not change proportionately with the increase in the output. Initially, it declines as the output increases and reaches its minimum at a certain level of output. Subsequently, it starts rising. This happens due to Law of Variable Proportion. Such behaviour of variable cost leads to a U shaped AVC curve, as shown in the Figure-9.5.
Moreover, the left side of the AVC curve, before reaching the minimum level, is much smaller than the right side of the curve. This is because the law of increasing return applies for much shorter range of output than the law of diminishing return. Technically speaking, between these two stages, the AVC will be at its minimum where law of constant return will apply.
The Average Cost is the Total Cost divided by the number of units of output produced, i.e., AC = TC/Q. It is also termed as unit cost which measures total cost per unit of output. The AC curve is also a U shaped curve (Figure- 9.6).
Since the TC is the sum of the TFC and TVC, the AC is also a sum of AFC and AVC. The relationship between AC, AFC and AVC can be shown as follows —
TC = TVC + AVC
TC/Q = TVC/Q + TFC/Q
Or, AC = AVC + AFC
The shape of AC curve depends upon the AFC and AVC curves. The AC curve falls sharply in the beginning since both the AFC and AVC fall. Gradually the AC curve becomes flatter as the fall in AFC becomes smaller while AVC starts rising after reaching its minimum. In this process, the AC will reach to its minimum value.
Subsequently, the AC will increase continuously as the output level increases. This is due to a rising AVC with a declining AFC, the former being much larger than the latter. Such behaviour will provide a U shape to the AC curve. Such relationship between the three curves is exhibited diagrammatically in Figure-9.6.
The MC is the incremental cost of producing the next unit of output or one additional unit of output. In other words, MC of the Nth unit of a commodity (MCN) will be –
(TC of producing N units) – (TC of producing N-1 units)
Or, MCN = TCN – TCN-1
A calculation of MC has been illustrated in the following example:
For the above example, diagrammatically, the MC curve will also look like a U, as shown below in Figure-9.7:
The figure shows that in the beginning MC falls as the output increases due to rising factor productivities. This continues till it reaches its minimum. Subsequently, it starts rising as the production enters the stage of diminishing return to the variable factor.
Incidentally, it may be pointed out that the MC is no way related to fixed cost since the fixed cost does not change with the level of output. Hence, there cannot be a marginal fixed cost. The MC is just the addition to the TVC when output is increased by one unit.
Relationship between Different Cost Curves:
The relationship between all the short run average and marginal cost curves can be illustrated by the following example:
The relationship shown across various cost concepts in the above Table can be used to highlight the following observations:
1. The TFC remains same while the TVC and the TC increases as the output level rises in accordance with the Law of Variable Proportion.
2. The TFC being the same at all the output levels, the AFC falls continuously from Rs.200 to just Rs.20 per unit, as output increases from 1 to 10 units. It will continue to do so if the output further increases. However, it will never become zero. Thus, we will continue to get a positive AFC despite its falling value.
3. The AVC declines from Rs.180 at output level one to Rs.130 at output level four due to rising productivities emerging out of the law of increasing return on the variable factor. At this level of output, the AVC reaches its minimum. It starts rising from the 5th unit of output to reach at Rs.260 per unit at the 10th unit of output. In this range of output firm encounters diminishing return on its variable factor leading to falling factor productivities. Such behaviour is reflected in a U shaped AVC curve.
4. The AC, which is summation of AFC and AVC, falls from Rs.380 per unit at the output level one to Rs.174 per unit at the 5th unit of output. This is the minimum level that the AC will reach to. Subsequently, it Start5 rising and reaches to Rs.280 per unit at the 10th unit of output.
5. Similarly, the MC also falls as the output increases but reaches its minimum much before AVC and AC. In the above example, its minimum is Rs.100 at the 2nd unit of output. In contrast, the AVC reaches its minimum at the 4th unit of output while the AC at the 5th unit of output.
6. Such behaviour of average and marginal cost curves further signifies that every plant is pre-designed to produce a single level of output optimally where AC will be at its minimum.
The above explained relationship between average and marginal cost curves can also be depicted diagrammatically in the following Figure-9.8.
One can make following observations based on Figure-9.8:
i. The AVC, AC and MC are U shape curves while AFC takes a downward sloping curve.
ii. Further, the AC curve is placed above the AVC curve with a vertical gap of the AFC.
iii. The gap between AC and AVC is more on its left hand segment (i.e., at the lower level of output) while the two comes closer as the output increases. The gap between the two represents the AFC which falls continuously as the output increases. It needs to be noted here that AVC and AC will never meet as the AFC will never become zero.
iv. Another point to note is that the AVC reaches its minimum (point A) earlier than that of the AC (point B).
v. The MC also falls initially but starts rising after reaching its minimum. However, its minimum (point C) comes before the minimum of the AC (point B) and the AVC (point A).
vi. This indicates that the MC will lie below AVC and AC when it is falling. While rising, the MC passes first through AVC and then the AC at their respective minimum. Thus, MC equals AVC and AC at their minimum.
vii. After this, the MC curve will lie above the AVC and the AC. This is because change in MC is much faster than the AVC and AC whether it is falling or rising.
Relationship between AC and MC:
Based on above Figure-9.8, specific points regarding the relationship between AC and MC can be stated as follows:
i. Both the AC and MC curves fall in the beginning. However, the MC reaches to its minimum first (point C) and starts rising. AC continues to fall and reaches to its minimum subsequently at a higher output level (point B).
ii. Up to this level, AC exceeds MC (AC > MC) and the AC curve lies above the MC curve.
iii. MU becomes equal to AC when the latter is at its minimum. As such, the MC curve intersects the AC curve at a point where the AC is at minimum.
iv. Following it, the MC exceeds AC (AC < MC) and the MC curve lies above the AC curve.
Cost Behaviour of a Firm in Long Run:
The long run cost behaviour of a firm can be understood with the help of following three types of costs curves:
1. Long Run Total Cost (LTC) curve
2. Long Run Average Cost (LAC) curve
3. Long Run Marginal Cost (LMC) curve
The LTC curve shows the least possible total cost of production for different levels of output under the condition of all factors are variable. The LTC curve can be derived from the short run total cost (STC) curves as there is a close relationship between LTC curve and all the STC curves.
Given that there are infinite plant sizes available in the long run, we can draw infinite STC curves, each belonging to a plant size and, each one of them will be represented by a point on the LTC curve. In other words, each point on the LTC curve will represent a STC curve. It is a point where the STC curve is tangent to LTC curve.
2. Long Run Average Cost Curve (LAC):
The LAC can be defined as the LTC divided by the level of output. That is, LAC = LTC/Q.
As per the traditional theory, the LAC curve is a U shaped curve, as shown in Figure-9.9. It shows that the LAC first declines, up to an output level OQ1, reaching to the minimum at point T and then rises. This is similar to a SAC curve with only difference in that the LTC curve is flatter than the SAC curve.
The U shaped LAC curve is attributable to the laws of returns to scale.
i. As the firm expands its scale of operation, scale economies result in an increasing returns to scale and, hence, the LAC declines.
ii. This is followed by constant returns to scale when the LAC is at its minimum (Point T).
iii. Subsequently, the LAC rises because diminishing returns to scale will come in force. As such, LAC curve assumes a positive slop.
Features of LAC Curve:
The LAC curve is a continuous curve i.e., each point of the LAC curve originates from a point on the SAC curve. At that point, the LAC curve is tangent to the SAC curve. Further, it is tangent to the SAC curves on the left of their minimum points when the LAC curve is falling and on the right of their minimum points when the LAC curve is rising. The LAC curve touches the minimum of SAC curve only when the optimum plant size is reached. This shows that the LAC curve presents a cumulative picture of the SAC curves.
Such a shape of the LAC curve implies that every plant is best suited to produce a single level of output optimally and there is no built-in flexibility in the form of reserve capacity. If the output produced is more or less, even by one unit, the average cost will not minimum. This drawback of the traditional theory has been rectified in the modern cost theory which provides a L-shaped cost curve in place of the U shaped one.
The LAC curve envelops all the SAC curves and, hence, also called an envelope curve. As such, neither any portion of the LAC curve can lie above any of the SAC curves nor it can intersect any of them. Each point of LAC will be a point of tangency with the SACs.
The LAC curve is also called a planning curve as it helps the firm to take a decision about the most appropriate size of the plant. Based on it, the firm chooses a short run plant which allows it to produce the anticipated output at the least possible cost.
Derivation of LAC Curve from SAC Curves:
The LAC curve can be deduced from the SAC curves. In order to derive it, let us assume that there are three methods of production at a particular point of time given the state of technology. Each of them has a different plant size or scale of operation: small, medium and a large one. Their respective cost curves are represented by SAC1, SAC2 and SAC3 as shown in the Figure-9.10(a).
Following discussion can be carried out on the basis of Figure-9.10(a):
i. The firm starts production with the small plant (SAC1) and produces OQ1 output at least average cost of R1Q1.
ii. Increasing the output from this level to OQ2 will lead to rising average cost (R4Q2) if the firm continues with SAC1. On the other hand, if the firm moves on to SAC2, the medium sized plant, the long run average cost of producing OQ2 will be only R2Q2.
iii. For an even higher level of output (OQ3), the firm can lower its average cost (R3Q3) in the long run by way of moving to large sized plant (SAC3) from medium sized plant (R5Q3).
iv. The long run average cost curve can be constructed by joining least cost points of the three SACs [Figure-9.10(b)].
Replacing the assumption of the only three plants to numerous plants, as in reality, the firm can obtain a continuous least average cost in the long run. Each of the numerous SAC curves will be suitable for a certain level of output. Joining all such points, as attempted in Figure 9.11, we get a continuous LAC curve which envelops all the SAC curves.
Each point of the so derived LAC curve will show a minimum cost for producing the corresponding level of output. This will be the optimal average cost for a given output level. The firm can, thus, use it to plan a suitable plant size for any desired level of output.
Based on this, the LAC curve can be defined as locus of tangency points with all the SAC curves.
LAC Curve and Constant Returns to Scale:
In case an industry is working under constant returns to scale, SAC curves will have a same level of least cost irrespective of level of output, as shown in Figure-9.12. The figure shows a same level of SAC (R1q1 = R2Q2 = R3Q3) even when output increases from OQ1 to OQ2 and further to OQ3. This indicates a scale neutral industry. Such a scenario will be observed when the industry follows a linear homogenous production function of first degree, such as a Cobb-Douglas production function.
In short, the important characteristics of the LAC curve vis-a-vis SAC curve can he highlighted as follows:
i. Both LAC and SAC curves are U-shaped though the former is flatter.
ii. The LAC curve shows minimum average cost at each level of output.
iii. It is used by the firm for planning purposes.
iv. It is an envelope curve enclosing all SAC curves.
v. It never intersects any of the SAC curves.
3. Long Run Marginal Cost Curve (LMC):
The LMC can be defined in a similar manner as an SMC. That is, an increase in LTC when an extra unit of output is produced. That is —
LMC = LTCn – LTCn-1
It can be derived with the help of LAC curve, SAC curves and SMC curves. For it,
i. We first derive LAC curve from SAC curve.
ii. Subsequently, we draw perpendicular on quantity axis (Le. X-axis) from the point of tangency of SAC curves and LAC curve.
iii. Those perpendiculars will intersect the SMC curve associated with the respective SAC curves.
iv. A curve joining the points of such intersections will form the long run LMC. Such a derivation has been attempted in Figure 9.13.
In short, the locus of points of intersection of the SMC curves with the vertical lines drawn from the points of tangency of corresponding SAC and LAC curves will form LMC curve.
A close look to the LMC curve shows that it lies below the LAC curve to the left of minimum point; it intersects the LAC curve at the minimum point and moves above the LAC curve to the right of minimum point. At the minimum point, where LMC intersect the LAC, both the short and long run average and marginal costs are equal. That is —
LAC = LMC = SAC = SMC
However, unlike LAC, it does not envelope the short run marginal cost curve.
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