Cost curve Totally Explained

Everything about Long Run Average Cost totally explained

In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of production, where they make the most profits. There are a few different types of cost curves, each relevant to a different area of economics.

The Short Run average total cost curve (SATC or SAC)

The average total cost curve is constructed to capture the relation between cost per unit and the level of output, ceteris paribus. A productively efficient firm organizes its factors of production in such a way that the average cost of production is at lowest point and intersects Marginal Cost. In the short run, when at least one factor of production is fixed, this occurs at the optimum capacity where it has enjoyed all the possible benefits of specialisation and no further opportunities for decreasing costs exist. This is usually not U shaped, it's a checkmark shaped curve. This is at the minimum point in the diagram on the right.Example: Q=2K^.5L^.5 STC=Pk(K)+Pw(Q²/4K) SATC or SAC= (Pk(K)/Q)+Pw(Q/4K)

The long-run average cost curve (LRAC)

The long-run average cost curve depicts the per unit cost of producing a good or service in the long run when all inputs are variable. The curve is created as an envelope of an infinite number of short-run average total cost curves. The LRAC curve is U-shaped, reflecting economies of scale when negatively-sloped and diseconomies of scale when positively sloped. Contrary to Viner, the envelope isn't created by the minimum point of each short-run average cost curve. This mistake is recognized as Viner's Error.
   In the long run, when all factors of production can be changed, the scale of the enterprise can be increased. In this case productive efficiency occurs at the optimum scale of output where all the possible economies of scale have been enjoyed and the firm isn't large enough to experience diseconomies of scale. This at output level Q2 in the diagram.
   In perfect competition, the LRAC curve is flat, at the point of equilibrium- there are constant returns to scale. Typical LRACs are U-shaped, which means that up to a certain optimum point, there are economies of scale, and as production increases beyond this, there are diseconomies of scale. LRAC are generally flatter than short run average cost curve.
   In some industries, the LRAC is L-shaped, and economies of scale increase 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.

The marginal cost curve (MC)

A marginal cost that graphically represents the relation between marginal cost incurred by a firm in the short-run product of a good or service and the quantity of output produced. This curve is constructed to capture the relation between marginal cost and the level of output, holding other variables, like technology and resource prices, constant. The marginal cost curve is U-shaped. Marginal cost is relatively high at small quantities of output, then as production increases, declines, reaches a minimum value, then rises. The marginal cost is shown in relation to marginal revenue, the incremental amount of sales that an additional product or service will bring to the firm. This shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing marginal returns - Diminishing returns).

Combining cost curves

Cost curves can be combined to provide information about firms. In this diagram for example, firms are assumed to be in a perfectly competitive market. The marginal cost curve will cut the average cost curve at its lowest point. In a perfectly competitive market a firm's profit maximising price would be at or above the price at which the average cost curve cuts the marginal cost curve. If the marginal revenue is above the average total cost price the firm is deriving an economic profit.

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