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Long-Run Supply Curve

Long-Run Supply Curve

Author: Kate Eskra

Determine the relationship between short-run and long-run average cost curves.

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Source: Image of Short Run Situations Graph created by Kate Eskra, Image of Long Run Supply Curve graph created by Kate Eskra

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Hi. Welcome to economics. This is Kate. This tutorial is on the Long Run Supply Curve. As always, any key terms are in red and any examples are in green.

In this tutorial, I'll be discussing the shape of the short run average cost curve. And you'll see that the long run average cost curve has a similar shape to that short run, and it's comprised of many short run average cost curves. You'll be able to recognize where a firm experiences economies and diseconomies of scale along its long run average cost curve.

OK. So since we're talking about short run and long run average cost curves, I figured I would just show you a reminder as to how we calculate any kind of average cost. Here we're looking at average total cost. So how I got these numbers is just taking the total cost column and dividing by the quantity.

Notice on this chart here, you can see how the average total cost falls at first and then rises in average cost curves will be the shape. And you'll see that graphically in a minute. But this, I wanted to show you, just represents one short run scenario.

OK. So let's talk about the short run. In the short run, a firm will be operating on what we call a fixed scale, because there's at least one fixed input. They can certainly vary some things, like the number of workers they hire or machines that they purchased, but there's one input at least that's fixed, like the size of their factory.

OK. So there-- as I showed you where average cost is falling at first and then rising, that results in a U shaped short run average cost curve. And they fall at first because of economies of scale, but also because of specialization of the workers and things like that. And then average costs eventually rise because of the law of diminishing marginal returns, which shows that at some point with our inputs when we hire too many workers, they're helping still probably to increase total production, but it's just that the next worker isn't quite as good as the one before in terms of what they add to total production.

What the firm does in the short run is they basically, given their constraints, they maximize profit or minimize loss. OK. So you've probably seen a graph like this before. And notice I'm just reminding you of some of the situations here. We use these cost curves to show that we can break even if price equals an average total cost. If price is up above average total cost, they're profitable. When they can't cover AVC, that's where we need to consider shutting down, down below here. And when they can cover it, they'll operate at a loss in between the two curves.

But this shows us that everything above the shutdown price that made up our short run supply curve. OK. But now we need to talk about the long run, because that's the subject of this tutorial. In the long run, all inputs and costs become variable. And so now the firm can alter its factory size and they really can affect their scale of operation.

And what we mean by scale of operation is how big are they going to get? So for example, a local business might decide not just to have one retail store anymore, but to open up more locations across the region and operate on a much bigger scale. Those things are only potential for a business in the long run.

OK. So again, the long run average cost curve will also be U shaped. And now we're really looking at economies of scale and diseconomies of scale. And we'll be looking at what happens to our average cost as we increase the scale of production.

So here's what it looks like. I know this looks like a whole lot. But what this is is-- SRAC stands for short run average cost. OK. So each of these SRACs represent a potential scale of operation. So this one here, this short run average cost curve 1, might be when that local business just opened up and had one store. Then maybe they open up a couple more stores in the region. Then they go, I don't know, and they're operating across the state. Then they're operating in the tri-state area. Then here's like maybe McDonald's once they've got national.

Whatever. They each represent a different scale of operation, and as we move to the right, you can see they're producing a much greater quantity. So the business is getting bigger as we move along these short run average cost curves. OK.

What the long run average cost curve is, is it's derived from all of these short run different scenarios. And what we do is we find the lowest point of every short run average cost curve and we draw our long run average cost curve. How we would use this sometimes is-- so let's say that the firm knew that they wanted to produce at output level quantity 3. What they would do is they would use the short run situations to see which short run size would minimize their costs.

And as you can see, if they want to produce this quantity, average cost curve 2 that would place us way up here in terms of average cost. So that would be way over-utilizing this size of a factory, let's say. We're too crammed. If we want to produce this much, we are way over-utilizing that plant size. But we're not big enough to get justified moving over here to short run average cost curve 4.

So the idea is that short run average cost scenario 3 would be the one that would be the best, if in fact we're going to stick with the quantity 3. OK. But now in the long run, the long run will always, like I said, be equal to or lie below any short run curve. Because in the long run, we would never operate at higher average costs than in the short run.

All inputs are variable, and so there are no constraints to minimizing costs. That's why this is the case. OK. So ultimately the goal here is to find which scale of operation will minimize average costs in the long run. Should we stay small? Should we get big? Should we grow really big? And as you can see in this picture, in the long run this fourth size minimizes our costs in the long run.

So what we're going to notice is that we experience economies of scale up to this point. And economies of scale is going to be defined as where your average costs are falling as you get bigger, meaning it's economical to grow in size. Past this point, notice as we get bigger and bigger and bigger, our average costs actually begin to rise again, and that's diseconomies of scale, where it's not economical anymore to grow your business any bigger than that. So here this would be the best size.

So in this tutorial, we talked about how the long run average cost curve is comprised of many of those short run average cost curves, with each of them representing a different scale or a different size of operation. The long run average cost curve declines when the firm is experiencing economies of scale, and then it rises when the firm experiences diseconomies of scale. The idea is that the firm is going to choose the scale of operation that minimizes their average cost in the long run. Thank you so much for listening. Have a great day.