Question

(1) Draw the diagram showing the relationship between SAC and LAC.

(2) Draw the diagram showing the relationship between SMC and LMC.

Answer 1

(1) Relationship between SAC and LAC -

Short Run Average Cost curve represents the cost per unit of the item produced in the short run, when there is a limit to the production capacity. The limit to the production capacity comes due to constraints on fixed factors, that can be altered in the long run. Below is a depiction of the relationship between long run and short run average cost curves -

This relationship helps in understanding the Long Run Average cost curve as derived by several short run cost curves based on the quantity produced using different stages of the plant. As the firm's size increases, there are changes in the short run cost curves and quantity produced, but there still remains the restriction in capacity of production. In the long run, all factors are variable in nature and hence, there is no restriction to the production capacity. However, the minimum of the Long run cost is due to the economies of scale and hence Long run average curve is never greater than any of the short run average cost curve. LAC is also known as the envelope / planning curve.

Relationship between LAC and LMC -

Long run Marginal cost curve and Long run Average cost curve are related in the same ways as short run marginal and average cost curves in that, the marginal cost curve cuts the average cost curve at its minimum point. However, both the long run curves are flatter than the short run curves due to variable factors and no restrictions to production, making economies of scale possible.

(2) Relationship between LMC and SMC -

Short run Marginal Cost curve refers to the change in total cost due to an increase of one unit of output due to change in variable factor. On the other hand, the Long run Marginal Cost curve is the change in total cost due to increase in one unit of output through increase in all the factors, as all factors are variable in the long run. Thus LMC is flatter than SMC as all factors of production are flexible.

The overall cost curve interaction is as follows, which shows role of the period (long run and short run) on the shapes of the cost curves. This is the optimal situation where SMC = LMC and SAC = LAC and the Average cost = Marginal Cost.