Question

True or false? Explain your reasoning. a. The short-run average total cost can never be less than the long-run average total cost. b. The short-run average variable cost can never be less than the long-run average total cost. c. In the long run, choosing a higher level of fixed cost shifts the long-run average total cost curve upward.

Short answer

Question: Analyze the truth of the following statements and provide reasoning for your answers: a) Short-run average total cost is always greater than or equal to long-run average total cost. b) Short-run average variable cost can never be less than long-run average total cost. c) Choosing a higher level of fixed cost always increases the long-run average total cost curve. Answer: a) True - The long-run average total cost (LRATC) is the lowest cost that can be achieved at each output level when all inputs are adjustable, which makes it equal to or lower than the short-run average total cost (SRATC) at any given output. b) False - In some cases, the short-run average variable cost may be less than the long-run average total cost, as it does not account for fixed costs. c) The statement is true only if an increase in fixed costs leads to lower variable costs and greater efficiency. In other cases, where higher fixed costs do not result in increased efficiency or lower variable costs, the statement would be false.

Step-by-step solution

Statement a: Short-run average total cost and long-run average total cost comparison

To determine the truth of this statement, we need to understand the relationship between short-run average total cost (SRATC) and long-run average total cost (LRATC). The SRATC is the average cost incurred in the short run when some factors of production are fixed, while the LRATC is the average cost incurred when all factors of production are variable, meaning the firm can adjust its scale of production. The LRATC is the lowest average total cost that can be achieved at each level of output when all inputs are adjustable. In other words, the LRATC is the "envelope" of an infinite number of SRATC curves, each representing a different level of fixed inputs. As such, it is always equal to or lower than the SRATC at any given output level. For this reason, statement a is *true*.

Statement b: Short-run average variable cost and long-run average total cost comparison

Now let's analyze the relationship between short-run average variable cost (SRVC) and long-run average total cost (LRATC). The short-run average variable cost includes only the variable costs of production, such as labor and raw materials. The long-run average total cost, on the other hand, includes both variable and fixed costs. In the short run, average variable cost may be lower than the long-run average total cost, as it does not account for fixed costs. However, in the long run, all costs become variable, and the long-run average total cost reflects the lowest possible cost structure for each output level. Therefore, it is possible for the short-run average variable cost to be less than the long-run average total cost, making statement b *false*.

Statement c: Choosing a higher level of fixed cost and its effect on the long-run average total cost curve

Lastly, we need to analyze how choosing a higher level of fixed costs impacts the long-run average total cost curve. In the long run, all costs are variable, and firms can adjust their scale of production by choosing the optimal level of fixed and variable factors to minimize the average total cost. A higher level of fixed costs may allow a firm to achieve lower average variable costs by choosing a more efficient production process or technology. However, if a firm opts for higher fixed costs without any gains in efficiency or production, the long-run average total cost curve will be higher, meaning that the firm will have higher average total costs at each output level. Consequently, the statement c is *true* if an increase in fixed costs leads to lower variable costs and greater efficiency. In other cases, where higher fixed costs do not result in increased efficiency or lower variable costs, the statement would be *false*.

Key concepts

Short-Run Average Total Cost (SRATC)

The Short-Run Average Total Cost, abbreviated as SRATC, is a crucial concept in economics. It reflects the average cost per unit of output when at least one factor of production is fixed. In other words, in the short run, businesses cannot change all inputs immediately.
The SRATC curve is typically U-shaped due to the law of diminishing returns. Initially, as production increases, costs per unit decrease due to increased efficiency. However, after reaching a certain point, the cost per unit may rise again as some factors become overutilized. This behavior leads to a characteristic U-shaped curve.
SRATC curves differ based on the various fixed input levels. Importantly, each level of fixed input has its own SRATC curve. A singular SRATC curve cannot be lower than the Long-Run Average Total Cost (LRATC) at any output level, making it an envelope of these various SRATC curves.

Long-Run Average Total Cost (LRATC)

The Long-Run Average Total Cost, or LRATC, is intimate with businesses’ operational flexibility. In the long run, all factors of production are variable. This means that businesses can scale their operations to achieve the most cost-efficient level of production for any output quantity.
The LRATC curve is also U-shaped, capturing economies of scale at its downward slope and diseconomies of scale at its upward slope. It effectively represents the lowest possible cost at which any output level can be produced when all inputs are adjustable.
LRATC acts as an envelope for all possible SRATC curves; it touches each SRATC at its minimum point. This implies that adjusting scale and resources is key for cost efficiency, and the LRATC will always be equal to or lower than SRATC at any output level.

Fixed Costs vs Variable Costs

Understanding the difference between fixed and variable costs is fundamental to grasping cost behavior in economics. Fixed costs do not change with the level of output. They encompass expenses like rent, salaries of permanent staff, and machinery costs. Regardless of how much is produced, fixed costs remain constant.
Variable costs, on the other hand, fluctuate with the level of production. They include costs such as raw materials, energy consumption, and wages directly linked to production levels.
In the short run, businesses carry both fixed and variable costs. In the long run, all costs are considered variable since companies have the flexibility to adjust all inputs. This flexibility aids in achieving optimal production efficiency.

Production Efficiency

Production efficiency in economics refers to producing the maximum output with given resources or producing a given output at the lowest possible cost. It is a reflection of how well a firm utilizes its resources.
Achieving production efficiency means minimizing waste and exploiting economies of scale. Efficient production processes lead to lower average costs, which can enhance a firm’s competitive edge in the market.
Businesses strive for production efficiency to enhance profitability. By selecting optimal levels of fixed and variable factors of production, firms can operate at the lowest point on the long-run average total cost curve. This results in the most cost-effective production level achievable.

Economies of Scale

Economies of Scale refer to the cost advantages that a firm can realize by increasing its level of production. As production scales up, the average cost per unit typically decreases. This happens because fixed costs are spread over a larger volume of output, and efficiencies are gained in both the production process and procurement of materials.
There are two types of economies of scale: internal and external. Internal economies arise from within the company due to improved operational efficiencies or innovations. External economies result from industry-wide factors or regional advantages.
Economies of scale continue to lower long-run average costs only up to a point. Beyond certain production levels, diseconomies of scale may kick in, leading to increased average costs due to over-complex production processes or management inefficiencies. Understanding where economies of scale transition to diseconomies is crucial for firms to maintain competitive advantage.