Question

The long-run average cost curve is called the envelope curve as it envelops the SAC's. Comment.

Short answer

Q: Comment on the long-run average cost (LRAC) curve, also known as the envelope curve, and its relationship with the short-run average cost (SAC) curves. A: The LRAC curve, or envelope curve, shows the lowest possible average cost for a firm in the long run for every production level. It envelops the SAC curves by marking the lowest point of each SAC curve, considering all possible production facility sizes and input combinations. This optimality can be reached by firms adjusting both labor and capital in the long run, as opposed to only adjusting labor in the short run. The distinctive shape of the envelope curve reflects the firm's ability to choose the optimal production level and input combination in the long run.

Step-by-step solution

Define Short-run Average Cost

Short-run Average Cost (SAC) refers to the average cost of production when at least one input, typically capital, is fixed. This means that the company can only adjust certain inputs, like labor, to change output levels. So the SAC curve represents the average cost of producing varying output levels with a fixed amount of capital.

Define Long-run Average Cost

Long-run Average Cost (LRAC) refers to the average cost of production when all inputs, including capital, can be adjusted. In the long run, companies can enter or exit a market and adjust the size of their production facilities, which allows them to invest in more or less capital. As a result, the LRAC represents the lowest average cost achievable when the firm has the freedom to choose the optimal combination of inputs for any level of output.

Relationship between SAC and LRAC

There are multiple short-run average cost curves, each of which corresponds to a specific level of fixed capital. The long-run average cost curve is formed by plotting the lowest point of each short-run average cost curve. In other words, the LRAC curve represents the minimum average cost that can be achieved for each level of output by adjusting both labor and capital optimally as opposed to only adjusting labor in the short run.

Explain the Envelope Curve

The Long-run average cost curve "envelops" the Short-run average cost curves because it marks the boundary for the lowest possible average cost for each level of output, considering all possible sizes of production facilities and input combinations. The LRAC acts as an envelope because it "hugs" the lowest points of each of the individual SAC curves, and as such, it represents the optimal production level for the firm in the long run.

Comment on the Envelope Curve

In conclusion, the long-run average cost curve, also known as the envelope curve, envelops the short-run average cost curves, because it represents the lowest possible average cost for the firm in the long run for every level of output. Firms can achieve this optimality by adjusting both labor and capital in the long run, as opposed to only adjusting labor in the short run. The envelope curve's distinctive shape is the result of the firm's ability to choose the optimal production level and input combination.