Long-run average total cost (LRATC) is a powerful business metric that reflects the average cost per unit of output in the long run, assuming all inputs are variable and production scale can change. The LRATC curve demonstrates the minimum total cost to produce any level of output over a prolonged period.
In long-term scenarios, unit costs tend to decrease compared to the short-term because companies have the flexibility to modify significant operational aspects, like expanding factories, to enhance optimal efficiency. Both management and investors strive to identify the lower limits of LRATC.
Understanding Long-Run Average Total Cost
Imagine a manufacturing company that constructs a new, larger plant. The long-term expectation is that the LRATC per unit will be lower than that of the old plant, thanks to economies of scale or cost advantages from enhanced production scope. As the production scale enlarges, average costs drop, production efficiency rises, and the company gains market competitiveness. This scenario, benefitting both consumers and producers with reduced prices and increased profits, is often deemed a positive-sum game.
Key Takeaways
- LRATC measures the average cost per unit over the long run.
- Companies gain flexibility to alter operations in the long run, enhancing efficiency.
How to Visualize Long-Run Average Total Cost
LRATC is visually represented as a curve illustrating the lowest costs achievable over time for different output levels. This LRATC curve can appear similar to several short-run average total cost curves combined, reflecting continuous operational improvements.
The LRATC curve can be divided into three segments or phases:
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Economies of Scale: Costs reduce as production efficiency improves. Initial product development incurs higher costs, but as more production lines are added, repeating and replicating operations lower those costs.
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Constant Returns to Scale: The company attains peak efficiency, stabilizing production costs. Bulk raw material sourcing and streamlined operational processes contribute to this stability.
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Diseconomies of Scale: Growing beyond an optimal point introduces higher costs due to added layers of bureaucracy and management, affecting overall decision-making and efficiency.
Example of Long-Run Average Total Cost
Consider the video game industry. Developing a game involves high initial costs. However, the expense of producing additional copies is marginal. Once the company establishes itself and increases the game’s demand, extra output to meet that demand decreases the overall long-term costs.
Related Terms: unit costs, economies of scale, constant returns to scale, diseconomies of scale.
