Srmc Srmc

Output

Figure 5.5 Lerner's Diagram

Costs

Output

Figure 5.6 Relations among Long Run Average and Marginal Cost Curves an expansion path, and for each different internal rate of return we have a different long run total cost curve. The lower the internal rate, the lower the total cost of producing an output, and as the area under the marginal cost curve is always equal to the total costs, at every output, the long run marginal cost curve associated with a lower interest rate cannot lie above the long run marginal cost curve associated with a higher internal rate. If the long run marginal cost curve for a lower internal rate always lies below the long run marginal cost curve for a higher internal rate, then the difference in total costs for the different interest rates will increase with output. It follows that the minimum points of higher return long run average cost curves occur at lower outputs than the minimum points of lower return long run average cost curves.11 It also follows that the long run average cost curve for a lower rate of return is always below the long run average cost curves for a higher rate of return. The long run average cost curves are completely nested within one another.

Even though the long run marginal cost curve depends upon the rate of return used in its construction, the short run marginal cost curve is independent of the rate of return.12 This is based on the assumption that the short run variable factors are truly short run. If we take a two factor production indifference map, we have that the short run marginal cost curve is based upon holding 'capital' constant while varying 'labor', whereas the long run marginal cost curve is based upon the expansion path where both are variable. In Figure 5.7, the amount of capital K0 can be used to produce Output O1 and Output O2. The short run marginal cost schedule for capital K0 is the rate of change in total cost as output is changed. This short run marginal cost schedule is independent of whether the rate of return used in the expansion path is r2 or r1. However, if the internal rate is r2, and the planned output is O2, then the combination L2 of labor and K0 of capital is the lowest cost combination. On the other hand, if the internal rate is r1, and the planned output is O1, then the combination of L1 of labor and K0 of capital is the lowest cost combination. If the amount of capital K0 is 'costed' at r1, then the long run total cost curve at output O1 based upon the rate of r1, and the short run total cost curve for plant K0 are equal. Short run total costs, costing capital at rate r1, for outputs both smaller and larger

Labor

Expansion path r1

, Expansion path r,

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