Question

Discuss why a firm's long run average cost curve is called an envelope curve. Will a firm in the long run always operate with productive efficiency? Discuss and illustrate with a graph. 2)

Answer 1

In the short run, the firm has fixed and variable costs. However, in the long run, all costs are variable. The firm having time-period long enough can build larger scale or type of plant to produce the anticipated output. The long run average cost curve is also U- shaped, but U- shape of the long run average cost curve is flatter than that of the short-run average cost curve. The Long run average cost curve is like an “envelope” which contains all possible short-run cost curves. As all points on a short-run average cost curve lie above or on the long run average cost curve, but never below; that is why Long run average cost curve is called 'envelope curve'.

productive efficiency occurs when a good or a service is produced at the lowest possible cost. A firm in the long run can not always have productive efficiency.

In long-run equilibrium for perfectly competitive markets, productive efficiency occurs where marginal cost equals average total cost. As the firm expands its scale of production, it experiences economies of scale(also called increasing returns to scale). This leads to a fall in long run average cost. However, as the scale of production increase beyond a point, it may experience diseconomies of scale(also known as decreasing returns to scale). This causes an increase in the long run average cost.

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