Long run average cost

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The long run average cost (LRAC or LAC) curve illustrates - for a given quantity of production - the average cost per unit which a firm faces in the long run (i.e. when no factors of production are fixed).

LRAC curve is derived from a series of short run average cost curves. It is also called the 'envelope curve' since it envelops all the short run average cost curve.

In perfect competition, the LRAC curve is flat, at the point of equilibrium- there are constant returns to scale. Typical LRACs are U-shaped, which means that up to a certain optimum point, there are economies of scale, and as production increases beyond this, there are diseconomies of scale. LRAC are generally flatter than short run average cost curve.

In some industries, the LRAC is L-shaped, and economies of scale increase indefinitely. This means that the largest firm tends to have a cost advantage, and the industry tends naturally to become a monopoly, and hence is called a natural monopoly. Natural monopolies tend to exist in industries with high capital costs in relation to variable costs, such as water supply and electricity supply.