2.5 Short-run and long-run costs
5 min read•august 16, 2024
Costs in production can be tricky. costs deal with fixed and variable factors, while costs assume all factors can change. This difference impacts how firms make decisions and manage expenses.
Understanding cost curves is key. They show how costs change with output and help firms find the sweet spot for production. Long-run average cost curves give insights into economies of scale and optimal plant size.
Short-run vs Long-run Costs
Time Horizon and Factor Flexibility
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- Short-run costs vary with output when at least one factor of production remains fixed (typically within a timeframe where firms cannot alter scale of operations)
- Long-run costs adjust over time as all factors of production become variable (allowing firms to change scale of operations)
- Key distinction lies in flexibility of input factors and time horizon for decision-making
- Short run firms face constraints on adjusting certain inputs
- Long run all inputs can be varied to optimize production
- Returns to scale concept applies only in long run (involves changes in all production factors)
- Examples of short-run fixed factors
- Factory size
- Specialized equipment
- Examples of long-run adjustable factors
- Labor force size
- Production
Cost Implications and Strategic Decisions
- Short-run cost management focuses on optimizing variable inputs given fixed constraints
- Long-run planning involves strategic decisions about optimal scale and technology
- Firms balance short-term profitability with long-term cost efficiency
- Short-run cost control often targets (raw materials, labor hours)
- Long-run cost reduction may involve capital investments or restructuring
- Examples of short-run cost decisions
- Adjusting production shifts
- Sourcing cheaper raw materials
- Examples of long-run cost decisions
- Building a larger factory
- Investing in automated production lines
Components of Short-run Costs
Fixed and Variable Costs
- (FC) remain constant regardless of output level
- Examples include rent, insurance, salaries of permanent staff
- Variable costs (VC) change directly with output level
- Examples include raw materials, direct labor, energy costs
- (TC) equals sum of fixed costs and variable costs for any given output level
- Formula:
- Average fixed cost (AFC) calculated by dividing total fixed costs by quantity of output
- Formula:
- Average variable cost (AVC) determined by dividing total variable costs by quantity of output
- Formula:
- (ATC) equals sum of average fixed cost and average variable cost
- Alternative calculation divides total cost by quantity
- Formula: or
- (MC) represents additional cost incurred to produce one more unit of output
- Formula:
Cost Behavior and Decision Making
- Understanding cost components crucial for pricing and production decisions
- Fixed costs create operating leverage affecting break-even point and profit sensitivity
- Variable costs directly impact profitability of each unit sold
- Marginal cost guides decisions on whether to increase or decrease production
- Cost structure varies by industry and affects competitive strategies
- Examples of industries with high fixed costs
- Airlines (aircraft leases, airport fees)
- Pharmaceutical companies (research and development)
- Examples of industries with high variable costs
- Retail (inventory, sales commissions)
- Restaurants (food ingredients, hourly wages)
Shape of Short-run Cost Curves
Curve Characteristics and Relationships
- Average fixed cost (AFC) curve slopes downward and approaches both axes asymptotically
- Reflects spreading of fixed costs over increasing output
- Average variable cost (AVC) curve typically U-shaped
- Shows initial increasing returns to variable factor followed by diminishing returns
- Average total cost (ATC) curve also U-shaped
- Combines effects of AFC and AVC curves
- Marginal cost (MC) curve U-shaped and intersects both AVC and ATC curves at their minimum points
- Intersection occurs because MC below AVC or ATC pulls average down, above pulls average up
- Law of diminishing marginal returns explains upward-sloping portions of AVC, ATC, and MC curves
- Additional units of variable input yield progressively smaller increases in output
- Relationship between curves illustrates economic principles
- Economies of scale
- Optimal production level
Economic Implications and Decision Making
- Shape of cost curves guides firms in determining optimal output levels
- Point where MC intersects ATC identifies profit-maximizing output in
- U-shape of ATC curve demonstrates trade-off between fixed cost efficiency and diminishing returns
- Firms operate in region where MC is rising to ensure stable equilibrium
- Cost curve analysis helps in capacity planning and expansion decisions
- Examples of using cost curves for decision making
- Determining whether to accept a one-time order below normal price
- Assessing when to shut down production in the short run
Short-run vs Long-run Average Costs
Long-run Cost Curve Derivation
- Long-run average cost (LRAC) curve derived from short-run average total cost (SRATC) curves for different plant sizes or scales of operation
- LRAC curve forms envelope of all possible SRATC curves
- Represents lowest average cost of production for each output level when all inputs variable
- At any given output level, LRAC curve tangent to most efficient SRATC curve for that output
- Shape of LRAC curve reflects economies of scale, constant returns to scale, and diseconomies of scale as firm expands operations
- Economies of scale occur when LRAC decreases as output increases
- Constant returns to scale present when LRAC remains constant as output changes
- Diseconomies of scale arise when LRAC increases as output expands beyond certain point
Economic Implications and Firm Strategy
- Minimum efficient scale illustrated by point where LRAC curve becomes flat
- Indicates smallest scale at which long-run average costs minimized
- Relationship between short-run and long-run average cost curves demonstrates how firms adjust scale of operations over time to achieve cost efficiency
- LRAC curve helps firms determine optimal long-term plant size and production capacity
- Shape of LRAC curve influences market structure and competitive dynamics
- Firms use LRAC analysis for strategic planning and investment decisions
- Examples of industries with significant economies of scale
- Automobile manufacturing
- Semiconductor production
- Examples of industries with relatively flat LRAC curves
- Local service businesses (barbershops, small restaurants)
- Customized professional services (law firms, consulting)
Key Terms to Review (18)
Allocative Efficiency: Allocative efficiency occurs when resources are distributed in a way that maximizes the total benefit to society, meaning that goods and services are produced at the level where consumer demand equals the cost of production. This condition is met when the price of a good or service reflects the marginal cost of producing it, ensuring that resources are allocated to their most valued uses.
Average Total Cost: Average total cost (ATC) is the total cost of production divided by the quantity of output produced, representing the per-unit cost of production. It includes both fixed and variable costs, giving a comprehensive view of the cost structure a firm faces. Understanding ATC is crucial for firms as it influences pricing decisions and profitability in different market conditions, especially under perfect competition where firms aim to minimize costs to remain competitive.
Decreasing returns to scale: Decreasing returns to scale occurs when an increase in inputs results in a less than proportional increase in output. This concept is essential in understanding how production functions behave in the long run and relates closely to economies and diseconomies of scale. When firms face decreasing returns to scale, expanding production can lead to inefficiencies and rising average costs, impacting overall cost structures and decision-making processes.
Fixed Costs: Fixed costs are expenses that do not change with the level of output produced by a firm. These costs remain constant regardless of how much or how little a company produces, making them essential for understanding cost structures and profitability in various market models. Fixed costs play a crucial role in determining profit margins and influence pricing strategies in competitive markets as well as in monopolistic and oligopolistic settings.
Increasing returns to scale: Increasing returns to scale occur when a proportional increase in all inputs results in a greater proportional increase in output. This concept is crucial because it implies that larger firms can produce more efficiently, leading to lower average costs as production expands. Understanding this phenomenon helps explain how firms can achieve economies of scale and the implications for long-run production and cost structures.
Input prices: Input prices refer to the costs associated with the resources used in the production of goods and services. These costs can include wages, raw materials, and utilities, and they directly impact the overall cost structure for firms. Changes in input prices can influence production decisions, supply levels, and ultimately market equilibrium by affecting how much firms are willing and able to supply at various price points.
Law of Diminishing Returns: The law of diminishing returns states that as more units of a variable input are added to a fixed input in the production process, the additional output generated from each additional unit of input will eventually decrease. This concept is crucial for understanding how short-run and long-run production costs evolve as firms adjust their inputs, affecting their cost structures and optimization strategies.
Long-run: The long-run is a period in economic analysis where all factors of production and costs are variable, allowing firms to adjust all inputs to achieve optimal production levels. In this timeframe, firms can enter or exit the market, and economies of scale can be realized, leading to different cost structures compared to the short-run.
Marginal Cost: Marginal cost is the additional cost incurred by producing one more unit of a good or service. It plays a crucial role in decision-making for firms, as it helps determine optimal production levels, pricing strategies, and resource allocation. Understanding marginal cost also relates to how firms behave in various market structures and influences overall market efficiency and economic growth.
Monopoly: A monopoly is a market structure where a single seller or producer dominates the entire market for a particular good or service, with significant barriers preventing other firms from entering. This leads to a lack of competition, allowing the monopolist to set prices above marginal cost and maximize profits, often resulting in reduced consumer welfare and inefficiencies in the market.
Opportunity Cost: Opportunity cost refers to the value of the next best alternative that is forgone when a choice is made. This concept is central to understanding economic decision-making, as it helps individuals and businesses evaluate trade-offs and make informed choices about resource allocation.
Perfect Competition: Perfect competition is a market structure characterized by a large number of small firms competing against each other, where no single firm can influence the market price. In this environment, products are homogeneous, and there are no barriers to entry or exit, leading to efficient resource allocation and optimal consumer welfare.
Productive efficiency: Productive efficiency occurs when a firm produces its goods at the lowest possible cost, utilizing resources in the most effective way without wasting any. Achieving this means that a firm is operating on its production possibilities frontier, where it cannot produce more of one good without sacrificing the production of another, making it a crucial concept in understanding how firms can maximize their output and minimize costs.
Short-run: The short-run refers to a time period in economic analysis where at least one factor of production is fixed, while others can be varied. This concept is crucial for understanding how firms make decisions regarding production and costs, as it influences the cost structure and output level during this limited timeframe.
Technology: Technology refers to the collection of tools, techniques, methods, and processes that are used to produce goods and services. It plays a crucial role in shaping production efficiency and influencing both short-run and long-run costs for firms, impacting their decision-making regarding resource allocation and production strategies.
Total Cost: Total cost refers to the overall expense incurred by a firm in producing a certain level of output, including both fixed and variable costs. Understanding total cost is essential for making informed production decisions and for analyzing cost behavior in the short run and long run. It serves as a foundational concept in determining optimal production levels and minimizing costs while understanding how costs change with different output levels.
Total Variable Cost: Total variable cost refers to the total expenses that change directly with the level of production. These costs fluctuate based on output; as production increases, total variable costs rise, and as production decreases, these costs fall. This concept is essential in understanding short-run and long-run cost structures, as variable costs play a crucial role in determining overall production efficiency and profitability.
Variable Costs: Variable costs are expenses that change in direct proportion to the level of production or output. These costs increase as more units are produced and decrease when production is reduced, making them a crucial element in understanding the cost structure of a business and its impact on supply decisions, profit maximization, and overall cost efficiency.