BE/U4 Topic 2 Short run cost, Long run Cost
The Short-run Cost is the cost which has short-term implications in the production process, i.e. these are used over a short range of output. These are the cost incurred once and cannot be used again and again, such as payment of wages, cost of raw materials, etc.
In a short-run, at least one factor of production is fixed while the other remains variable. Therefore, in the short-run, the level of output can be increased only by increasing the variable factors such as labor, raw materials while the other factors such as capital, plant size, remains unchanged. The short-run cost includes both the fixed cost (that do not change with the change in the level of output) and variable cost (that varies with the variations in the level of output). Some factors remain fixed due to the time constraints imposed on a company.
For example, Suppose a company observes a sudden surge in the demand for its goods and in order to meet the increased demand in the short-run, it can increase its level of output only by varying the variable factors. Such as, the company can employ more labor or purchase the raw material in bulk, but however, the plant size or the machinery cannot be altered to enhance the production capacity of the firm. Thus, all the cost incurred on the variable factors such as labor and raw material constitutes the short-run cost.
From an analytical point of view, the short run costs vary with the change in the total output, but however, the size of the firm remains the same. Thus, the short-run cost is treated as a variable cost.
Short-Run Total Cost
A typical short-run total cost curve (STC) is shown in Fig. 1 This curve indicates the firm’s total cost of production for each level of output when the usage of one or more of the firm’s resources remains fixed.
When output is zero, cost is positive because fixed cost has to be incurred regardless of output. Examples of such costs are rent of land, depreciation charges, license fee, interest on loan, etc. They are called unavoidable contractual costs. Such costs remain contractually fixed and so cannot be avoided in the short run.
The only way to avoid such costs is by going into liquidation. The total fixed cost (TFC) curve is a horizontal straight line. Total variable is the difference between total cost and fixed cost. The total variable cost curve (TVC) starts from the origin, because such cost varies with the level of output and hence are avoidable. Examples are electricity tariff, wages and compensation of casual workers, cost of raw materials etc.
In Fig. 1 the total cost (OC) of producing Q units of output is total fixed cost OF plus total variable cost (FC).
Clearly, variable cost and, therefore, total cost must increase with an increase in output. We also see that variable cost first increase at a decreasing rate (the slope of STC decreases) then increase at an increasing rate (the slope of STC increases). This cost structure is accounted for by the law of Variable Proportions.
The Long-run Cost is the cost having the long-term implications in the production process, i.e. these are spread over the long range of output. These costs are incurred on the fixed factors, Viz. Plant, building, machinery, etc. but however, the running cost and the depreciation on plant and machinery is a variable cost and hence is included in the short-run costs.
The long-run cost is incurred when the firm decides to change its production capacity over time in order to respond to the anticipated economic profits and losses. In short-run, all the factors of production and costs are variable and hence the level of output can be changed by varying all the factors, the even capital.
In the long run, even the fixed cost becomes the variable cost as the size of the firm or scale of production increases. The entrepreneurship, land, labor, capital goods, etc. all vary to attain the desired level of profits in the long run, and the cost of each factor adds to the long-run costs.
The long-run stage is characterized by planning and implementation wherein the producer decides on the level of production and take long-run decisions that affect the overall cost of the firm. The long-run decisions include leaving or entering the market, expanding or contracting the company’s operations, changing the quantity of production, etc.
Long Run Total Cost
Long run Total Cost (LTC) refers to the minimum cost at which given level of output can be produced. According to Leibhafasky, “the long run total cost of production is the least possible cost of producing any given level of output when all inputs are variable.” LTC represents the least cost of different quantities of output. LTC is always less than or equal to short run total cost, but it is never more than short run cost.
As shown in Figure, short run total costs curves; STC1, STC2, and STC3 are shown depicting different plant sizes. The LTC curve is made by joining the minimum points of short run total cost curves. Therefore, LTC envelopes the STC curves.
Long Run Average Cost
Long run Average Cost (LAC) is equal to long run total costs divided by the level of output. The derivation of long run average costs is done from the short run average cost curves. In the short run, plant is fixed and each short run curve corresponds to a particular plant. The long run average costs curve is also called planning curve or envelope curve as it helps in making organizational plans for expanding production and achieving minimum cost.
Suppose there are three sizes of the plant and no other size of the plant can be built. In short run, the plant sizes are fixed thus, organization increase or decrease the variable factors. However, in the long run, the organization can select among the plants which help in achieving minimum possible cost at a given level of output.
From Figure, it can be noted that till OB amount of production, it is beneficial for the organization to operate on the plant SAC2 as it entails lower costs than SAC1. If the plant SAC2 is used for producing OA, then cost incurred would be more. Thus, in the long run, it is clear that the producer would produce till OB on plant SAC2. On SAC2, the producer would produce till OC amount of output. If an organization wants to exceed output from OC, it will be beneficial to produce at SAC3 than SAC2.
Thus, in the long run, an organization has a choice to use the plant incurring minimum costs at a given output. LAC depicts the lowest possible average cost for producing different levels of output. The LAC curve is derived from joining the lowest minimum costs of the short run average cost curves.
It first falls and then rises, thus it is U- shaped curve. The returns to scale also affect the LTC and LAC. Returns to scale implies a change in output of an organization with a change in inputs. In the long run, the output changes with respect to change in all inputs of production.
In case of increasing returns to scale (IRS), organizations can double the output by using less than twice of inputs. LTC increases less than the increase in the output, thus, LAC falls. In case of constant returns to scale (CRS), organizations can double the output by using inputs twice.
LTC increases proportionately to the output; therefore, LAC becomes constant. On the other hand, in case of decreasing returns to scale (DRS), organizations can double the output by using inputs more than twice. Thus, LTC increases more than the increase in output. As a result, LAC increases.
As shown in Figure, up to M, LAC slopes downward. This is because at this stage IRS is applied. On the other hand, at M, LAC becomes constant. After M, LAC slopes upwards implying DRS.
Long Run Marginal Cost
Long run Marginal Cost (LMC) is defined as added cost of producing an additional unit of a commodity when all inputs are variable. This cost is derived from short run marginal cost. On the graph, the LMC is derived from the points of tangency between LAC and SAC.
If perpendiculars are drawn from point A, B, and C, respectively; then they would intersect SMC curves at P, Q, and R respectively. By joining P, Q, and R, the LMC curve would be drawn. It should be noted that LMC equals to SMC, when LMC is tangent to the LAC.
In Figure, OB is the output at which
SAC2 = SMC2 = LAC = LMC
We can also draw the relation between LMC and LAC as follows:
When LMC < LAC, LAC falls
When LMC = LAC, LAC is constant
When LMC > LAC, LAC rises