Major long term and Short term decisions
In economics, it’s extremely important to understand the distinction between the short run and the long run. As it turns out, the definition of these terms depends on whether they are being used in a microeconomic or macroeconomic context. There are even different ways of thinking about the microeconomic distinction between the short run and the long run.
The long run is defined as the time horizon needed for a producer to have flexibility over all relevant production decisions. Most businesses make decisions not only about how many workers to employ at any given point in time (i.e. the amount of labor) but also about what scale of an operation (i.e. size of factory, office, etc.) to put together and what production processes to use. Therefore, the long run is defined as the time horizon necessary not only to change the number of workers but also to scale the size of the factory up or down and alter production processes as desired.
In contrast, economists often define the short run as the time horizon over which the scale of an operation is fixed and the only available business decision is the number of workers to employ. (Technically, the short run could also represent a situation where the amount of labor is fixed and the amount of capital is variable, but this is fairly uncommon.) The logic is that even taking various labor laws as a given, it’s usually easier to hire and fire workers than it is to significantly change a major production process or move to a new factory or office. (One reason for this likely has to do with long-term leases and such.) As such, the short run and the long run with respect to production decisions can be summarized as follows:
- Short run: Quantity of labor is variable but the quantity of capital and production processes are fixed (i.e. taken as a given).
- Long run: Quantity of labor, the quantity of capital, and production processes are all variable (i.e. changeable).
The long run is sometimes defined as the time horizon over which there are no sunk fixed costs. In general, fixed costs are those that don’t change as production quantity changes. In addition, sunk costs are those that can’t be recovered after they are paid. A lease on a corporate headquarters, for example, would be a sunk cost if the business has to sign a lease for the office space. Furthermore, it would be a fixed cost because, after the scale of the operation is decided on, it’s not as though the company will need some incremental additional unit of headquarters for each additional unit of output it produces.
Obviously the company would need a larger headquarters if it decided to make a significant expansion, but this scenario refers to the long-run decision of choosing a scale of production. There are no truly fixed costs in the long run since the firm is free to choose the scale of operation that determines the level at which the costs are fixed. In addition, there are no sunk costs in the long run, since the company has the option of not doing business at all and incurring a cost of zero.
In summary, the short run and the long run in terms of cost can be summarized as follows:
- Short run: Fixed costs are already paid and are unrecoverable (i.e. “sunk”).
- Long run: Fixed costs have yet to be decided on and paid, and thus are not truly “fixed.”
The two definitions of the short run and the long run are really just two ways of saying the same thing since a firm doesn’t incur any fixed costs until it chooses a quantity of capital (i.e. scale of production) and a production process.
Market Entry and Exit
Economists differentiate between the short run and the long run with regard to market dynamics as follows:
- Short run: The number of firms in an industry is fixed (even though firms can “shut down” and produce a quantity of zero).
- Long run: The number of firms in an industry is variable since firms can enter and exit the marketplace.
The distinction between the short run and the long run has a number of implications for differences in market behavior, which can be summarized as follows:
The Short Run:
- Firms will produce if the market price at least covers variable costs, since fixed costs have already been paid and, as such, don’t enter the decision-making process.
- Firms’ profits can be positive, negative, or zero.
The Long Run:
- Firms will enter a market if the market price is high enough to result in positive profit.
- Firms will exit a market if the market price is low enough to result in negative profit.
- If all firms have the same costs, firm profits will be zero in the long run in a competitive market. (Those firms that have lower costs can maintain positive profit even in the long run.)
In macroeconomics, the short run is generally defined as the time horizon over which the wages and prices of other inputs to production are “sticky,” or inflexible, and the long run is defined as the period of time over which these input prices have time to adjust. The reasoning is that output prices (i.e. prices of products sold to consumers) are more flexible than input prices (i.e. prices of materials used to make more products) because the latter is more constrained by long-term contracts and social factors and such. In particular, wages are thought to be especially sticky in a downward direction since workers tend to get upset when an employer tries to reduce compensation, even when the economy overall is experiencing a downturn.
The distinction between the short run and the long run in macroeconomics is important because many macroeconomic models conclude that the tools of monetary and fiscal policy have real effects on the economy (i.e. affect production and employment) only in the short run and, in the long run, only affect nominal variables such as prices and nominal interest rates and have no effect on real economic quantities.