Cost in Short Run and Long Run

(With Diagram)
Cost in Short Run:
It may be noted at the outset that, in cost accounting, we adopt
functional classification of cost. But in economics we adopt a
different type of classification, viz., behavioural classification-cost
behaviour is related to output changes.

In the short run the levels of usage of some input are fixed and costs
associated with these fixed inputs must be incurred regardless of the
level of output produced. Other costs do vary with the level of output
produced by the firm during that time period.

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The sum-total of all such costs-fixed and variable, explicit and

implicit- is short-run total cost. It is also possible to speak of semi-
fixed or semi-variable cost such as wages and compensation of
foremen and electricity bill. For the sake of simplicity we assume
that all short run costs to fall into one of two categories, fixed or
variable.

Short-Run Total Cost:

A typical short-run total cost curve (STC) is shown in Fig. 14.3. 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. 14.3 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.

Average and Marginal Cost:

One can gain a better insight into the firm’s cost structure by
analysing the behaviour of short-run average and marginal costs.
We may first consider average fixed cost (AFC).

Average fixed cost is total fixed cost divided by output,

i.e., AFC = TFC /Q

Since total fixed cost does not vary with output average fixed cost is
a constant amount divided by output. Average fixed cost is relatively
high at very low output levels. However, with gradual increase in
output, AFC continues to fall as output increases, approaching zero
as output becomes very large. In Fig. 14.4, we observe that the AFC
curve takes the shape of a rectangular hyperbola.

We now consider average variable cost (AVC) which is arrived at by

dividing total variable cost by output,

i.e., AVC= — TVC/Q

In Fig. 14.4, AVC is a typical average variable cost curve. Average
variable cost first falls, reaches a minimum point (at output level Q2)
and subsequently increases.
The next important concept is one of average total cost (ATC).

It is calculated by dividing total cost by output,

It is, therefore, the sum of average fixed cost and average variable
cost.

The ATC curve, illustrated, is U-shaped in Fig. 14.4 because the AVC
cost curve is U-shaped. This is accounted for by the Law of Variable
Proportions. It first declines, reaches a minimum (at Q3 units of
output) and subsequently rises. The minimum point on ATC is
reached at a larger output than at which AVC attains its minimum.
This point can easily be proved.
ATC = AFC + AVC

We know that and that average fixed cost continuously falls over the
whole range of output. Thus, ATC declines at first because both AFC
and AVC are falling. Even when AVC begins to rise after Q2, the
decrease in AFC continues to drive down ATC as output increases.
However, an output of Q3 is finally reached, at which the increase in
AVC overcomes the decrease in AFC, and ATC starts rising.
Since ATC = AFC + AVC, the vertical distance between average total
cost and average variable cost measures average fixed cost. Since
AFC declines over the entire range of output. AVC becomes closer
and closer to ATC as output increases.

We may finally consider short-run marginal cost (SMC). Marginal

cost is the change in short-run total cost attributable to an extra unit
of output: or

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Short-run marginal cost refers to the change in cost that results

from a change in output when the usage of the variable factor
changes. As Fig. 14.4 shows, marginal cost first declines, reaches a
minimum at Qx (note that minimum marginal cost is attained at a
level of output less than that at which AVC and ATC attain their
minimum) and rises thereafter.
The marginal cost curve intersects AVC and ATC at their respective
minimum points. This result follows from the definitions of the cost
curves. If marginal cost curve lies below average variable cost curve
the implication is clear: each additional unit of output adds less to
total cost than the average variable cost.
Thus average variable cost has to fall. So long as MC is above AVC,
each additional unit of output adds more to total cost than AVC.
Thus, in this case, AVC must rise.

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Thus when MC is less than AVC, average variable cost is falling.

When MC is greater than AVC, average variable cost is rising. Thus
MC must equal AVC at the minimum point of AVC. Exactly the same
reasoning would apply to show MC crosses ATC at the minimum
point of the latter curve.

a. Short-run Cost Functions:

Summary of the Main Points All the important short-run cost
relations may now be summed up:

The total cost function may be expressed as:

TC = k + ƒ(Q) where k is total fixed cost which is a constant, and
ƒ(Q) is total variable cost which is a function of output.

ATC = k/Q + ƒ(Q)/ Q = AFC + AVC. Since k is a constant and Q

gradually increases, the ratio k/Q falls. Hence the AFC curve is a
rectangular hyperbola.

Here

where ƒ'(Q) is the change in TVC and may be called marginal

variable cost (MVC). Thus, it is clear that MC refers to MVC and has
no relation to fixed cost. Since business decisions are largely
governed by marginal cost, and marginal costs have no relation to
fixed cost, it logically follows costs do not affect business decisions.

b. Relation between MC and AC:

There is a close relation between MC and AC. When AC is falling,
MC is less than AC. This can be proved as follows:

When AC is falling,
c. Cost Elasticity:
On the basis of the relation between MC and AC we can develop a
new concept, viz., the concept of cost elasticity. It measures the
responsiveness of total cost to a small change in the level of output.

It can be expressed as:

So it is the ratio of MC to AC.

The properties of the average and marginal cost curves and their
relationship to each other are as described in Fig. 14.4. From the
diagram the following relationships can be discovered.

(1) AFC declines continuously, approaching both axes

asymptomatically (as shown by the decreasing distance between
ATC and AVC) and is a rectangular hyperbola.

(2) AVC first declines, reaches a minimum at Q2and rises thereafter.

When AVC is at its minimum, MC equals AVC.
(3) ATC first declines, reaches a minimum at Q3, and rises there-
after. When ATC is at its minimum, MC equals ATC.
(4) MC first declines, reaches a minimum at Q1, and rises thereafter.
MC equals both AVC and ATC when these curves are at their
minimum values.
The lowest point of the AVC curve is called the shut (close)- down
point and that of the ATC curve the break-even point. These two
concepts will be discussed in the context of market structure and
pricing. Finally, we see that MC lies below both AVC and ATC over
the range in which these curves decline; contrarily, MC lies above
them when they are rising.

Table 14.2 numerically illustrates the characteristics of all the cost

curves. Column (5) shows that average fixed cost decreases over the
entire range of output. Columns (6) and (7) depict that both average
variable and average total cost first decrease, then increase, with
average variable cost attaining a minimum at a lower output than
that at which average total cost reaches its minimum. Column (8)
shows that marginal cost per 100 units is the incremental increase
in total cost and variable cost.

If we compare columns (6) and (8) we see that marginal cost (per
unit) is below average variable and average total cost when each is
falling and is greater than each when AVC and ATC are rising.

Long-Run Costs: The Planning Horizon:

We may recall from our discussion of production theory that the
long run does not refer to ‘some date in the future. Instead, the long
run simply refers to a period of time during which all inputs can be
varied.

Therefore, a decision has to be made by the owner and/or manager

of the firm about the scale of operation, that is, the size of the firm.
In order to be able to make this decision the manager must have
knowledge about the cost of producing each relevant level of output.
We shall now discover how to determine these long-run costs.’

Derivation of Cost Schedules from a Production Function:

For the sake of analysis, we may assume that the firm’s level of
usage of the inputs does not affect the input (factor) prices. We also
assume that the firm’s manager has already evaluated the
production function for each level of output in the feasible range and
has derived an expansion path.

For the sake of analytical simplicity, we may assume that the firm
uses only two variable factors, labour and capital, that cost Rs. 5 and
Rs. 10 per unit, respectively.

The characteristics of a derived expansion path are shown in

Columns 1, 2 and 3 of Table 14.4. In column (1) we see seven output
levels and in Columns (2) and (3) we see the optimal combinations
of labour and capital respectively for each level of output, at the
existing factor prices.

These combinations enable us to locate seven points on the

expansion path.

Column (4) shows the total cost of producing each level of output at
the lowest possible cost. For example, for producing 300 units of
output, the least cost combination of inputs is 20 units of labour and
10 of capital. At existing factor prices, the total cost is Rs. 200. Here,
Column (4) is a least-cost schedule for various levels of production.

In Column (5), we show average cost which is obtained by dividing

total cost figures of Column (4) by the corresponding output figures
of Column (1). Thus, when output is 100, average cost is Rs. 120/100
= Rs. 1.20. All other figures of Column (5) are derived in a similar
way.

From column (5) we derive an important characteristic of long-run

average cost: average cost first declines, reaches a minimum, then
rises, as in the short-run. In Column (6) we show long-run marginal
cost figures.
Each such figure is arrived at by dividing change in total cost by
change in output. For example, when output increases from Rs. 100
to Rs. 200, the total cost increases from Rs. 120 to Rs. 140.
Therefore, marginal cost (per unit) is Rs. 20/100 = Re. 0.20.
Similarly, when output increases from 600 to 700 units, MC per
unit is 720-560/100 =160/100 =1.60

Column (6) depicts the behaviour of per unit MC: marginal cost first
decreases then increases, as in the short run.

We may now show the relationship between the expansion path and
long-run cost graphically. In Fig. 14.6 two inputs, K and L, are
measured along the two axes. The fixed factor price ratio is
represented by the slope of the isocost lines I1I’1, l2l’2 and so on.
Finally, the known production function gives us the isoquant map,
represented by Q1, Q2and so forth.

From our earlier discussion of long-run production function we

know that, when all inputs are variable (that is, in long-run), the
manager will choose the least cost combinations of producing each
level of output. In Fig. 14.6, we see that the locus of all such
combinations is expansion path OP’ B’R’S’.

Given the factor-price ratio and the production function (which is

determined by the state of technology), the expansion path shows
the combinations of inputs that enables the firm to produce each
level of output at the lowest cost.

We may now relate this expansion path to a long-run total cost

(LRTC) curve. Fig. 14.7 shows the ‘least cost curve’ associated with
expansion path in Fig. 14.6. This least cost curve is the long-run to-
tal cost curve. Points P,B,R and S are associated with points P’, B’, R’
and S’ on the expansion path. For example, in Fig. 14.6 the least cost
combination of inputs that can produce Q1 is K1 units of capital and
L1 units of labour.
Thus, in Fig. 14.7, minimum possible cost of producing Q1 units of
output is TC1, which is K1 + wL1, i.e., the price of capital (or the rate
of interest) times K1, plus the price of labour (or the wage rate) times
L1. Every other point on LRTC is derived in a similar way.

Since the long run permits capital-labour substitution, the firm may
choose different combinations of these two inputs to produce
different levels of output. Thus, totally different production
processes may be used to produce (say) Q 1 and Q2 units of output at
the lowest attainable cost.
On the basis of this diagram we may suggest a definition of the long
run total cost. The time period during which even/thing (except
factor prices and the state of technology or art of production) is
variable is called the long run and the associated curve that shows
the minimum cost of producing each level of output is called the
long- run total cost curve.

The shape of the long-run total cost (LRTC) curve depends on two
factors: the production function and the existing factor prices. Table
14.4 and Fig. 14.7 reflect two of the commonly assumed char-
acteristics of long-run total costs. First, costs and output are directly
related; that is, the LRTC curve has a positive slope. But, since there
is no fixed cost in the long run, the long run total cost curve starts
from the origin.

Another characteristic of LRTC is that costs first increase at a

decreasing rate (until point B in Fig. 14.7), and an increasing rate
thereafter. Since the slope of the total cost curve measures marginal
cost, the implication is that long-run marginal cost first decreases
and then increases. It may be added that all implicit costs of
production are included in the LRTC curve.

Long-Run Average and Marginal Costs:

We turn now to distinguish between long run average and marginal
costs.

Long-run average cost is arrived at by dividing the total cost of

producing a particular output by the number of units produced:

LRTC= LRTC/Q

Long-run marginal cost is the extra total cost of producing an

additional unit of output when all inputs are optimally adjusted:

LRTC= ∆ LRTC /∆Q

It, therefore, measures the change in total cost per unit of output as
the firm moves along the long run total cost curve (or the expansion
path).

Fig. 14.8 illustrates typical long-run average and marginal cost

curves. They have essentially the same shape and relation to each
other as in the short run. Long-run average cost first declines,
reaches a minimum (at Q2 in Fig. 14.8), then increases. Long-run
marginal cost first declines, reaches minimum at a lower output
than that associated with minimum average cost (Q1 in Fig. 14.8),
and increases thereafter.
The marginal cost intersects the average cost curve at its lowest
point (L in Fig. 14.8) as in the short-run. The reason is also the
same. The reason has been aptly summarized by Maurice and
Smithson thus: “When marginal cost is less than average cost, each
additional unit produced adds less than average cost to total cost; so
average cost must decrease.

When marginal cost is greater than average cost, each additional

unit of the good produced adds more than average cost to total cost;
so average cost must be increasing over this range of output. Thus
marginal cost must be equal to average cost when average cost is at
its minimum”.

The Shape of the LAC: Economies and Diseconomies of

Scale:
The shape of the long-run average cost depends on certain
advantages and disadvantages associated with large scale
production. These are known as economies and diseconomies of
scale.

Economies of Scale:
Various factors may give rise to economies of scale, that is, to
decreasing long-run average costs of production.

Greater Specialization of Resources:

With an expansion of a firm’s scale of operation, its opportunities
for specialization—whether performed by men or by machines—are
greatly enhanced. It is because a large-scale firm can often divide
the tasks and work to be done more readily than a small-scale firm.

More Efficient Utilization of Equipment:

In some industries, the technology of production is such that a large
unit of costly equipment has to be used. The production of
automobiles, steel and refined petroleum are obvious examples.

In such industries, companies must be able to afford whatever

equipment is necessary and must be able to use it efficiently by
spreading the cost per unit over a sufficiently large volume of
output. A small-scale firm cannot ordinarily do these things.

Reduced Unit Costs of Inputs:

A large-scale firm can often buy its inputs-such as its raw materials-
at a cheaper price per unit and thus gets discounts on bulk
purchases. Moreover, for certain types of equipment, the price per
unit of capacity is often much less than larger sizes purchased.

For instance, the construction cost per square foot for a large factory
is usually less than that for a small one. Again, the price per
horsepower of various electric motors varies inversely with the
amount of horsepower.

Utilization of by-products:
In certain industries, larger-scale firms can make effective use of
many by-products that would go waste in a small firm. A typical
example is the sugar industry, where by-products like molasses and
bagasse are made use of.

Growth of Auxiliary Facilities:

In certain places, an expanding firm often benefits from, or
encourages other firms to develop, ancillary facilities, such as
warehousing, marketing, and transportation systems, thus saving
the growing firm considerable costs. For example, commercial and
industrial establishments often benefit from improved
transportation and warehousing facilities.

Diseconomies of Scale:
With continuous expansion of the scale of operation of a firm, a
point may ultimately be reached when diseconomies of scale begin
to exercise a more than offsetting effect on the firm’s cost curve. As a
result, the long-run average cost curve starts to rise.

This is attributable to the following two main reasons:

Decision-Making Role of Management:
As a firm becomes larger, heavier burdens are placed on the
management so that eventually this resource input is overworked
relative to others and ‘diminishing returns’ to management set in. In
fact, management is an indivisible input which is not capable of
continuous variation. With increase in the size of organisation there
occurs delay in decision-making.

Competition for Resources:

Rising long-run average costs can occur as a growing firm
increasingly bids labour or other resources away from other
industries. In the real world, it is very difficult, if not virtually
impossible, to determine just when diseconomies of scale are
encountered and when they become strong enough to outweigh the
economies of scale.

In business where economies of scale are negligible, diseconomies

may soon assume paramount significance causing LAC to turn up at
a relatively small volume of output. Panel A of Fig. 14.9 shows a long
run average cost curve for a firm of this type. In other cases,
economies of scale assume strategic significance.
Even after the efficiency of management starts declining,
technological economies of scale may offset the diseconomies over a
wide range of output. Thus, the LAC curve may not slope upward
until a very large volume of output is produced. This case (typified
by the so-called natural monopolies) is illustrated in Panel B of Fig.
14.9.

In many actual situations, however, neither of these extremes

describes the behaviour of LAC. A very modest scale of operation
may not set in until a very large volume of output is produced. In
such a situation, LAC would have a long horizontal section as shown
in Panel C of Fig. 14.9.

It is widely agreed by economists and business executives that this

type of LAC curve describes many production processes in the real
commercial world. For theoretical analysis, however, we continue to
assume a “representative” LAC, such as that illustrated earlier in
Fig. 14.8.

Average Cost in the Long Run: Smooth Envelope Case:

We know that in the short-run the firm has a fixed plant and it has a
short run U-shaped cost curve SAC. If a new and larger plant is
built, the new SAC will be drawn further to the right.
We assume that the firm is still in the planning stage and yet to
undertake any fixed commitment. It can now draw all possible
different U-shaped SAC curves, from which to choose one SAC for
each specified level of output that promises the lowest cost. As out-
put increases, the firm moves to a new SAC curve.

In the long run, the firm can change the size of the plant. Starting
from zero output level, successively larger plants typically have
lower and lower ATC up to some output level and then successively
higher ATC curves beyond. The three representative ATC curves
associated with the three successively larger plants are shown in Fig.
14.11(a).

Plant I is the best plant for output levels less than 900 units because
its AC curve is the lowest to the left of point a. Plant II is the best
plant size for output levels between 900 to 2,000 units, because its
AC curve is the lowest between point a and b. Plant III is the best
plant size for output levels greater than 2,000 units, since its AC
curve is the lowest beyond point b.

If these are only three possible plant sizes, the long run ATC curve
will consist of the segments of Plant I’s AC curve up to point a, the
segment of plant II’s AC curve between points a and b, and the
segment of Plant Ill’s AC curve from point of b and so on. The thick
LAC is composed of the three lowest branches of SACs. This is why
the LAC is called the envelope curve.

Fig. 14.11(b) is the smooth envelope case. Writes Samuelson: “In the
long run, a firm can choose its best plant sizes and its lower
envelope curve.” Since there is an infinite number of choices, we get
 LAC as a smooth envelope. And, as in the short-run, we can derive
LMC from LAC, and LMC emerges from the minimum point of LAC
with a smoother slope than the SMC curve.

Related Posts:
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2. Short-Run and Long-Run Costs (With Diagram)
3. Short Run and Long Run Average Cost Curve
4. Short-Run Cost of Production (With Diagram)