Long Run and Short Run Cost

1. What are long run and short run costs? Why is it important to differentiate between these 2 concepts?

In this section we will be defining long run and short run costs and their effects on businesses. This will lead us to a better understanding of the reasoning behind the differentiating between the two concepts etc.

Short run cost: cost is the amount that the firm pays to buy inputs for production. Costs of production may be divided into fixed costs and variable costs. Fixed costs are those costs that do not vary with the quantity of output produced, they have to be paid even if output is zero, and refer to the costs of the fixed factors of production. They do not alter as output increases. They differ from firm to firm, but mainly include building, size of plant and costs of capital equipment. However, variable costs are those costs that do vary with the quantity of output produced, such as raw materials, components and some labor costs, if more labor has to be employed, the output will increase.

In the short run, firms can not build another factory to produce output, therefore, the increase of production depends on the variable cost. According the marginal revenue (N.G.Mankiw, 1976)-the extra revenue gained by selling one or more unit per time period, when the fixed cost is unchanged, the productivity of variable cost is in decreasing slope, therefore, the short run cost is increasing. This is the law of diminishing returns. The law of diminishing returns is a short run phenomenon. It states that, as a factor of production is added to one or more fixed factors, the marginal product of the variable factor will first rise, but will eventually fall when more and more variable factors are added. The average product will also first rise and then fall; the total product will do likewise.

The most important characteristic of short run cost are as follows: the fixed costs do not depend on the amount of output and cannot be adjusted immediately, however, variable cost can be changed immediately following the decision what output to produce (It can be seen figure 1.1, Soure: http://www.sfu.ca/~schwindt/econ290[12/11/2003] ).

Now lets take a look on average cost and marginal cost. The average cost (AC) and marginal cost (MC) are two important concepts in short run cost. (Sloman J. & Sutcliffe M., 1998)Average costs can be determined by dividing the firms costs by the quantity of output produced. The average cost is the typical cost of each unit of product. AC can be divided into average fixed cost (AFC), average variable cost (AVC) and average cost (AC).

Because in the short run, the fixed cost can not be changed, the average fixed cost will decrease with the increase of total production. With the increase of production, the marginal cost (MC) which (Sloman J. & Sutcliffe M., 1998) measures the increase in total cost that arises from an extra production. AFC and AC are showed in decreasing, minimum and increasing period which are in U shapes(It can be seen figure 1.2). Short run variations in output depend on the law of diminishing returns. The equal increments of the variable costs produce smaller and smaller additions to total production.

Figure 1.1 Total cost of a firm Figure 1.2 Average and Marginal Cost

Source: http://www.sfu.ca/~schwindt/econ290 [12/11/2003] Source: http://www.sfu.ca/~schwindt/econ290 [12/11/2003]

Long run cost: if a firm has enough time to increase production by any means possible, it is in the long run-a period that is long enough so that all costs are variable. In the long run, firm can change all factors of production to reach the output it wants to produce. It is full flexibility; firms can choose the best the least costly combination of factors to produce any given output that is the optimum combination of factors. All the factors of production are variable; therefore there are no fixed or variable costs in the long run. The long run cost curve increases with the increasing of output. For example, firms can build up another factory in a long time, therefore increase their production.

Now I will explain it on the curve to understand better. The long run average cost (LRAC) curve is in U shape which presents the economies of Scale,