Short-Run and Long-Run Costs

This section explores the different types of costs a firm incurs, differentiating between short-run and long-run production periods. Understanding these cost structures is fundamental to analyzing firm behavior and profitability.

Fixed Costs

Fixed costs are expenses that do not change with the level of output in the short run. These costs are incurred even if the firm produces zero output.

• Examples: Rent on a factory, insurance premiums, salaries of permanent staff, depreciation on equipment.
• In the short run, fixed costs are unavoidable.
• In the long run, fixed costs can be altered (e.g., by moving to a new location or selling equipment).

Variable Costs

Variable costs are expenses that change in direct proportion to the level of output. As output increases, variable costs increase; as output decreases, variable costs decrease.

• Examples: Raw materials, wages of temporary staff, energy consumed in production.
• In the short run, variable costs can fluctuate with changes in output.

Total Costs

Total costs represent the sum of all fixed costs and variable costs incurred by a firm.

$$ TC = FC + VC $$

Average Costs

Average costs measure the cost per unit of output.

• Average Fixed Cost (AFC): The fixed cost divided by the quantity of output.

$$ AFC = \frac{FC}{Q} $$

• Average Variable Cost (AVC): The variable cost divided by the quantity of output.

$$ AVC = \frac{VC}{Q} $$

• Average Total Cost (ATC): The total cost divided by the quantity of output.

$$ ATC = \frac{TC}{Q} $$

The relationship between AFC, AVC, and ATC is often U-shaped. This is because as output increases, fixed costs are spread over more units, causing AFC to fall. Initially, as variable costs rise with output, AVC may also rise. However, at some point, increasing output can lead to economies of scale in variable costs, causing AVC to fall. Eventually, increasing output can also lead to economies of scale in fixed costs, causing ATC to fall.

Marginal Costs

Marginal cost is the additional cost incurred by producing one more unit of output.

$$ MC = \frac{\Delta TC}{\Delta Q} $$

The marginal cost curve typically intersects the average cost curves at their minimum points. This is a crucial concept for determining the optimal level of production.

Short-Run Cost Curves

The short-run cost curves (ATC, AVC, MC) illustrate how costs change as output varies, holding fixed factors constant.

Output (Q)	Total Cost (TC)	Average Total Cost (ATC)	Average Variable Cost (AVC)	Marginal Cost (MC)
0	$100	-	-	-
1	$150	$150	$150	$50
2	$250	$125	$75	$100
3	$350	$116.67	$83.33	$100
4	$480	$120	$60	$20
5	$600	$120	$48	$20

Long-Run Costs

In the long run, all factors of production are variable. This allows firms to adjust all costs, including fixed costs.

• Total Cost Function: The total cost function in the long run can be derived from the short-run cost functions by removing the constraints on fixed factors.
• Cost Minimization: Firms in the long run aim to minimize their average total cost by choosing the optimal combination of inputs.
• Economies of Scale: These occur when the average total cost decreases as output increases. This can be due to factors such as specialization of labor, efficient use of capital, and bulk purchasing.
• Diseconomies of Scale: These occur when the average total cost increases as output increases. This can be due to factors such as management difficulties, communication problems, and motivation issues.

Long-Run Cost Curves

The long-run cost curves (LRATC) show the lowest possible average total cost for each level of output, assuming the firm can choose the optimal combination of inputs.

LRATC curves are typically U-shaped, reflecting the potential for both economies and diseconomies of scale.

Relationship between Short-Run and Long-Run Costs

The long-run cost curves represent the possible average total cost curves that a firm can achieve in the long run. The short-run average cost curves are typically tangent to the long-run average total cost curve at the minimum average total cost point.

Figure