ECONOMIC ANALYSIS

Module 4. Concepts of costs

Lesson 17
SHORT RUN AND LONG RUN COSTS, COST CURVES AND THEIR SHAPES

17.1 Introduction

The time period in which it is possible to vary the output by varying only the amount of variable factors such as labour and raw materials. In the short run, the fixed factors such as capital equipment, managerial persons, factory building etc cannot be changed. Thus in the short run if an organization intends to increase production, then it can be done by hiring more workers or buying and using more raw materials. In the short run it is not possible to enlarge the size of the plant. Thus in the short run only variable factors can be varied and the fixed factors remain the same.

In long run time period it is possible to vary all factors of production. Thus it is possible to increase output in long run either by increasing capital equipment or by adding capacity to existing plant or installing an altogether new plant of bigger size.

17.2 Short Run Total Cost Schedule

The cost - output relationship (Cost behaviour) is seen in the short run as well as long run. Thus there are two types of cost function, short run cost function which shows cost output relationship for a given scale of output in the short run and long run cost function shows the behaviour of costs with changing scale of output in the long run.

17.2.1 Short run cost behavior

The short run cost behaviour is explained by following hypothetical example.

Table 17.1 The short run total cost schedule

The data in the above table shows the behaviour of total fixed cost, total variable cost, Total cost in the short run. Following assumptions are made about the data: price of labour is Rs. 12 per Unit and Price of capital is Rs 30 per Unit.

17.2.2 Behaviour of total cost

1. Total fixed cost remains same at Rs. 150 at all levels of output. Even when production is not done (TP = 0), total fixed cost is Rs. 150.

2. Total Variable costs varies with the output. When production is not done, Total Variable cost is zero.

Total cost varies directly as total variable cost. In the short run fixed cost remains same and change in total cost are affected due to change in variable costs.

Fig. 17.1 Behaviour of total cost, total variable cost and fixed cost

17.2.3 Short run average cost curves

For a hypothetical example, Average cost curves are shown in following Table 17.2.

Table 17.2 Average cost

Fig. 17.2 Behaviour of average cost

From the above figure, following conclusions can be drawn about short run cost curve:

1. As output increases, average fixed cost decreases. The total fixed cost remains same for all level of output, but average fixed cost decreases continuously because of spreading it over more number of units as output increases.

2. Average variable cost first decreases and then increase as output increases.

3. Average total cost decreases initially. It remains same at a point for a while and then go on increasing as output increases.

4. Marginal cost decreases initially but then increases as the output is increased.

5. When the average cost is minimum, marginal cost is equal to average cost.

17.3 Long Run Cost Curves

In the long run, all the factor inputs are variable. In the long run it is possible for the organization to change the overall plant capacity as per demand. In the long run there is no distinction of fixed and variable costs. There is only variable or direct cost as total cost.

Long run is a vision of future. It is a planning horizon. In the long run also, all economic activities actually operate in the short run. Thus a long run consists of many possible short run situations and a choice is made for actual courses of operation from them. Thus long run average cost curve is the envelope of the number of short run cost curves. It is drawn as tangent to the short run average cost curves. Long run cost curve is shown in following figure in which long run cost curve is drawn on the basis of 3 possible plant sizes.

Fig. 17.3 Behaviour of long run cost