In the short-run it is assumed that firms can’t easily increase their capital (K) and so this is considered a fixed input, whereas it is believed they can easily increase the amount of labour (L) by hiring more workers or offering over-time, so labour is considered a variable input.

There are 2 different types of costs; fixed and variable. Fixed costs are costs that do not vary with how much the firm chooses to produce, this is generally capital, such as factories and machines however to an extent electricity and other utilities can be considered as fixed costs unless they are on a certain tariff. Sunk costs are costs that cannot be recovered if the firm closes, examples of these might be a computer package.

Variable costs on the other hand are costs that vary with the amount the firm produces. The more the firm produces the more raw materials and labour it is going to need – these are considered variable costs.

The marginal cost is the cost of producing one extra unit of output and in the short run marginal cost rises due to the law of diminishing marginal returns.

(Short-Run) Total costs = Total Fixed Costs + Total Variable Costs

(Short-Run)  Average Cost = Total Cost / Quantity Produced

(Short-Run)  Marginal Cost = ΔSTC / ΔOutput (this can also be found by differentiating Total costs)

(Short-Run)  Average Variable Cost = Total Variable Costs / Output

(Short-Run)  Average Fixed Cost = Total Fixed Costs / Output

On the graph to the right the firm’ fixed costs will be the area between ATC and AVC.

NB: The marginal cost curve intersects the average curves at their minimum levels as if the marginal is below average then the average must be falling and if the marginal is above the average then it would pull the average up.

In the short run a firm will continue production if it can cover its variable costs. This will allow it to make some contributions to its incurred fixed costs. Contribution = Price – Variable Cost, if C ≥ 0 then the firm will continue to operation in the short run. If it can only cover variable costs (C=0) then the firm is indifferent to shut down or not. If C<0 then the firm would be advised to shut down as it can’t pay of its fixed costs and is making a loss on its variable costs (a loss on any marginal product). NB: Product is the same as output.

The Marginal Product (MP) is the inverse of the Marginal Cost (MC) curve and the Average Product (AP) is the inverse of the Average Cost (AC) curve. 

Diminishing Marginal Returns

In the short run the diminishing marginal returns law exists which states that as more of a variable factor, Labour (L), is added to a fixed factor, Capital (K), there will be a point where the marginal product of labour will fall thus raising marginal costs. This is because in the short run we are assuming capital to be a fixed factor (investment in the long run can lead to an increase in the stock of capital goods) and so if the variable factor labour were to increase they would still be using the limited amount of capital and hence will eventually be less productive marginally.

In the long run all factors of production are variable and hence the law of diminishing returns no longer exists.

Short Run Average Cost Curve

The short run average total cost is calculated as short run total cost divided by output. This appears as a U shaped curve because as output is expanded average costs fall (output, the denominator, is a greater number) however at a point diminishing marginal returns leads to the curve becoming positively correlated.

Long Run Average Cost (Envelope) Curve

The long run average cost curve is derived from a series of short run average cost curves and so is often described as the envelope curve. 

NB: The MES of all short run average cost curves (bar SRAC3) don’t touch the LRAC curve. The MES of SRAC3 curve touches the LRAC curve also at its MES point.

 

 

 

 

 

 

If a firm is producing in the most efficient way possible in the long run, but they then want to expand, they will have to expand along a short run average cost curve as they will be limited by their fixed factors. However, in the long run they can get more of the fixed factors and so will move back down to the long run average cost curve. This is why the LRAC is made up of a series of SRAC curves.

From the graph above we can see that to produce Q₁ output it is cheaper to be operating on the SRAC₂ curve than it is to be on the SRAC₁ curve.

^Long-Run Average Cost Curve

The LRAC is down is downward sloping due to economies of scale, as real output increases average costs fall until the Minimum Efficient Scale (MES) point, this is the lowest point on the LRAC curve and is where economies of scale stop. The long-run marginal cost curve would always intersect the LRAC curve at this point. After the MES point there may be constant returns, this is a horizontal line (as shown in the bottom left graph) where no economies or diseconomies of scale are found. After this there may be diseconomies of scale, where the more output a firm produces the higher its average costs.

Minimum Efficient Scale (MES)

The MES is the output for a firm in the LR where the economies of scale have been fully utilised. On a graph this would appear as the lowest point on the LRAC curve. The MES will vary from industry to industry, when the ratio of fixed costs to variable costs is high then the greater the output the lower the average costs. Therefore if the MES is further to the right of a graph then there are greater economies of scales to be found. 

The graph to the left shows an MES that can be achieved at fairly low levels out output, this means the costs faced between a small firm (output Q1) will be similar to a large firm (output Q2). Therefore we would expect the market share of any one firm to be fairly low. There are also few economies of scale to be gained in this industry. 

Conversely the graph to the right shows an MES that can be only be achieved at relatively high levels output, therefore large firms will have smaller costs than small firms and therefore larger firms would benefit from the economies of scale in this market. Therefore mergers and takeovers may be advised in this industry. 

If the minimum efficient scale can be reached at a low level of output then there will be a low market concentration as there are relatively little economies of scale to be found. This means that if a firm operates at an output of 10 and another firm operates at an output of 100, the costs will be similar (as there are no economies of scale to reduce the cost regardless of the output). 

Alternatively if the minimum efficient scale can only be reached at a high level of output then there will be a high market concentration as there will be few firms in the market, exploiting economies of scale by producing a lot of output. It would also encourage mergers to exploit these economies of scale.

Page last updated on 20/10/13