short-run versus long-run costs

Short-Run versus Long-Run Costs

Short-Run versus Long-Run Costs

• Fixed costs are not totally uncontrollable.

• In the long-run, all inputs are variable and fixed costs can also be varied

• Firms will also choose their fixed costs in the long run based on the level of output they expect to produce

Short-Run versus Long-Run Costs

• Selena’s Gourmet Salsas is considering whether to acquire additional food-preparation equipment

• Total cost will be affected two ways:1. Firm will have to either rent or boy the additional

equipment (will = higher fixed cost in the short run)2. If workers have more equipment, they will be more

productive and fewer workers will be needed to product any given output so variable cost for any output will be reduced

Short-Run versus Long-Run Costs

This side shows VC as well as TC and ATC

assuming a fixed cost of $108 (from previous

examples)The ATC curve for this

fixed cost is ATC1

This side shows the firm’s VC , TC, and ATC with the higher level of fixed cost.

The ATC for the fixed cost of $216 is given by

ATC2

Selena buys the additional food-preparation

equipment, doubling its fixed cost to $216 but

reducing its VC at any level of output

Short-Run versus Long-Run Costs

• When the output is small, ATC is smaller when Selena forgoes the additional equipment and maintains the lower fixed cost of $108: ATC1 is below ATC2

Short-Run versus Long-Run Costs

• Why does ATC change like then when fixed cost increases?

• When output is low, the increase in fixed cost from the additional equipment outweighs the producing in VC from higher worker productivity

• If Selena plans to produce 4 or fewer cases per day, what should she choose?

Short-Run versus Long-Run Costs

• Generally, for each output level, there is some choice of fixed cost that minimizes the firm’s ATC for that output level

• ATC curves we have seen are defined for a given level of fixed cost – they are defined for the short run and called the “short-run ATC curves”

Short-Run versus Long-Run Costs

• If Selena has been producing 2 cases of salsa per day with a fixed cost of $108 but found herself increasing her output to 8 cases per day for the foreseeable future, then in the long run she should purchase more equipment and increase her fixed cost to a level that minimizes ATC at the 8-cases-per-day output level

Short-Run versus Long-Run Costs

• Long-run average total cost curve (LRATC) is the relationship between output and ATC when fixed cost has been chosen to minimize ATC for each level of output

• If there are many possible choices of fixed cost, the LRATC will have a smooth U shape

Short-Run versus Long-Run Costs• Distinctions between short-run and

long-run:– Long run is when a producer has time to

choose the fixed cost appropriate for its desired level of output, that producer will be at some point on the LCATC curve

– If the output level is altered, they will no longer be on its LRATC curve and will be instead moving along its current short-run ATC curve

–Will return to its LRATC curve when it readjusts its fixed cost for its new output level

Short-Run versus Long-Run CostsIf Selena has chosen the level of fixed cost that minimizes short-run average total cost

at an output of 6 cases, and actually produces 6 cases, then she will be at point Con LRATC and

ATC6

But if she produces only

3 cases, she will move to

point B.

If she expects to produce only 3 cases for a long time, in the long

run she will reduce her fixed cost and move to point A on ATC3

If she produces 9 cases (putting her

at point Y) and expects to continue this for a long time,

she will increase her fixed cost in the long run and move

to point X

Short-Run versus Long-Run Costs• Distinction between short-run and long-run

ATC is extremely important• A company that has to increase output

suddenly to meet a surge in demand will find that in the short run its ATC rises sharply because it is hard to get extra production out of existing facilities

• But in due time, they can build factories or add machinery, short-run ATC falls

Returns to Scale

• What determines the shape of the long-run ATC curve?

• Scale – the size of the firm’s operations• Firms that experience scale effects in

production find that their long-run ATC changes substantionally depending on the quantity of output they produce

Returns to Scale

• Increasing Returns to Scale (economies of scale) – is when long-run ATC declines as output increases

• Example: Selena’s Gourmet Salsas experiences increasing returns to scale over output level ranging from 0 to 5 cases of salsa per day

Returns to Scale

• Decreasing Returns to Scale (diseconomies of scale) is when long-run ATC increases as output increases

• Example: Selena experiences decreasing returns to scale at output levels greater than 7 cases

Returns to Scale

• Constant Returns to Scale is when long-run ATC is constant as output increases

• Example: Selena has constant returns to scale when its produces anywhere from 5 to 7 cases of salsa per day.

Returns to Scale• What explains these scale effects in

production?– Increased specialization – increasing returns due

to larger output level– Very large initial setup cost (auto manufacturing)

– increasing returns due to a high fixed cost in the form of factories and equipment necessary to produce any output

– Decreasing returns are found in large firms when experience problems of coordination and communications

Summing Up CostsMeasurement Definition Mathematical

term

Short Run

Fixed CostCost that does not

depend on the quantity of output

produced

FC

Average Fixed Cost

Fixed cost per unit of output

AFC = FC/Q

Summing Up CostsMeasurement Definition Mathematical

term

Short Run and Long Run

Variable CostCost that depends on the quantity of output

producedVC

Average Variable Cost

Variable cost per unit of output AVC = VC/Q

Total CostThe sum of fixed cost

(short run) and variable cost

TC = FC (short run) + VC

Average total cost (average

cost)

Total cost per unit of output ATC = TC/Q

Marginal CostThe change in total cost generating by producing one more unit of output

MC = ∆TC/∆Q

Summing Up CostsMeasurement Definition Mathematical

term

Long Run

Long-run average total

cost

Average total cost when fixed cost has been chosen

to minimize average total cost for each level of

output

LRATC

Short-Run versus Long-Run Costs Notes

Short-Run versus Long-Run Costs

• Fixed costs are not totally uncontrollable.

• In the long-run,

• Firms will also choose their fixed costs in the long run based on the level of output they expect to produce

Short-Run versus Long-Run Costs

• Selena’s Gourmet Salsas is considering whether to acquire additional food-preparation equipment

• Total cost will be affected two ways:1. Firm will have to either rent or boy the additional

equipment

2. If workers have more equipment, they will be more productive and fewer workers will be needed to product any given output so variable cost for any output will be reduced

Short-Run versus Long-Run Costs

Short-Run versus Long-Run Costs

• When the output is small, ATC is smaller when Selena forgoes the additional equipment and maintains the lower fixed cost of $108: ATC1 is below ATC2

Short-Run versus Long-Run Costs

• Why does ATC change like then when fixed cost increases?

• If Selena plans to produce 4 or fewer cases per day, what should she choose?

Short-Run versus Long-Run Costs

• Generally, for each output level, there is some choice of fixed cost that minimizes the firm’s ATC for that output level

• ATC curves we have seen are defined for a given level of fixed cost –

Short-Run versus Long-Run Costs

• Long-run average total cost curve (LRATC) is the relationship between output and ATC when fixed cost has been chosen to minimize ATC for each level of output

Short-Run versus Long-Run Costs• Distinctions between short-run and

long-run:– Long run is when a producer has time to

choose the fixed cost appropriate for its desired level of output, that producer will be at some point on the LCATC curve

– If the output level is altered, they will no longer be on its LRATC curve and will be instead moving along its current short-run ATC curve

–Will return to its LRATC curve when it readjusts its fixed cost for its new output level

Short-Run versus Long-Run Costs

Short-Run versus Long-Run Costs• Distinction between short-run and long-run

ATC is extremely important• A company that has to increase output

suddenly to meet a surge in demand will find that in the short run its ATC rises sharply because it is hard to get extra production out of existing facilities

• But in due time, they can build factories or add machinery, short-run ATC falls

Returns to Scale

• What determines the shape of the long-run ATC curve?

• Firms that experience scale effects in production find that their long-run ATC changes substantionally depending on the quantity of output they produce

Returns to Scale

• Increasing Returns to Scale (economies of scale) –

• Example: Selena’s Gourmet Salsas experiences increasing returns to scale over output level ranging from 0 to 5 cases of salsa per day

Returns to Scale

• Decreasing Returns to Scale (diseconomies of scale)

• Example: Selena experiences decreasing returns to scale at output levels greater than 7 cases

Returns to Scale

• Constant Returns to Scale is when long-run ATC is constant as output increases

• Example: Selena has constant returns to scale when its produces anywhere from 5 to 7 cases of salsa per day.

Returns to Scale• What explains these scale effects in

production?– _________________________– increasing

returns due to larger output level– Very large initial setup cost (auto manufacturing)

– increasing returns due to a high fixed cost in the form of factories and equipment necessary to produce any output

– Decreasing returns are found in large firms when experience problems of coordination and communications

Summing Up CostsMeasurement Definition Mathematical

term

Short Run

Fixed CostCost that does not

depend on the quantity of output

produced

Average Fixed Cost

Fixed cost per unit of output

Summing Up CostsMeasurement Definition Mathematical

term

Short Run and Long Run

Variable CostCost that depends on the quantity of output

producedAverage

Variable CostVariable cost per unit of

output

Total CostThe sum of fixed cost

(short run) and variable cost

Average total cost (average

cost)

Total cost per unit of output

Marginal CostThe change in total cost generating by producing one more unit of output

Summing Up CostsMeasurement Definition Mathematical

term

Long Run

Long-run average total

cost

Average total cost when fixed cost has been chosen

to minimize average total cost for each level of

output