This chapter discusses short-run and long-run decisions, based on the corresponding cost curves. In the long run, a firm can fully adjust all its inputs. In the short run, some inputs are fixed. The length of the short run varies from industry to industry.
The production function shows the maximum output that can be produced using given quantities of inputs. The inputs are machines, raw materials, labour and any other factors of production. The production function summarizes the technical possibilities faced by a firm.
The total cost curve is derived from the production function, for given wages and rental rates of factors of production. The long-run total cost curve is obtained by finding, for each output, the least-cost method of production when all inputs can be varied. If the relative price of using a factor of production rises, the firm substitutes away from that factor in its choice of production techniques.
Average cost is total cost divided by output. The long-run average cost curve (LAC) is derived from the long-run total cost curve.
LAC is typically U-shaped. As output rises, at first average costs fall because of
indivisibilities in production, the benefit of specialization and engineering advantages of large
scale. There are increasing returns to scale on the falling part of the U. The rising part of the
U reflects diseconomies of scale.
Much of manufacturing has economies of scale. For some industries, particularly personal services, economies of scale run out at quite low output levels.
When marginal cost is below average cost, average cost is falling. When marginal cost is above average cost, average cost is rising. Average and marginal cost are equal only at the lowest point on the average cost curve.
In the long run the firm supplies the output at which long-run marginal cost (LMC) equals MR provided price is not less than the level of long-run average cost at that level of output. If price is less than long-run average cost, the firm goes out of business.
In the short run the firm cannot adjust some of its inputs. But it still has to pay for them. It
has short-run fixed costs (SFC) of production. The cost of using the variable factors is shortrun
variable cost (SVC). Short-run total costs (STC) are equal to SFC plus SVC.
The short-run marginal cost curve (SMC) reflects the marginal product of the variable factor holding other factors fixed. Usually we think of labour as variable but capital as fixed in the short run. When very little labour is used, the plant is too big for labour to produce much. Increasing labour input leads to large rises in output and SMC falls. Once machinery is fully manned, extra workers add progressively less to output. SMC begins to rise.
Short-run average total costs (SATC) are equal to short run total costs (STC) divided by
output. SATC is equal to short-run average fixed costs (SAFC) plus short-run average
variable costs (SAVC). The SATC curve is U-shaped. The falling part of the U results both
from declining SAFC as the fixed costs are spread over more units of output and from
declining SAVC at low levels of output. The SATC continues to fall after SAVC begins to
increase, but eventually increasing SAVC outweighs declining SAFC and the SATC curve
slopes up.
The SMC curve cuts both the SATC and SAVC curves at their minimum points.
In the short run the firm supplies the output at which SMC is equal to MR, provided price is
not less than short-run average variable cost. In the short run the firm is willing to produce
at a loss provided it is recovering at least part of its fixed costs.
The LAC curve is always below the SATC curve, except at the point where the two coincide. This implies that a firm is certain to have higher profits in the long run than in the short run if it is currently producing with a plant size that is not best from the viewpoint of the long run.
