File Name: cost output relationship in short run and long run .zip
- Theory of Costs
- Cost Output Relationship in Short Run & Long Run Cost Curves
- Cost-Output Relationship
Cost Output Relationship in Short Run. Time element plays an important role in price determination of a firm. During short period two types of factors are employed. One is fixed factor while others are variable factors of production. Fixed factor of production remains constant while with the increase in production, we can change variable inputs only because time is short in which all the factors cannot be varied.
Theory of Costs
In the short run the levels of usage of some input are fixed and costs associated with these fixed inputs must be incurred regardless of the level of output produced. Other costs do vary with the level of output produced by the firm during that time period. The sum-total of all such costs-fixed and variable, explicit and implicit- is short-run total cost. It is also possible to speak of semi-fixed or semi-variable cost such as wages and compensation of foremen and electricity bill.
For the sake of simplicity we assume that all short run costs to fall into one of two categories, fixed or variable. A typical short-run total cost curve STC is shown in Fig. When output is zero, cost is positive because fixed cost has to be incurred regardless of output. They are called unavoidable contractual costs.
Such costs remain contractually fixed and so cannot be avoided in the short run. The total fixed cost TFC curve is a horizontal straight line. Total variable is the difference between total cost and fixed cost. The total variable cost curve TVC starts from the origin, because such cost varies with the level of output and hence are avoidable. Examples are electricity tariff, wages and compensation of casual workers, cost of raw materials etc.
In Fig. Clearly, variable cost and, therefore, total cost must increase with an increase in output. We also see that variable cost first increase at a decreasing rate the slope of STC decreases then increase at an increasing rate the slope of STC increases.
This cost structure is accounted for by the law of Variable Proportions. We may first consider average fixed cost AFC. Since total fixed cost does not vary with output average fixed cost is a constant amount divided by output. Average fixed cost is relatively high at very low output levels. However, with gradual increase in output, AFC continues to fall as output increases, approaching zero as output becomes very large. We now consider average variable cost AVC which is arrived at by dividing total variable cost by output,.
It first declines, reaches a minimum at Q 3 units of output and subsequently rises. This point can easily be proved. We know that and that average fixed cost continuously falls over the whole range of output. Since AFC declines over the entire range of output. We may finally consider short-run marginal cost SMC. Marginal cost is the change in short-run total cost attributable to an extra unit of output: or. Short-run marginal cost refers to the change in cost that results from a change in output when the usage of the variable factor changes.
As Fig. Thus average variable cost has to fall. Thus, in this case, AVC must rise. Exactly the same reasoning would apply to show MC crosses ATC at the minimum point of the latter curve. Hence the AFC curve is a rectangular hyperbola. Since business decisions are largely governed by marginal cost, and marginal costs have no relation to fixed cost, it logically follows costs do not affect business decisions.
There is a close relation between MC and AC. This can be proved as follows:. On the basis of the relation between MC and AC we can develop a new concept, viz. It measures the responsiveness of total cost to a small change in the level of output. From the diagram the following relationships can be discovered. These two concepts will be discussed in the context of market structure and pricing. Table Column 5 shows that average fixed cost decreases over the entire range of output.
Instead, the long run simply refers to a period of time during which all inputs can be varied. In order to be able to make this decision the manager must have knowledge about the cost of producing each relevant level of output. We shall now discover how to determine these long-run costs. For the sake of analytical simplicity, we may assume that the firm uses only two variable factors, labour and capital, that cost Rs.
The characteristics of a derived expansion path are shown in Columns 1, 2 and 3 of Table In column 1 we see seven output levels and in Columns 2 and 3 we see the optimal combinations of labour and capital respectively for each level of output, at the existing factor prices. Column 4 shows the total cost of producing each level of output at the lowest possible cost. For example, for producing units of output, the least cost combination of inputs is 20 units of labour and 10 of capital.
At existing factor prices, the total cost is Rs. Here, Column 4 is a least-cost schedule for various levels of production. In Column 5 , we show average cost which is obtained by dividing total cost figures of Column 4 by the corresponding output figures of Column 1.
Thus, when output is , average cost is Rs. All other figures of Column 5 are derived in a similar way. From column 5 we derive an important characteristic of long-run average cost: average cost first declines, reaches a minimum, then rises, as in the short-run. In Column 6 we show long-run marginal cost figures. Each such figure is arrived at by dividing change in total cost by change in output. For example, when output increases from Rs. Therefore, marginal cost per unit is Rs.
Column 6 depicts the behaviour of per unit MC: marginal cost first decreases then increases, as in the short run. We may now show the relationship between the expansion path and long-run cost graphically.
Finally, the known production function gives us the isoquant map, represented by Q 1 , Q 2 and so forth. We may now relate this expansion path to a long-run total cost LRTC curve. For example, in Fig. Thus, in Fig. Every other point on LRTC is derived in a similar way. Thus, totally different production processes may be used to produce say Q 1 and Q 2 units of output at the lowest attainable cost.
On the basis of this diagram we may suggest a definition of the long run total cost. First, costs and output are directly related; that is, the LRTC curve has a positive slope. But, since there is no fixed cost in the long run, the long run total cost curve starts from the origin. Since the slope of the total cost curve measures marginal cost, the implication is that long-run marginal cost first decreases and then increases. It may be added that all implicit costs of production are included in the LRTC curve.
Long-run average cost is arrived at by dividing the total cost of producing a particular output by the number of units produced:. Long-run marginal cost is the extra total cost of producing an additional unit of output when all inputs are optimally adjusted:. It, therefore, measures the change in total cost per unit of output as the firm moves along the long run total cost curve or the expansion path. They have essentially the same shape and relation to each other as in the short run.
The marginal cost intersects the average cost curve at its lowest point L in Fig. The reason is also the same. The shape of the long-run average cost depends on certain advantages and disadvantages associated with large scale production. These are known as economies and diseconomies of scale. Various factors may give rise to economies of scale, that is, to decreasing long-run average costs of production.
It is because a large-scale firm can often divide the tasks and work to be done more readily than a small-scale firm. The production of automobiles, steel and refined petroleum are obvious examples. A small-scale firm cannot ordinarily do these things.
A large-scale firm can often buy its inputs-such as its raw materials-at a cheaper price per unit and thus gets discounts on bulk purchases. For instance, the construction cost per square foot for a large factory is usually less than that for a small one.
Again, the price per horsepower of various electric motors varies inversely with the amount of horsepower. In certain industries, larger-scale firms can make effective use of many by-products that would go waste in a small firm. A typical example is the sugar industry, where by-products like molasses and bagasse are made use of.
As a result, the long-run average cost curve starts to rise. With increase in the size of organisation there occurs delay in decision-making. Panel A of Fig. This case typified by the so-called natural monopolies is illustrated in Panel B of Fig.
In many actual situations, however, neither of these extremes describes the behaviour of LAC. A very modest scale of operation may not set in until a very large volume of output is produced. It is widely agreed by economists and business executives that this type of LAC curve describes many production processes in the real commercial world.
We know that in the short-run the firm has a fixed plant and it has a short run U-shaped cost curve SAC.
Cost Output Relationship in Short Run & Long Run Cost Curves
In the short run the levels of usage of some input are fixed and costs associated with these fixed inputs must be incurred regardless of the level of output produced. Other costs do vary with the level of output produced by the firm during that time period. The sum-total of all such costs-fixed and variable, explicit and implicit- is short-run total cost. It is also possible to speak of semi-fixed or semi-variable cost such as wages and compensation of foremen and electricity bill. For the sake of simplicity we assume that all short run costs to fall into one of two categories, fixed or variable. A typical short-run total cost curve STC is shown in Fig. When output is zero, cost is positive because fixed cost has to be incurred regardless of output.
Those costs which are incurred by a firm in the production of any commodity on the basis of total fixed cost and total variable cost. Total costs are calculated on the.
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Variable costs change according to the quantity of goods produced; fixed costs are independent of the quantity of goods being produced. In economics, the total cost TC is the total economic cost of production. It consists of variable costs and fixed costs.
Reading: Short Run and Long Run Average Total Costs
In this article we will discuss about the cost-output relation during long run and short run cost curves. Time element plays an important role in price determination of a firm. During short period two types of factors are employed. One is fixed factor while others are variable factors of production. Fixed factor of production remains constant while with the increase in production, we can change variable inputs only because time is short in which all the factors cannot be varied.
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