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 fi rm 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 short-run 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.
