BTF1
Syllabus A. The Business Organisation, Its Stakeholders A5. Micro Economics Factors

A5c. Economic Behaviour of Costs 3 / 4

Syllabus A5c)

Explain the economic behaviour of costs in the short and long term.

THE ECONOMIC BEHAVIOUR OF COSTS IN THE SHORT AND LONG TERM

Short vs Long run

  1. The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied.

  2. The long run is a period of time in which the quantities of all inputs can be varied.

There is no fixed time that can be marked on the calendar to separate the short run from the long run.

The short run and long run distinction varies from one industry to another."

Long run

  • In the long run, firms change production levels in response to (expected) economic profits or losses, and the land, labour, capital and entrepreneurship (factors of production) vary to reach associated long-run average cost.

  • The long run is associated with the long run average cost (LRAC) curve in microeconomic models along which a firm would minimize its average cost (cost per unit) for each respective long-run quantity of output.

  • Long run marginal cost (LRMC) is the added cost of providing an additional unit of commodity from changing capacity level to reach the lowest cost associated with that extra output. 

    The concept of long-run cost is also used in determining whether the long-run is expected to induce the firm to remain in the industry or shut down production.

  • The long run is a planning and implementation stage. Here a firm may decide that it needs to produce on a larger scale by building a new plant or adding a production line. 

    The firm may decide that new technology should be incorporated into its production process.

  • The firm thus considers all its long-run production options and selects the optimal combination of inputs and technology for its long-run purposes.

  • Long-run decisions are risky because the firm must anticipate what methods of production will be efficient, not only today, but also for many years in the future, when the costs of labour and raw materials will no doubt have changed.

  • The decisions are also risky because the firm must estimate how much output it will want to product.  

    Is the industry to which it belongs growing or declining? 

    Will new products emerge to render its existing products less useful than an extrapolation of past sales suggest?

Short run

Once the decisions are made and implemented and production begins, the firm is operating in the short run with fixed and variable inputs.

  • The short run is the conceptual time period in which at least one factor of production is fixed in amount and others are variable in amount.

  • Costs that are fixed, say from existing plant size, have no impact on a firm's short-run decisions, since only variable costs and revenues affect short-run profits.

  • In the short run, a firm can raise output by increasing the amount of the variable factor(s), say labour through overtime.