Short-Run versus Long-Run Costs

Fixed costs are not totally uncontrollable. Fixed costs are not totally uncontrollable. In the long-run, all inputs are variable and fixed costs can also be varied 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 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 Selena’s Gourmet Salsas is considering whether to acquire additional food- preparation equipment Total cost will be affected two ways: 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 ATC 1 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 ATC 2 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 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? 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 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? 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 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” 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 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 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 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: 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 If 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 ATC 6 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 ATC 3 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 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 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 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? What determines the shape of the long-run ATC curve? Scale – the size of the firm’s operations 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 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 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 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 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 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 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. 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? 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 Costs MeasurementDefinitionMathematical term Short Run Fixed Cost Cost 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 Costs MeasurementDefinitionMathematical term Short Run and Long Run Variable Cost Cost that depends on the quantity of output produced VC Average Variable Cost Variable cost per unit of outputAVC = VC/Q Total Cost The sum of fixed cost (short run) and variable cost TC = FC (short run) + VC Average total cost (average cost) Total cost per unit of outputATC = TC/Q Marginal Cost The change in total cost generating by producing one more unit of output MC = ∆TC/∆Q

Summing Up Costs MeasurementDefinitionMathematical 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. Fixed costs are not totally uncontrollable. In the long-run, 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 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 Selena’s Gourmet Salsas is considering whether to acquire additional food-preparation equipment Total cost will be affected two ways: Total cost will be affected two ways: 1.Firm will have to either rent or boy the additional equipment 1.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

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 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? 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? 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 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 – 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 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: 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

Distinction between short-run and long-run ATC is extremely important 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 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 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? 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 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) – 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 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) Decreasing Returns to Scale (diseconomies of scale) Example: Selena experiences decreasing returns to scale at output levels greater than 7 cases 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 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. 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? 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 Costs MeasurementDefinitionMathematical term Short Run Fixed Cost Cost that does not depend on the quantity of output produced Average Fixed Cost Fixed cost per unit of output

Summing Up Costs MeasurementDefinitionMathematical term Short Run and Long Run Variable Cost Cost that depends on the quantity of output produced Average Variable Cost Variable cost per unit of output Total Cost The sum of fixed cost (short run) and variable cost Average total cost (average cost) Total cost per unit of output Marginal Cost The change in total cost generating by producing one more unit of output

Summing Up Costs MeasurementDefinitionMathematical 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