Short-Run vs. Long-Run Costs

  • Business must make decisions on whether to spend money now (fixed) or spend money later (variable)

  • If a firm plans on producing a high amount of output, it might make sense to have a high fixed cost

  • Conversely, if a firm plans on producing a small amount of output, it might make sense to have a low fixed cost

  • Choosing the optimal level of fixed cost requires a lot of planning

    Cost of case At low output levels, low fixed cost yields lower average total cost. 250 200 150 100 50 78.00 75.00 81.60 90.00 99.43 At high output levels, high fixed cost yields lower average total cost. Low fixed cost O 1 2 3 4 - S108) 5 6 High fixed cost 7 8 9 10 Quantity of salsa (cases) Low fixed cost (FC — High fixed cost (FC = 216) Quantity of salsa (cases) 1 2 4 5 6 7 8 9 10 High variable cost 12 48 108 192 300 432 588 768 972 1,200 Total cost 120 156 216 300 408 540 696 876 1,080 1,308 Average total cost of case ATCI 120.00 109.50 120.00 130.80 Low variable cost 6 24 54 96 150 216 294 384 486 600 Total cost 222 240 270 312 366 432 510 600 702 816 Average total cost of case 222.00 120.00 90.00 78.00 73.20 72.00 72.86 75.00 78.00 81.60

Long-Run Average Total Cost (LRATC)

  • Meaning

    • the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output

    • If there are many possible choices of fixed cost, the long-run average total cost curve will have the familiar, smooth U shape.

  • Graph

    Cost of case Economies of scale Diseconomies ofscale سس سكسر ATC6 ATCg \]RATC 3 Quantity of salsa (cases)

  • Short-run and long-run average total cost curves differ because a firm can choose its fixed cost in the long run.

  • 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 C on LRATC and ATC6.

  • But if she produces only 3 cases, then 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 ATC3.

  • Likewise, 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

  • Example

    • cosy Suppose that a firm that has historically produced 15,000 caps, experiences a sharp, permanent increase in demand that leads it to produce 000 units. Explain how its average total cost will change in the short run and in the long-run. Explain what the firm should do instead if it believes the change in demand is temporary. CAPS BfC 25 e c

Returns to Scale

  • Economies of scale

    • when long-run average total cost declines as input increases

    • ATC decreases as Q increases

  • Diseconomies of scale

    • when long-run average total cost increases as output increases

    • ATC increases as Q increases

  • Graph

    一 wo

Sources of Economies of Scale

  • Increased specialization that larger output levels allow

    • a larger scale of operation means that workers are very specialized individuals

  • Large initial set-up cost

    • in auto manufacturing, electricity generating or petroleum refining, there exist high fixed costs to enter the industry

  • Network externalities

    • the effect that one user of a good or service has on the value of that product to other people

    • When network effect it present, the value of a product or service if dependent on the number of others using it (ie. Telephone, Facebook, Twitter, eBay)

Sunk Cost

  • Definition

    • cost that should be ignored when making a decision

    • A cost that has already happened that cannot be recovered

  • As the old saying goes, "There's no use crying over spilled milk"

  • Example

    • You go to an All You Can Eat Brazilian BBQ Restaurant, pay $40 after eating a salad and you are full.

    • What's the rational thing to do in order to get your money's worth?

    • WALK OUT! SUNK COST!

    • Marginal Benefit > Marginal Cost: Keep doing

    • Marginal Cost > Marginal Benefit: Leave!

Summary of Costs

Mathematical term Short run Short run and long run Long run Measurement fixed cost Average fixed cost Variable cost Average variable cost Total cost Average total cost (average cost) Marginal cost Long-run average total cost Definition Cost that does not depend on the quantity of output produced Fixed cost per unit of output Cost that depends on the quantity of output produced Variable cost per unit of output The sum of fixed cost (short run) and variable cost Total cost per unit of output The change in total cost generated by producing one more unit of output Average total cost when fixed cost has been chosen to minimize average total cost for each level of out)L1t FC AFC vc AVC FC/Q VC/Q n (short run) ATC= TC/Q MC=ATC/AQ RATC

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