Short Run Cost Function

Short Run Cost Function

A firms short run cost function tell us the minimum
cost necessary to produce a particular output level.
For simplicity the following assumptions are made:
The firm employs two inputs, labor and capital
Labor is variable, capital is fixed
The firm produces a single product
Technology is fixed
The firm operates efficiently
The firm operates in competitive input markets
The law of diminishing returns holds

 The following average cost functions will be

useful in our analysis
Average total cost (AC) is the average per unit
cost of using all of the firms inputs.
Average variable cost (AVC) is the average
per-unit cost of using the firms variable inputs.
Average fixed cost (AFC) is the average perunit cost of using the firms fixed inputs.

 Mathematically,
AVC=TVC/Q
AFC=TFC/Q
ATC=TC/Q=(TFC+TVC)/Q=AFC+AVC

illustrates how the short run

cost measures can be calculated.

Graphically, these results are be

depicted in the figure below.

 Important Observations
AFC declines steadily over the range of
production.
In general, AVC, AC and MC are u-shaped.
MC measures the rate of change of TC
When MC<AVC, AVC is falling
When MC>AVC, AVC is rising
When MC=AVC, AVC is at its minimum
The distance between AC and AVC represents AFC

 A change in input prices

will act to shift the cost
curves.
If there is a reduction in
the costs associated with
the fixed inputs, the
average total cost will
shift downward. AVC
and MC will remain
unaffected.

 If there is a reduction in
the cost associated with
the variable inputs, then
the MC, AVC and AC
will all shift downward.

Long Run Cost Function

Long Run Cost Function

Long run marginal cost (LRMC) measures
the change in long run cost associated with a
change in output
Long run average cost (LRAC) measures the
average per-unit cost of production when all
inputs are variable.
In general, the LRAC is u-shaped.

 When LRAC is declining we say that the firm

is experiencing economies of scale.
Economies of scale implies that per-unit costs
are falling.
When LRAC is increasing we say that the firm
is experiencing the diseconomies of scale.
Diseconomies of scale implies that per-unit
costs are rising.

 The figure illustrates the

general shape of the
LRAC

 Reasons for Economies of Scale

Increasing returns to scale
Specialization in the use of labor and capital
Indivisible nature of many types of capital equipment
Productive capacity of capital equipment rises faster
than purchase price
Economies in maintaining inventory of replacement
parts and maintenance personnel
Discounts from bulk purchases
Lower cost of raising capital funds

Spreading promotional and R & D costs

Management efficiencies
Decreasing returns to scale
Disproportionate rise in transportation costs
Inputs market imperfections
Management coordination and control
problems
Disproportionate rise in staff and indirect labor

Economies of Scale

 economies of scaleare the cost advantages that

enterprises obtain due to size, output, orscaleof
operation, with cost per unit of output generally
decreasing with increasingscaleas fixed costs are
spread out over more units of output.
Diseconomies of scaleis an economic concept
referring to a situation in which economies
ofscaleno longer function for a firm. Rather than
experiencing continued decreasing costs per increase
in output, firms see an increase in marginal cost when
output is increased.
(AC=TC/Q) Average cost= Total cost/Quantity

Economies of Scale occur for various reasons.

Specialization and division of

labor
Bulk buying
Financial economies.

 Minimum Efficient Scale is defined as the lowest production point at which longrun total average costs (LRATC) are minimized.

Minimum Efficient Plant Size the point where increasing the scale of production
of an individual plant within the industry yields
no significant unit cost benefits

Advantages of Large Scale Production

Internal Economies- Internal economies arise within
the firm because of the expansion of the size of a
particular firm.
Economies of Organization- With an increase in the
size of the firm, the cost of management is reduced.
Division of Labor-The large scale production is
always associated with more and more division of
labor. With the division of labor per worker output
increases. Hence, per unit labor cost is reduced in
large scale production.

Disadvantages of Large Scale Production

Less Supervision- A large scale producer cannot pay

full attention to every detail in various departments.
Costs often rise on account of the dishonesty of workers.
Thus, due to inefficient and inadequate supervision, the
cost of production goes up.
Unequal Distribution of Wealth- All wealth and
incomes of the country get concentrated in the pockets
of big producers due to large scale production. There is
unequal distribution of wealth and resources on account
of the large scale production. The rich become richer
and the poor become poorer.