ADVERTISEMENTS:
In this article we will discuss about the cost-output relation during long run and short run cost curves.
Cost-Output Relation during Short Run or Short Run Cost Curves:
Time element plays an important role in price determination of a firm. During short period two types of factors are employed. One is fixed factor while others are variable factors of production. Fixed factor of production remains constant while with the increase in production, we can change variable inputs only because time is short in which all the factors cannot be varied.
Raw material, semi-finished material, unskilled labour, energy, etc., are variable inputs which can be changed during short run. Machines, capital, infrastructure, salaries of managers and technical experts are included in fixed inputs. During short period an individual firm can change variable factors of production according to requirements of production while fixed factors of production cannot be changed.
ADVERTISEMENTS:
The cost-output relation during short period can be studied with the help of short run cost curves based on short run costs as given below:
A. Short Run Total Costs:
Short run total costs of a firm are of following types:
(1) Total Costs:
ADVERTISEMENTS:
Those costs which are incurred by a firm in the production of any commodity on the basis of total fixed cost and total variable cost.
Total costs are calculated on the basis of the following formula:
Total cost (TC) = Total fixed cost (TFC) + Total variable cost (TVC)
Total costs change due to change in the total variable costs only during short period because total fixed costs (TFC) remain constant.
ADVERTISEMENTS:
Short run total costs can be seen from the following table:
The table reveals that total fixed cost remain constant when the production is zero or its is increasing while total variable cost is zero when production is zero and it changes with the change in output and total cost is the aggregate of total fixed cost and total variable cost.
(2) Total Fixed Cost (TFC):
ADVERTISEMENTS:
Those costs which remain constant when the output is zero as well as it is increasing are called total fixed costs. Such costs are borne by the firm whether there is production or not. These costs are not concerned with the production of a commodity. Plant, land and building, machinery, tools, equipment, implements, contractual rent, insurance fee, maintenance cost, property tax, interest on the capital, manager’s salary, etc., are the items which are included in total fixed costs.
These costs are borne even there is zero production during short period. The Table 1 shows when production is zero the total fixed cost is Rs. 100 and when it is 10 units even then it is Rs. 100. Hence, total fixed costs remain constant. These costs are also known as supplementary costs, general costs, indirect costs and overhead costs. TFC is shown in Diagram 1 which is perfectly horizontal to OX-axis.
(3) Total Variable Costs (TVC):
ADVERTISEMENTS:
Those costs which vary with the production of a commodity during short period and they have direct relation with the change in production. When production is zero these costs will be zero and when production increases they will move in the same direction. These costs are incurred on raw material, direct wages and expenses on energy or power. Variable costs are also called prune costs or direct costs. Total variable costs show an increasing trend as shown in Diagram 1.
Thus, total costs are the summation (aggregates) of total fixed costs and total variable costs. All these costs are related to short run production. They are shown in the Diagram 2 on the basis of the Table 2.
The Diagram 2 shows TC, TFC and TVC. TFC is parallel to OX-axis and it remains constant whether production is zero or it is 10 units. TVC starts from zero production where it is zero and goes on increasing with the increase in output. TC is the total of TFC and TVC. When production is zero total cost is equal to TFC and it increases with increase in production. The difference between TVC and TC is equivalent to TFC which remains constant.
B. Average Costs or Per Unit Costs:
During short period average costs or per unit costs can be divided into following categories:
(1) Average fixed costs (AFC)
(2) Average variable costs (AVC)
(3) Average Costs (AC)
(4) Marginal Cost (MC).
(1) Average Fixed Cost (AFC):
The average fixed cost is the total fixed cost divided by the volume of output. There is an inverse relation between output and average fixed cost. With the increase in output average fixed cost decreases and with the decrease in output the average fixed cost will increase. The shape of average fixed cost curve becomes rectangular hyperbola with the increase in output.
It is calculated from the following formula:
AFC = TFC/O
O is volume of output AFC and TFC are average fixed cost and total fixed cost.
(2) Average Variable Cost (AVC):
The average variable cost is total variable cost divided by the volume of output. Average variable cost falls with the increase in output, reaches at its minimum and then starts rising. By the operation of law of increasing returns the AVC decreases, and by the operation of constant returns leads to constancy in AVC and the law of diminishing returns leads to increase in AVC. The shape of AVC is U-shaped because of the operation of the laws of returns during short period.
The AVC is calculated by the formula given below:
AVC = TVC/O
AVC and TVC are average variable cost and total variable cost while O is the volume of output.
(3) Average Cost (AC):
Average cost is also called average total cost (ATC) during short period because it is the aggregate of AFC and AVC. AC can be calculated from total cost (TC) divided by the volume of output or by aggregating AVC and AFC.
The following is the formula of calculating AC:
AC = TC/O
AC and TC are average cost and total cost while O is the volume of output.
Another formula for the calculation of AC is as given under:
AC = AFC + AVC
The AC curve decreases with the increase in output and remains constant up to a point and thereafter it increases with the increase in output. Its shape is U-shaped because of the operation of the laws of return during short period.
(4) Marginal Cost (MC):
It is an addition to total cost by producing an additional unit of output. It can be calculated as the change in total cost divided by an additional unit change in the output.
The formula for its calculation is as given below:
MC = ΔTC/ΔO
MC is marginal cost, ΔTC is change in TC and ΔO is change in the volume of output.
For example, if the total cost (TC) of 5 units of a commodity is Rs. 550 and 6 units of a commodity is Rs. 600, then the marginal cost of 6th units is Rs. 50.
It can be calculated on the basis of the above formula as given under:
MC = ΔTC/ΔO = 50/1 = 50 or Rs. 50
The MC cost changes with the change in AVC and it is independent of fixed cost. In the beginning the MC falls, reaches at its minimum and thereafter continuously rises. MC is also U- shaped. The MC curve cuts the AC and AVC curves at their minimum points.
The cost-output relation during short period can be seen from Table 2.
The table reveals the trends in total costs (TFC and TVC), average cost (AFC and TVC) and MC. TFC remains constant and TVC goes on increasing and consequently TC is also increasing. AFC is decreasing, but it is positive. AVC decreases, remains constant and thereafter increases. AC also decreases, remains constant and shows an increasing trend. MC increases, remains constant and thereafter shows an increasing trend.
On the basis of the Table 2 we can show the costs and output relation during short period in the following diagram:
The diagram shows AC, AFC, AVC and MC on OY-axis and units of output on OX-axis. AC, MC and AVC are U-shaped curves. The U-shaped curves are on account of the operation of the laws of return during short period. AFC curve shows a decreasing trend. MC curve passes through the minimum points of AC and AVC curves.
There is a close relationship between AC and MC as given below:
(1) AC and MC fall in the beginning but MC falls more rapidly than AC and MC is below AC or AC is greater than MC (AC>MC).
(2) When AC rises, MC also rises but it rises more rapidly than the AC and MC is greater than AC (MC>AC).
(3) When AC is minimum it is equal to AC. The MC curve cuts the AC curve at its minimum point.
The relation between AC and MC can be seen from the following diagram during short period:
The diagram shows AC and MC on OY-axis and volume of output on OX-axis.
Cost-Output Relation during Long Run or Long Run Cost Curves:
Long period gives sufficient time to business managers to change even the scale of production. All the factors of production are variable. All the costs are variable costs and there is no fixed cost. The supply of goods can be adjusted to their demands because scale of production and factors of production can be changed. In the long run we can study the long run average cost curve and long run marginal cost curve.
I. Long Run Average Cost (LAC):
In the long run, all the factors of production are variable and the firm has a variety of choices to select the size of the plants and the factors of production to be employed. Various short run average cost curves represent the various sizes of the plants available to a firm. We can get the long run average cost curve with the help of all the short run average cost curves. The long run average cost curve envelopes all the short run average cost curves in it. It is also called an ‘Envelope Curve’ or ‘Planning Curve’.
The long run average cost curve is also a flat U-shaped curve as shown in the following diagram:
The diagram shows long run cost on OY-axis and output on OX-axis. SAC, SAC1, SAC2, SAC3 and SAC4 are short run average cost curves which represent the different size of plants. LAC has been drawn by combining all those points of least cost of producing the corresponding output. The least per unit cost of production is OQ, OQ1, OQ2, OQ3, OQ4, and OQ5 respectively.
II. Long Run Marginal Cost (LMC):
The long run marginal cost is an addition to the long run total cost when an additional unit of a commodity is produced. It is calculated as the short run marginal cost is calculated. Long run marginal cost curve is also U-shaped but the fall and rise in the marginal cost curve is not sharp but it is gradual.
The LAC and LMC can be seen from the following diagram:
The diagram shows that LAC and LMC are shown on OY- axis while output is shown on OX-axis. The shape of LAC and LMC are U-shaped. The relation between LAC and LMC is the same as is between short run average cost (SAC) and short run marginal cost (SMC) curves. The LMC curve cuts the LAC curve from its minimum point.
Why LAC Curve is U-Shaped?
In the short run SAC curve is U-shaped because the laws of return operate but in the long run LAC is also U-shaped because the laws of return of scale operate, namely, law of increasing returns to scale, law of constant returns to scale and the law of diminishing returns to scale.
As the level of output is expanded or scale of operation is increased by the large firm they will enjoy economies of scale but if these firms produce beyond their installed capacity then they might get diseconomies of scale. Economies of scale bring down the fall in unit cost and diseconomies results into rise in it.
Economies of Scale:
Economies of scale are the results of the operation of laws of return to scale in long run. They are of two types:
(1) Internal economies of scale
(2) External economies of scale.
(1) Internal Economies:
Internal economies of scale are those economies which are on account of the size and operations of an individual firm itself and not from the outside factors.
These economies may be of following categories:
(a) Managerial economies.
(b) Marketing economies.
(c) Specialisation economies.
(d) Technical economies.
(a) Managerial Economies:
Managerial economies means that with the expansion of the output on account of the change in scale of production the whole expanded scale is looked after by the personnel in the organisation and administrative cost decreases with the increase in output.
(b) Marketing Economies:
Marketing economies are concerned with the bulk purchases of raw material while producing on the large scale leads to decrease in the cost of production. Selling in lot saves time, money and energy. Transportation cost will also be reduced.
(c) Specialisation Economies:
Specialisation economies are on account of division of labour and specialisation when large scale production is carried on. The cost of production reduces due to specialisation and division of labour in a business firm.
(d) Technical Economies:
Technical economies arise on account of large scale production in the use of plant, machinery and work processes. Advanced technology is used which reduces the cost of production when the production is carried on large scale.
(2) External Economies:
External economies arise on account of the external factors and they are enjoyed by all the firms in the area or industry as a whole. When an area is industrially well developed then there will be development of labour market, banking, insurance, financial institutions, means of communication and transportation, social overhead and cheap water, electricity and ancillaries.
When a new firm or new industrial unit is set up all these benefits will be available in that area. All these facilities will reduce the cost of production of all the industrial units in that area.
As a result of all the internal and external economies the unit cost of production falls and the LAC and LMC will also fall.
Diseconomies of Scale:
Diseconomies means the losses incurred by the firms or industrial units in an area.
These diseconomies are of two types:
(1) Internal diseconomies of scale.
(2) External diseconomies of scale.
(1) Internal Diseconomies:
These diseconomies are concerned with the size and operation of individual firm or industry.
These diseconomies are of the following categories:
(a) Managerial diseconomies
(b) Technical diseconomies
(c) Marketing diseconomies
(d) Specialisation diseconomies.
(a) Managerial Diseconomies:
When the size of operation of a firm increases the span of control becomes large and thereby the employer-employee relations are adversely affected leading to increase in the cost of production. It is resulted into managerial diseconomies.
(b) Technical Diseconomies:
Under technical diseconomies when the output is taken on large scale after a given point the break down rate may increase in the cost of production.
(c) Marketing Diseconomies:
Marketing diseconomies arise on account of the adverse effect on the control and coordination over marketing activities because of the large scale production and it increases the cost of production.
(d) Specialisation Diseconomies:
Specialisation diseconomies are concerned with the division of labour and specialisation introduced by a firm with the operation of the large scale production. But after a point due to monotony, fatigue and lack of coordination between different layers of personnel administration the cost of production increases that gives birth to these diseconomies.
(2) External Diseconomies:
Such loss or external diseconomies are incurred by business firms or industrial units in an area. Concentration and localisation of industries adversely affect the industrial peace in that area and strikes, lockouts, go slow tactics, gheraos, industrial accidents, emergence of dirty colonies, water pollution, air pollution, etc., increase the cost of production of all firms and industrial units. Means of communication and transportation are overburdened.
Hence, the internal and external diseconomies will increase the LAC curve and LMC curve upward and the cost will increase.
Comments are closed.