Cost Output Relationship in Short Run and Long Run
Cost Output Relationship in Short Run and Long Run: In determining a firm’s pricing, the time factor is critical. Two sorts of variables are used throughout brief periods of time. One is a fixed factor, whereas the others are production variables. Fixed factors of production stay constant, but variable inputs may be changed as production increases only because time is limited and all factors cannot be changed at the same time.
Variable inputs, such as raw materials, semi-finished materials, unskilled labour, energy, and so on, may be adjusted in the short term. Fixed inputs include machines, capital, infrastructure, and management and technical expert pay. An individual business may adjust variable factors of production according to production needs within a short period of time, while fixed elements of production cannot be modified.
Cost Output Relationship in Short Run and Long Run
(I) Output at a Fixed Cost Average
The lower the fixed cost per unit, i.e. the average fixed cost, the higher the production. The reason for this is because overall fixed costs stay constant regardless of production.
For all sorts of businesses, the link between production and fixed costs is ubiquitous.
When a result, as production increases, the average fixed cost decreases. Because some elements are indivisible, total fixed costs stay constant but average fixed costs decrease. Indivisibility indicates that the factor cannot be employed in a lesser amount if a smaller outcome is desired. It is to be utilised in its entirety.
(ii) Variable Cost and Output Averages
As a facility produces more and more units, the average variable costs will reduce at first, then climb. This is because, when additional units of variable components are added to a fixed plant, the efficiency of the inputs initially rises, then falls. In reality, near a firm’s optimal production, the variable elements tend to produce more effectively than at extremely low output levels.
However, once the optimal capacity is achieved, any additional increase in production would almost certainly result in a significant rise in average variable cost. Greater production is possible, but it comes with a far higher average variable cost. For instance, if more and more employees are hired. It may eventually result in overpopulation and poor organisation. Furthermore, employees may be required to be paid more for overtime labour.
(iii) Total Cost and Output Averages
Average overall expenses, often known as average costs, will decrease at first and subsequently climb. The important thing to notice here is that in the case of average cost, the turning point occurs a bit later than in the case of average variable cost.
The average cost is made up of the average fixed and variable costs. As we can see, average fixed costs continue to shrink as production grows, but average variable costs initially fall and then climb. The average total cost will decrease as long as the average variable cost decreases. However, beyond a certain point, the average variable cost will begin to grow. The average total cost will continue to fall if the increase in variable cost is smaller than the decrease in fixed cost.
The average total cost will only rise if the increase in average variable cost exceeds the decrease in average fixed cost. As a result, although the average variable cost may have begun to climb, the average total cost will continue to fall since the increase in average variable cost is smaller than the decrease in average fixed cost. The end result is a decrease in average cost.
The lowest cost-output level is the one where the average total cost, not the average variable cost, is the lowest. In reality, the average variable cost will be higher than its minimum at the lowest cost-output level (average variable cost). The optimal output level is also the lowest cost-output level. It’s possible that this isn’t the maximum output level. A company may opt to create more than the cheapest amount of production.
(iv) Curves of Short-Run Output Costs
Graphs may also be used to depict the cost-output relationships. It can be shown that when production climbs from lower to higher levels, the average fixed cost curve (AFC curve) lowers. As a result, the average fixed cost curve has a rectangular hyperbola form.
The average variable cost curve (AVC curve) begins to rise before the average total cost curve (ATC curve). Furthermore, the lowest cost output level corresponds to point LT on the ATC curve rather than point LV on the AVC curve.
It’s also worth noting that the marginal cost curve (MC curve) touches both the AVC and ATC curves at their minimum positions in Fig. This is a really basic concept to grasp. If the marginal cost (MC) is smaller than the average cost (AC), the average cost (AC) will be lowered. If the MC is higher than the AC, the AC will be pulled up. If the MC is the same as the AC, it will not pull the AC up or down. As a result, the MC curve intersects the AC curve at its lowest point.
The location on the average variable cost curve is similar. It makes no difference whether MC is rising or falling. LT denotes the lowest total cost, whereas LV denotes the lowest variable cost.
The following is a summary of the interrelationships between AVC, ATC, and AFC:
- ATC will collapse if both AFC and AVC fall.
- If AFC declines while AVC increases, it’s a win-win situation.
- (a) ATC will decline if the decrease in AFC exceeds the increase in AVC.
- (b) ATC will not decline if the decrease in AFC equals the increase in AVC.
- (c) Where the decline in AFC is smaller than the increase in AVC, ATC will rise.
Long-Term Cost-Output Relationship
The long run is defined as a time span long enough to make all expenses, even those that are fixed in the short run, variable. Variations in production are only achievable in the short term within the range allowed by fixed plant and equipment. However, in the long term, the entrepreneur has a variety of options, including the development of different types and sizes of plants.
As a result, there are no fixed expenses since the company has enough time to properly adjust its facility. All costs become variable as a result. As a result, long-run costs will relate to the costs of generating various levels of output as a result of changes in plant size or production scale. The long-run cost-output connection is visually shown by the long-run cost curve, which shows how costs fluctuate as production scale changes.
With the use of an example, the notion of long-run costs may be better described. Assume that a corporation runs under the average total cost curve U2 and generates OM at any given period. It is now desirable to generate ON. The firm’s average cost curve will be NT if it sticks on the old scale. The new cost curve will be U3 if the firm’s size is changed. As a result, the average cost of manufacturing ON will be NA.
The NA value is lower than the NT value. As a result, the new scale is superior than the previous one and should be used. The average cost of creating ON product in the long term is NA. This is often referred to as the long-term cost of creating ON product. It’s worth noting that we’ll use NA as the long-run cost just as long as the U3 scale is still in the design stages and hasn’t been implemented. The NA cost will be the short-run cost of generating ON output after the scale is established.
To construct a long-run cost curve, we must first construct a series of short-run average cost curves (SAC curves), each of which represents a different scale or size of the plant, including the optimal scale. The long-run cost curve may now be drawn as a tangent to the full family of SAC curves, touching each SAC curve at one point.