Average Cost (long and short-run)

by Nathan Reese


Average total cost is total cost divided by number of units of output, or average fixed costs + average variable costs. Average fixed costs are fixed costs divided by the number of units of output. Average variable costs are variable costs divided by the number of units of output. Managers can make decisions about production based upon average costs, but those decisions will differ depending on if they are making a decision to keep producing a product in the short-run or the long-run.

The Short-Run

The actual time period that makes up the economic short run depends on how long the fixed input remains fixed.
Fixed costs are costs that do not vary with output. Therefore, when production increases average fixed costs decrease because the fixed costs are spread out among more units of outputs. Average variable costs decrease at first due to economies of scale, then will begin to increase when marginal costs exceed average variable costs. As seen in the graph below, as more quantity is produced, the average variable cost line gets closer to the average total cost. This is because the difference between ATC and AVC is AFC, and as more outputs are produced, fixed costs are spread out among more units so the gap gets smaller.

short_run.JPG

In the short-run, companies will continue producing as long as average variable costs are less than price, even if average total costs are greater than price. The reason for this is because in the short-run, fixed costs can not be eliminated so they should be treated as sunk costs. If average variable costs exceed price, the firm should stop producing in order to minimize losses.


The Long-Run

The economic long-run looks beyond current commitments to a future period in which all inputs can be varied. A typical long-run problem is the decision of whether to adjust capacity, seek a larger or smaller facility, to change product lines, or to adopt a new technology. In the long-run a firm can produce any level of output they wish by increasing capital and/or labor. The long-run average cost (LRAC) curve shows the minimum average cost of producing alternative levels of outputs. The LRAC curve is made up of many Short Run Average Cost curves. Below are three examples of what a LRAC curve may look like.



Constant Return to Scale
In this case, minimum costs will be the same as more is produced in the long-run.
constant.JPG

Decreasing Returns to Scale
In this case, producing more actually increases the average cost due to diseconomies of scale. More and more costs are incurred as more labor and capital is needed.
decreasing.gif

Increasing Returns to Scale
In this case, economies of scale causes LRAC to decrease as more is produced. This can occur when a large amount of division of labor is needed to produce something, and more is able to be produced without having to increase costs by much. Not all LRAC curves will look like one of these, often times there will be an increasing returns to scale at first and then the curve will reach a minimum before diseconomies of scale cause decreasing returns to scale.
increasing.gif

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Questions


1. True or False: In the short-run, firms should stop producing if Average Variable Cost exceeds Average Total Costs
a. True
b. False


2. In the short-run firms should stop producing if:

a. ATC < Price
b. AVC > Price
c. ATC > Price
d. AVC < Price


3. Which costs are fixed in the long-run?

a. Labor
b. Capitol
c. Variable Costs
d. none of the above


4. If the slope of a long-run average cost curve decreases as output increases, the firm shows:
a. Constant returns to scale
b. Increasing returns to scale
c. Diseconomies of scale
d. Decreasing returns to scale


5. The cost function of a firm is C(Q) = 40 + 6Q². What is the average variable cost if 15 units are produced?

a. 40
b. 100
c. 90
d. 92.67


Answers

1. False, Average Variable Cost can never exceed Average Total Cost because ATC=AVC+FC

2. b. AVC > Price; AVC must be less than price in order to make a profit or at least minimize losses. Fixed costs shouldn't be considered because they are sunk costs, so if ATC is $1 more than Price, but fixed costs are $5 then the firm would continue to produce in order to minimize losses.

3. d. none of the above; All costs, including capitol and labor are variable in the long run

4. b. Increasing returns to scale; If the slope of the LRAC curve is decreasing, then average costs are getting lower as more outputs are being produced

5. c. Variable costs are 6Q² because they are the only costs affected by change in quantity. 6x15²=1350 (VC). 1350/15=90






Baye, M. (2006), Managerial economics and business strategy. McGraw-Hill, Irwin.

http://en.wikipedia.org/wiki/Short-run

http://www.humboldt.edu/~microeco/cost.htm

http://www.whitenova.com/thinkEconomics/lrac.html

http://william-king.www.drexel.edu/top/prin/txt/Cost/cost18.html