Modern Theory Of Cost: Short Run

Short-Run Costs Curves Under Modern Theory

The short-run Average costs consist of the Average fixed costs and Average variable costs. Because of the U- shaped AVC curve under the traditional theory, the Plant is designed to optimally produce a single level of output (at the minimum point of AVC CURVE). In case there is any departure from the optimizing output, there arises an excess capacity or unplanned capacity.

If the firm produces a lower level of output OX1 then costs would be high compared to OXm level of output. The short-run Average variable costs (SAVC) has a Saucer-type shape where there is a flat- stretch corresponding to the ‘RESERVE CAPACITY‘ or the ‘PLANNED CAPACITY‘ – which the Plant builds to provide flexibility in the firm’s production process.

The Shapes of Short Run Average Variable Cost Curves Under Traditional and Modern Theory of Costs

1. Average Fixed Cost Curve

The Average Fixed cost curve under conditions of Reserve capacity is downward sloping- falling continuously as output expands.

AVERAGE COST CURVE is the sum of AFC and AVC. Initially, both AFC and AVC are falling up to OX1 level of output, causing the Average Cost to fall. Between X1 and X2 levels of output, AFC continues to fall, but AVC remains constant, causing AC to decline. At X2 level of output, the Reserve capacity is fully utilized, and so beyond this point, AC starts rising.

2. Average Variable Cost

The Average Variable cost is equal to the total variable cost divided by the total output.

AVC = TVC ÷ Q = (P × V) ÷ Q, where P is the price per unit of input and V is the quantity of variable input.

The Average Variable cost curve is not ‘U’ Shaped as under the traditional theory but ‘trough shaped/ saucer-shaped’ under the Modern theory of cost due to the ‘RESERVE CAPACITY’ maintained by the firm.

3. Marginal Cost Curve

The MC curve intersects the SAVC curve at its minimum point. Since the SAVC curve reaches its minimum point not at a single point but over the whole flat stretch e1e2, therefore the short-run Marginal cost curve (SMC) coincides with the SAVC over the entire range of output corresponding to the flat stretch of the SAVC Curve.

For any output less than OX1, the SMC curve will lie below the Saucer-shaped SAVC curve, and for any output higher than OX2, the SMC curve will be above the SAVC curve. Thus, over the flat stretch pertaining to the Reserve Capacity, the short-run marginal cost curve coincides with the SAVC Curve.

Relationship Between Short Run Average Variable Cost and Marginal Cost Curves

The falling portions of the SAVC Curve show the reduction in costs due to better utilization of the fixed factors and the consequent rise in productivity of the variable factors. The rising portion of the SAVC Curve depicts the rise in costs on account of diminishing returns from the variable factor and also overutilization of the fixed factors. The SAVC Curve has a flat stretch over a range of output wherein the SAVC is equal to the short-run marginal cost, both being constant per unit of output.

The short-run Average cost curve continues to fall even over the range of output X1 and X2, corresponding to the flat stretch of the SAVC Curve where in SAVC is assumed to be constant. As Average cost consists of Average fixed cost and Average variable cost, and Average fixed cost continues to fall as the level of output increases.

Even after the Planned Reserve capacity is exhausted, the Short-run Average cost curve continues to decline despite the rise in SAVC because AFC continues to fall throughout. Eventually, the rise in short-run Average cost becomes greater than the fall in Average fixed cost, and the short-run Average cost starts to rise.

The SAC Curve is intersected at its lowest point by the short-run marginal cost curve as in the case of the traditional theory of costs. Beyond OX3 level of output, the SAVC Curve asymptotically approaches the short-run Average cost SAC since the gap between the two curves gradually diminishes on account of falling AFC but the two can never coincide because AFC cannot be zero.

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