Traditional Theory of Costs: Short Run

Short Run Costs of Production

These are broadly comprised of the total, average and marginal costs.

1. Total Costs (TC)

It is the sum of the total fixed cost and total variable cost.

TC = TFC + TVC

Total Cost (TC) is the actual cost incurred to produce a given quantity of output.

2. Total Fixed Costs

It refers to the sum of all the expenditures by the firm on fixed inputs like land, depreciation of machinery, insurance etc. The payments for such factors are fixed in the short run and independent of the level of output. Even at zero level of production, the firm has to incur fixed costs which remain unchanged at all levels of output. The TFC curve runs parallel to the X-axis. For e.g. the cost incurred by a firm on fixed machinery, building blocks remain fixed over a given span of time.

3. Fixed Cost and Sunk Costs

Sunk costs are costs that have been incurred but cannot be retrieved if the firm goes out of business. Fixed costs can be escaped by going out of business. An example of Sunk costs is the expenditure incurred in purchasing a machine which does not have an alternative use when the firm decides to go out of business.

4. Total Variable Costs

It refers to the firm’s total expenditure on variable factors. Variable costs vary directly with the change in the level of output. Examples of such costs are costs of labour, raw materials, transportation etc. TVC is zero when output is zero. TVC has an inverse ‘S‘-Shape reflecting the law of variable proportions.

5. Short Run Average Costs

In order to find out the per unit profit, the firm has to make a comparison between the per unit cost or the average costs and the per unit price or simply the price. The Average Cost is the sum of the Average fixed costs (AFC) and the Average variable cost (AVC).

6. Average Fixed Cost Curve

AFC is the per unit cost of the fixed factors of production. AFC= TFC/Q .The AFC is a rectangular hyperbola because the multiplication of AFC with the quantity of output produced always yields a fixed value. The AFC will never touch the x-axis as the AFC cannot be zero, however large the level of output. Also, AFC curve never touches the Y- axis as TFC is a positive value at zero output, and any positive value divided by zero will give an infinite value.

7. Average Variable Cost Curve

It refers to the per unit cost of the variable factors of production. AVC= TVC/Q, where Q is the level of output.

Since the total variable costs (TVC) are determined by the law of variable proportions, the AVC falls initially and rises later. The AVC is a dish-shaped curve.

Average costs are the sum of the Average fixed costs and Average variable costs.

AC = TC/Q

AC = TFC/Q + TVC/Q

AC = AFC + AVC

8. Marginal Cost (MC)

It refers to the incremental cost and is the addition to the total cost as a result of a unit increase in the output.

MC = ΔTC/ΔQ

MC = ΔTVC/ΔQ

Since the fixed cost remains constant in the short-run, the marginal cost is also defined as the increase in total variable cost due to a unit increase in output.

Mathematically,

MCn = TCn – TCn-1

where-

MCn = marginal cost of producing the n^th unit

TCn = total costs of producing the n units

TCn- 1= total costs of producing ‘n-1‘ units

Marginal costs are the first derivative of the total cost function. MC = ΔTC/ΔQ. Graphically, the marginal cost is the slope of the total cost curve. With an inverse S-shaped of the total cost curve, the MC curve is U- shaped. In the short-run, the AC, AVC, and MC curves are U-shaped, and AFC is a rectangular hyperbola.

The relationship between AC and MC is as follows:

1. When the MC curve is below the AC curve, the AC falls.
2. When the MC curve is above the AC curve, the AC rises.
3. The MC curve intersects the AC curve at its minimum point.

The MC curve intersects AVC curve and AC curve at their minimum points.

9. Relationship Between Average Cost Curve and Average Variable Cost Curve

The U-shape of AVC and AC curves is due to the law of variable proportions. The behaviour of the AC curve depends on the behaviour of the AVC and AFC curves. Initially, both AFC and AVC are falling, leading to a fall in AC. The minimum point of AC occurs to the right of the minimum point of AVC. After reaching its minimum point, it starts rising.

However, the AFC continues to fall. The AC reaches its minimum point when the rate of fall of AFC is equal to the rate of rise of AVC. When the rate of rise in AVC becomes greater than the rate of fall in AFC, the AC starts rising. The vertical distance between AC and AVC is the AFC, which continues to decline as the output increases.

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6. Concept of Equilibrium & Dis-equilibrium in Economics
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39. Cobb Douglas Production Function
40. CES Production Function
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42. Translog Production Function
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44. Traditional Theory of Costs: Short Run
45. Traditional Theory of Costs: Long Run
46. Modern Theory Of Cost: Short-run and Long-run
47. Modern Theory Of Cost: Short Run
48. Modern Theory Of Cost: Long Run
49. Empirical Evidences on the Shape of Cost Curves
50. Derivation of Short-Run Average and Marginal Cost Curves From Total Cost Curves
51. Cost Curves In The Long-Run: LRAC and LRMC
52. Economies of Scope
53. The Learning Curve
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56. Perfect Competition: Demand Curve
57. Perfect Competition Equilibrium: Short Run and Long Run
58. Monopoly: Meaning, Characteristics and Equilibrium (Short-run & Long-run)
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