We may easily relate the nature of cost to the money or input for producing goods in business, retail, and manufacture. Particularly, economics are interested in the so called opportunity cost, which describes the case when you devote your investment in one project, program or business, you are thus not able to start another one and might lose some potential benefit that the latter will bring. Opportunity cost is not necessarily money, but can also include the lost happiness, time, self-fulfilment and so on.
Apart from opportunity cost, it’s of significance to know avoidable cost. The term describes the cost that can be avoided if you stop producing some service or good. However, not all cost can be avoided in a short period and might be avoided in the further future. To put it another way, there is always a fixed cost in the short run. For example, when a big machine is introduced at a price of £ 100000, the fixed cost is not avoidable. Almost all the initial investment is able to be avoided if you stop producing the good; actually, the cost is before the production stage ever starts. However if the investment is realised in an alternative way, that is, to hire the machine instead of possessing it, then the cost can be stopped as you stop production or end up the hire contract.
This brings to a general category of cost into short-run cost and long-run cost. The short run is a period that the business cannot fully adjust to the sudden change in a project or program. There is, as referred above, certain fixed cost of production which exists even when the production is zero. If the firm cannot make money it may even lose money from the initial investment. Compared with long run cost, the short run cost must be relatively higher, since in short run the firm has to spend certain money in adjusting itself to certain change. This is the second another characteristic for short run cost. By saying short run, there is not a definite confinement between short run and long run, which however, rather depends on different projects. For example, it may take several years to build a dam but only a few months to set up a website. The scale of “short” run varies to the case of projects accordingly (David,2009, 105-115).
While short run cost mainly cover the initial investment, the long run cost should take into consideration of all the cost that might be called for in the whole project lifecycle. A firm won’t judge its business from the short run cost and short run benefit, because even if the firm loses money in the initial stage, it may still be fairly promising if the long run benefit is much higher than long run cost. It is therefore, always worth of study on how to convert a short run loss to a long run benefit, and that requires a further look at the detail of short/long run cost and certain functions and mechanism behind them.
In short run cost function, to simplify the case, there is only one of the input that its quality can be varied by the firm. Then the total cost becomes:
Where P is the price for the input, Y is the quantity of the input, and K is the fixed cost as studied in above context. In the case with one input, i.e. the price of the input is constant, so that we can rewrite the above equation as the function of the quantity of input:
With the only variable, the change may have some impressive effect on the marginal cost behaviour.
Figure 1 MC, ATC, AVC, AFC curve (cost in the long run, 2011)
Here several economic terms are to be discussed to describe the short run function. Average fixed costs (AFC), is the firm’s fixed cost over the quantity and can be expressed as: AFC=K/q. Average variable cost (AVC), is the variable cost over the quantity, i.e. AVC=f(q)/q. And average total cost (ATC) is the total cost over the quantity, ATC= C/q=( f(q)+K )/q. Average total cost is the sum of average fixed cost and average variable cost. Lastly, marginal cost is the increased cost when the quantity increases by one unit. Marginal cost (MC) can be expressed as: MC= dC/dq=d(f(q)+K )/dq, it is the slope of the cost varying with quality.
As seen in Figure 1, the shape of the short run average fixed costs (AFC), short run average variable costs (AVC), and short run average total cost (ATC) curves and the marginal cost curve are depicted.
The short run marginal cost (MC) curve will at beginning drop, and then rises at some point. When it keeps going up along with quality, it will intersect with the short run average various cost curve (AVC) and short run average total cost curve (ATC) at their minimum point respectively (Paul,1980,67-71).
When production began to increase initially various production factors have not been fully effective, therefore, the yield very small. As production progresses, increased utilization of production factors, the growth rate of output growth is greater than the cost, so the marginal cost decreases with the increase of production. When the yield increased to a certain extent, due to the role of the law of diminishing marginal returns, marginal cost would increase with increased production. If you do not take into account the initial short-term situation, then it is mainly changes in law: First, the marginal cost of production increases with the decrease, when production increased to a certain extent, to increase with the production, so the marginal cost curve is a first decline and then increase the “U” shaped curve.
Both MC curve and the AC curve are U shaped, which are due to the marginal cost of factor inputs decrease or increase. However economic implications and geometric meaning are different. MC curve reflects the TC curve points on the slope of the tangent, while AC curve is the TC curve connecting the points with the origin of the slope. MC curve so comes earlier than the AC curve reached the lowest point. MC curve and AC curves intersect at the lowest point on the AC curve. At this point, MC = AC, is the marginal cost is equal to average cost. On the left of the point, AC is on top of the MC, AC has been decreasing, AC> MC, which means marginal cost is less than the average cost. On the right of the point, AC is under the MC, and AC has been increasing, AC <MC, the marginal cost is greater than average cost. AC is the change with changes in MC, when the MC down to a more low, the corresponding decline in AC has to follow, but it is a higher level with the previous average, and therefore must be greater than MC. Even when the MC reached the lowest point and the goes up, AC is still larger than MC and the AC will continue to decline. Until the intersection with the increase of MC, AC begins reaching the lowest point, and then turned to increase. And after this point, the opposite, AC, or as changes with the MC, when the MC to a higher point, the corresponding increase in AC have to follow, but it is a lower level with the previous average, and therefore must be small in the MC, the marginal cost is greater than average cost.
The average fixed cost decreases with increasing yield and the curve is a hyperbola. The rate of decrease is great at first, but the rate is decreasing. Therefore, the average fixed cost curve is steep at first, indicating that when production begin to increase, the decrease is large; later it becomes more and more flat, indicating that with the increase in production, the decrease is smaller.
When studying long run cost, economies and diseconomies of scale are two relative terms. Economies of scale is at a certain range of production, with the increase in production, average cost is decreasing. (Dudley,1998, 171) Economies of scale in production is due to at a certain range, little change can be considered fixed costs, then the new products can share more of the fixed costs, as well as the total costs. People choose and control the scale of production, increase production and obtain lower costs, and thus obtain the best value for money. Economies of scale or productivity of the economy of scale is to determine the optimal scale of production problems.
Diseconomies of scale is when scale of production expanded, the long-term average cost increases. Diseconomies of scale can be categorized to internal and external diseconomies. Firstly, the internal Diseconomies of scale is mainly due to the decreasing management efficiency as enterprise scale increases. Not inherent to the long-term average cost curve of the economy from its lowest point began to rise. On the other hand, the external diseconomies of scale meaning, the reasons for its performance. Refers to the external economy is not the long-term average cost as the industry increased the scale of the phenomenon of the expansion, which is rooted in industry expanded due to the deterioration of the external environment company, such as factor prices rise, sales fall in market conditions and so on. When long-term average external cost curve move upward vertically, which means at the level of each unit of production, the long-term average cost of fee now increases than in the past(Gregory, 2008, 281-282).
Long-term average cost (LAC Long-run Average Cost) long-term average cost per unit of product, is numerically equal to the total cost divided by the long-term production.
Long-term average cost curve is the average cost curve envelope.
It means, in the long term, manufacturers will each select the optimal output level for scale of production, which will minimize the average cost of production levels. In this envelope line, a continuous change in the level of each production, there is a tangent point for SAC LAC curve and the curve. The SAC curve represents the output of the production scale which is the best production scale, and the cut point corresponding to the corresponding average cost which is the lowest average cost.
The long-run average cost curve is of U shape, which is very similar with this short-term average cost curve shape. However, the reasons for the formation of U-shape are quite different: In short-term average cost curve U-shape is due to the role of the law of diminishing marginal returns. In long-run average cost curve U-characteristics is determined by the long-term production economies of scale and diseconomies of scale.
Figure 2 long-run average cost curve (Economies of scale,2011)
Note that LAC curve means the smallest average cost that firms within each level of production in the long run can achieved. In long term, manufacturers can always find the best production scale to achieve the lowest average cost to produce. While economies of scale in the long run would cause the average costs decline, diseconomies of scale would cause long-term average costs to increase. Both economies of scale and diseconomies of scale are caused by the changes in production scale by manufacturer. Therefore they’re also called the internal economy and internal non-economic. LAC decreasing curve shows the characteristics of falling after rising. (William, 2009, 127-129) Normally, in the production process of most industries, the scale of the internal dis-economic situation will not arise until the companies enjoy the full benefits of the internal economy of scale, but it generally appears at a very high output level. In addition, long-term average cost curve shape are related with the different characteristics of the industry concerned. (Ian, 2009, 47-48) In some industries duration of stages in the constant returns to scale is several months short, but some are very long. However, they will eventually reach the situation of decreasing returns to scale.
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Dudley Jackson (1998) Profitability, mechanization, and economies of scale, Great Britain: N.M.171,180
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N.A. (1997). Economies of scale. United States: Office for Official Publications of the European Communities, 67-71
William J. Baumol,(2009) Economics: Principles and Policy. United States: South-Western Cengage learning, 127-129
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