Short-run and long-run costs; economies and diseconomies of scale
Short-run costs split into fixed and variable, and marginal cost drives decisions. In the long run, average cost falls with economies of scale, then rises.
Cost concepts
Economists count explicit costs (money paid out: wages, rent, materials) and implicit costs (the opportunity cost of the owner's own time and capital, including normal profit). In the short run, some inputs are fixed, so costs split into total fixed cost (TFC), which does not change with output (rent, insurance, loan interest), and total variable cost (TVC), which rises with output (raw materials, fuel, piece-rate wages). Average costs are per unit: AFC = TFC ÷ Q, AVC = TVC ÷ Q, ATC = TC ÷ Q. Marginal cost (MC) is the extra cost of one more unit. In the long run, all inputs are variable, so all costs are variable.
Worked example: building a cost table (TC, AC and MC)
A bakery's fixed cost is Rs. 10,000 a day. Its total variable cost for 1 to 6 batches of bread a day is Rs. 4,000, 7,000, 9,000, 12,000, 17,000 and 24,000. Find TC, MC, AFC, AVC and ATC.
- TC = TFC + TVC: 14,000; 17,000; 19,000; 22,000; 27,000; 34,000 (TC at zero output = 10,000).
- MC = change in TC: 14,000 − 10,000 = 4,000; 3,000; 2,000; 3,000; 5,000; 7,000.
- AFC = 10,000 ÷ Q: 10,000; 5,000; 3,333; 2,500; 2,000; 1,667 (rounded).
- AVC = TVC ÷ Q: 4,000; 3,500; 3,000; 3,000; 3,400; 4,000.
- ATC = TC ÷ Q: 14,000; 8,500; 6,333; 5,500; 5,400; 5,667 (rounded). Check: AFC + AVC at Q = 5 is 2,000 + 3,400 = 5,400. ✓
- MC is lowest at the 3rd batch (2,000); AVC is lowest at 3-4 batches (3,000); ATC is lowest at 5 batches (5,400).
Minimum ATC is Rs. 5,400 per batch at 5 batches. MC (5,000 for the 5th batch) is below ATC while ATC falls, and above it (7,000 for the 6th) once ATC rises.
The bakery's cost table (Rs. per day)
| Q | TFC | TVC | TC | MC | AFC | AVC | ATC |
|---|---|---|---|---|---|---|---|
| 0 | 10,000 | 0 | 10,000 | - | - | - | - |
| 1 | 10,000 | 4,000 | 14,000 | 4,000 | 10,000 | 4,000 | 14,000 |
| 2 | 10,000 | 7,000 | 17,000 | 3,000 | 5,000 | 3,500 | 8,500 |
| 3 | 10,000 | 9,000 | 19,000 | 2,000 | 3,333 | 3,000 | 6,333 |
| 4 | 10,000 | 12,000 | 22,000 | 3,000 | 2,500 | 3,000 | 5,500 |
| 5 | 10,000 | 17,000 | 27,000 | 5,000 | 2,000 | 3,400 | 5,400 |
| 6 | 10,000 | 24,000 | 34,000 | 7,000 | 1,667 | 4,000 | 5,667 |
Shapes of the short-run cost curves
- TFC is a horizontal line; AFC falls continuously as fixed cost is spread over more units.
- AVC, ATC and MC are U-shaped: they fall at first (increasing returns to the variable input) and rise later (diminishing returns).
- MC cuts AVC and ATC at their lowest points. When MC is below an average, the average falls; when MC is above it, the average rises.
- The vertical gap between ATC and AVC is AFC, so it narrows as output grows.
- The minimum of AVC comes at a lower output than the minimum of ATC.
Long-run costs
In the long run the firm can choose any plant size. Each plant size has its own short-run average cost (SAC) curve. The long-run average cost (LAC) curve joins the lowest cost of producing each output with the best plant size; it envelopes the SAC curves, so it is called the envelope or planning curve. LAC is usually U-shaped: it falls as output grows because of economies of scale, may be flat over a range, and rises when diseconomies of scale set in. The output where LAC first reaches its minimum is the minimum efficient scale.
Economies and diseconomies of scale
| Type | Meaning | Example |
|---|---|---|
| Technical economies | Larger, more efficient machines and specialised workers | A large tea factory with modern rolling and drying lines |
| Purchasing and marketing economies | Bulk buying discounts; advertising spread over more output | A supermarket chain buying rice in bulk |
| Financial economies | Big firms borrow more cheaply and easily | A listed conglomerate raising funds through shares or debentures |
| Managerial and risk-bearing economies | Specialist managers; spreading risk across many products and markets | A diversified group operating in hotels, retail and transport |
| External economies | Lower costs from growth of the whole industry in an area | Garment firms in export processing zones sharing skilled labour and suppliers |
| Diseconomies of scale | Poor coordination, slow communication, low motivation, bureaucracy; external congestion and rising input prices | Delays and duplication in a very large organisation |
Large groups such as John Keells and Cargills enjoy purchasing and financial economies that a small grocery cannot. Garment makers clustered in the Katunayake and Biyagama export processing zones gain external economies: shared suppliers, transport links and a pool of trained workers.
Short answer: “Distinguish fixed cost from variable cost.” Fixed costs do not change with output in the short run (rent, insurance); variable costs change with output (materials, fuel).
Structured question: “Given TFC = Rs. 10,000 and a TVC schedule, calculate TC, MC, AFC, AVC and ATC, and state where ATC is minimum.” TC = TFC + TVC; MC = ΔTC; averages ÷ Q. In the bakery example, minimum ATC is Rs. 5,400 at 5 batches.
Essay: “Explain the short-run cost curves and why the long-run average cost curve is U-shaped.” Define the cost concepts, show a cost table and the U-shaped curves with MC cutting AVC and ATC at their minimum, then explain LAC as an envelope shaped by economies and diseconomies of scale.
MC is the leader: it pulls the averages down while below them and up once above them, so it cuts AVC and ATC at their lowest points. Economies of scale: T-P-F-M-R (Technical, Purchasing, Financial, Managerial, Risk-bearing).