Short Run Average Cost Definition
There are certain prerequisites for starting up a Business. The first and foremost step is drafting a proper Business plan which includes both the long run as well as the short-run expenses. Calculating your cost beforehand helps you figure out your profit and the number of units that are to be produced. The short-run average cost determines the cost of fixed and variable short-run factors which in turn helps in estimating the average production. It includes variable cost, marginal cost, fixed cost and total cost. The factors which have to be bought every time you want to increase the production quantity are variable costs as they vary with the number of goods produced. On the other hand, there are certain requirements for the production process like land, labour etc, which are to be maintained compulsory irrespective of the profit and loss. It not only gives you an idea about the total cost of production but also helps in working out the average cost of manufacturing a single unit. All these costs can also be graphically depicted on the short-run average cost curve.
Let us now understand every aspect of the short-run average cost definition one by one through this blog.
Short-Run Average Cost Vs Long-Run Average Cost:
In the production process, the manufacturer has to buy many goods like raw materials, pay wages to the labour and salaries to the employees, rent to the landowner etc, all these costs are incurred to produce a good. So, an estimate is made before starting the production process on the cost that would incur in the production process. If the estimate is done for a short period that does not consider the change in the number of goods, it is called short-run average cost. We can derive it by dividing the entire cost by the total number of goods that we want to produce. If the same estimate is calculated for long term production, then it is a long-run average cost.
Types of Costs For Production
Before discussing the average cost curve in the short-run, we must know about the various types of costs that are needed to be considered before starting production.
1. Fixed Cost
It comprises all those costs that do not change with the amount of produce. For example, if you are planning to set up a pizza manufacturing unit, the cost of the land and equipment (like an oven) will not be affected even if you were to increase the production, i.e. it will remain ‘fixed’.
2. Variable Cost
It includes those expenses that are bound to change with the number of products manufactured. Labour, raw materials, electricity, etc. are all examples of variable costs.
3. Total Cost
It is obtained by adding the fixed cost and the variable cost.
4. Marginal Cost
It refers to the cost of production that would be required to manufacture one additional unit of a product. It is calculated using the following formula-
\[MC = \frac{\triangle{TC}}{\triangle{Q}}\]
Here, the numerator represents the change in the total cost, and the denominator denotes the change in output. It will be further discussed in the short-run average cost curve.
Calculation of Short-Run Average Total Cost
Let us now have a look at the various short-run average cost functions.
1. Short-run average variable cost - It is the variable cost of production per unit product. The formula for short-run average variable cost can be written as -
AVC = TVC / Q
Where AVC is the average variable cost and TVC is the total variable cost.
2. Short-run average fixed cost - It is defined as the fixed cost for production per unit of output. It is calculated as -
AFC = TFC / Q
Where AFC is the average fixed cost and TFC is the total fixed cost.
3. Short-run average total cost - It refers to the total cost of production per unit product. The formula for the short-run average total cost is as follows-
ATC = TC / Q
Where ATC is the average total cost, TC is the total cost.
The short-run average total cost can also be calculated as the sum of short-run average variable cost and average fixed cost.
ATC = AVC + AFC
All these functions are important for plotting the cost curves in the short-run.
The Short-Run Average Cost Curve
After having talked about the short-run average cost definition and a thorough understanding of its components, we will now discuss the average cost curve in the short-run.
(Image will be uploaded soon)
On the X-axis is the cost of production (in rupees) and on the Y-axis is the quantity of output.
The graph of the average fixed cost goes on decreasing because it is a fixed number and as we keep dividing it by the increasing number of products, it keeps getting smaller. The marginal cost curve goes down and up because of the law of diminishing marginal returns. It goes down at first due to the additional output produced by the workers as they specialize, but eventually, it starts rising because the resources become limited after a certain period.
The short-run average total cost curve and the short-run average variable cost curve also go down first, intersect the curve of marginal cost at their minimum, and then goon rising to form a U-shape. This graph could also be used to calculate total costs by finding out the area under a particular curve.
Did You Know?
In 1998, Alan Blinder, former vice president of the American Economics Association, conducted a survey in which 200 US firms were shown different cost curves and asked to specify which one of those curves represented the US economy the best. He found that about 88.4% of firms reported cost curves with constant or marginal cost.
FAQs on Short Run Average Costs Simplified
1. What is Short-Run Average Cost (SRAC) and why is it important for a firm?
Short-Run Average Cost (SRAC), also known as Average Total Cost (ATC), is the cost per unit of output in a period where at least one factor of production is fixed. It is calculated by dividing the total cost by the quantity of output produced. It is crucial for a firm because it helps in determining the optimal level of output to produce, setting the price for its products to ensure profitability, and making decisions about whether to continue production or shut down in the short run.
2. What are the main components of short-run costs?
In the short run, a firm's total costs are divided into two main components:
- Fixed Costs (FC): These are costs that do not change with the level of output. They must be paid even if the firm produces nothing. Examples include rent for the factory, salaries of permanent staff, and insurance.
- Variable Costs (VC): These are costs that vary directly with the level of output. As production increases, variable costs increase. Examples include raw materials, electricity used for production, and wages of temporary labour.
The Total Cost (TC) is the sum of Fixed Costs and Variable Costs (TC = FC + VC).
3. How do you calculate the different types of short-run average costs?
There are three key types of short-run average costs, each calculated with a specific formula:
- Average Fixed Cost (AFC): This is the fixed cost per unit of output. The formula is AFC = Total Fixed Cost (TFC) / Quantity (Q). AFC always decreases as output increases.
- Average Variable Cost (AVC): This is the variable cost per unit of output. The formula is AVC = Total Variable Cost (TVC) / Quantity (Q).
- Average Total Cost (ATC): This is the total cost per unit of output. It can be calculated in two ways: ATC = Total Cost (TC) / Quantity (Q), or by adding the average fixed and average variable costs: ATC = AFC + AVC.
4. Why is the Short-Run Average Cost (SRAC) curve U-shaped?
The U-shape of the Short-Run Average Cost (SRAC) curve is a result of the combined effect of two other costs. Initially, the SRAC falls because the Average Fixed Cost (AFC) declines sharply as output increases, and the Average Variable Cost (AVC) also falls due to increasing returns. However, after reaching a minimum point, the SRAC begins to rise because the effect of the Law of Diminishing Marginal Returns sets in, causing the AVC to rise steeply, which outweighs the effect of the falling AFC.
5. What is the relationship between the Marginal Cost (MC) curve and the Average Cost curves in the short run?
The relationship is purely mathematical and graphical. The Marginal Cost (MC) is the cost of producing one additional unit.
- When MC is less than AVC or ATC, it pulls the average down, causing the AVC and ATC curves to fall.
- When MC is greater than AVC or ATC, it pulls the average up, causing the AVC and ATC curves to rise.
Consequently, the MC curve intersects both the AVC and ATC curves at their absolute minimum points. This is a fundamental concept in the theory of costs.
6. Can you provide a real-world example of short-run costs for a business?
Consider a small bakery operating in a rented shop. In the short run:
- Its fixed costs would include the monthly rent for the shop, the installment payments on its oven, and the salary of its permanent manager. These costs remain the same whether it bakes 10 cakes or 100 cakes.
- Its variable costs would include the cost of flour, sugar, eggs, electricity for the oven, and wages for part-time bakers who are paid by the hour. These costs increase as the bakery produces more cakes.
7. What is the key difference between Short-Run Average Cost (SRAC) and Long-Run Average Cost (LRAC)?
The fundamental difference lies in the flexibility of production factors. In the short run, at least one factor of production, such as the factory size or heavy machinery, is fixed. The firm can only change its output by altering its variable inputs. In the long run, all factors of production are variable. A firm can change its factory size, purchase new machinery, and alter its entire scale of operation. Therefore, the LRAC curve represents the lowest possible average cost for any given output when all inputs are adjustable.
8. What happens to different short-run costs when a firm produces zero output?
When a firm's output (Q) is zero in the short run:
- Total Fixed Cost (TFC) remains a positive value, as costs like rent must still be paid.
- Total Variable Cost (TVC) is zero, as no raw materials or production-related labour are used.
- Average Fixed Cost (AFC), which is TFC/Q, becomes mathematically undefined or infinite, as you cannot divide by zero.
- Average Variable Cost (AVC) is also undefined.
The concept of 'cost per unit' is meaningless when no units are being produced.
