Short Run Average Costs

Bookmark added to your notes.
View Notes
×

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 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. 

[Image to be added Soon]

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’. 

  1. 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. 

  1. Total Cost  

It is obtained by adding the fixed cost and the variable cost. 

  1. 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=\[\frac{ ΔTC}{ ΔQ}\]

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.] 

  1. 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.]

  1. 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 to be added 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 go on 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. 

FAQ (Frequently Asked Questions)

1. What is the Law of Diminishing Marginal Returns?

Answer: Under the context of the short-run average cost definition, the law of diminishing marginal return states that with the increase in a single factor of production while all other factors are kept constant, the incremental output of a production process is bound to decrease after a point of time. This happens in the case of the marginal cost curve which, in turn, affects the short-run average total cost curve and the short-run average variable cost curve. This happens because after some time the constant factors become a constraint for the factor that is increasing, and this leads to an overall decline in the marginal output. 

2. How does the Curve of Marginal Cost Affect the Average Cost Curve in the Short-Run?

Answer: While plotting the short-run average cost curve, it is seen that the marginal cost curve takes a U-shape due to the law of diminishing marginal returns. If the marginal cost is lesser than the average total cost and the average variable cost, it pulls them down with itself. For example, if the short-run average total cost 150 rupees and the marginal cost is 50 rupees, so, this will decrease the average total cost. As long as the marginal cost is less than the average cost, it will pull down the average total cost curve in the short-run. However, as soon as it becomes more than the average cost, the short-run average cost curve will go up.