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
1. What is the law of diminishing marginal returns?
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?
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, 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.
3. What is the average short-run cost?
When you start a Business, you need to estimate the possible cost that you might be incurred on factors of production to produce a good. This will help you in estimating how many goods of different quantities on average. It not only gives you an estimate of the average cost incurred to produce one unit but also tells you the approximate cost of the total cost of production. It is further divided into an average variable cost, average fixed cost, marginal and total cost. To know more about these costs and how to calculate them in detail, please read the above article about Short Run Average cost. The short-run average cost of any number of goods is very easy to calculate, you should divide the entire cost whether it is the variable cost or fixed cost with the total number of goods.
4. What are the types of costs of production incurred by the capitalist or a producer?
Ro produces a good or to deliver a service, a Businessman or a capitalist needs to buy raw materials, employ labourers, pay rents or buy lands, spend money on designs and advertisement. All these costs incurred to produce the goods or deliver the service is called the cost of production. There are four basic types of costs of production namely, marginal cost, variable cost, fixed cost and average cost.
Fixed costs are the same no matter what the output is. For example, if you take land on rent, irrespective of your production and Business, you are obliged to pay the rent. Fixed cost is best explained by this example. And also you have to pay your employees irrespective of your profit and loss.
On the other hand, variable costs change with the output produced, the variable cost increases if the number of goods produced increases and vice versa. For example, if you are making and selling pens, it might cost you more if you want to produce more pens as the raw materials like ink, plastic, and refills also increase. And if you do not want to sell any pens, you do not need to buy any of these goods and the variable cost remains zero
Marginal cost is the amount the Businessman or the capitalist has to spend to produce one extra good of the product.
Total cost is the total amount spent to produce a good hence, the sum of variable cost and the fixed cost is the total cost.
5. What is the difference between the long-run average cost and the short-run average cost?
Short-run average cost is the average cost incurred by the producer to make a good. It is an estimation made before starting the production process and helps in giving an overview of what would be the cost, how many goods could be produced and what is the base price that could be fixed on the product. It helps the producer to mobilize the resources. When the cost is estimated in the short run, it does not include the variations on the product quantity but when the same is estimated in the long run, it considers the difference in goods produced.