Short-Term and Long-Term Costs

Types of Costs in the Short Run

Understanding the structure of costs is the foundation for making decisions about pricing, production volume, and business strategy. A manager who does not understand their firm’s costs is like a pilot who cannot see the instrument panel—disaster is only a matter of time.

Fixed Costs (FC — Fixed Costs)

Fixed costs are costs that do not depend on the volume of output. Even if the firm produces nothing (Q = 0), it incurs fixed costs. They are associated with fixed factors of production.

Examples: rent for premises, equipment depreciation, salary of management personnel, insurance premiums, loan payments, licensing fees.

Specific example: A restaurant pays 300,000 rubles/month in rent, 100,000 rubles/month in administrator’s salary, 50,000 rubles/month in insurance. Total FC = 450,000 rubles/month—regardless of whether it serves 0 or 1,000 clients.

Variable Costs (VC — Variable Costs)

Variable costs are costs that change with the volume of output. The more the firm produces, the higher the variable costs.

Examples: raw materials and supplies, piece-rate labor, electricity (for production), transportation for delivery, packaging.

Specific example: A restaurant spends, on average, 500 rubles per dish for food products, 200 rubles for cooking electricity, 100 rubles for disposable materials (napkins, etc.). VC per dish = 800 rubles. For 500 dishes/month: VC = 400,000 rubles. For 1,000 dishes/month: VC = 800,000 rubles.

Total Costs (TC — Total Cost)

TC = FC + VC

At Q = 0: TC = FC (variable costs are zero). As Q increases: TC grows due to increasing VC.

Average Costs

• Average Fixed Costs (AFC) = FC / Q — decrease as Q increases (fixed costs are “spread” across more units). This explains why mass production is cheaper: the cost of the factory is “smeared” over millions of units.

• Average Variable Costs (AVC) = VC / Q — usually decrease at first (specialization and division of labor), then increase (diminishing returns).

• Average Total Costs (AC or ATC) = TC / Q = AFC + AVC — have a U-shape: decrease at first (due to falling AFC and AVC), then increase (AVC increase outweighs AFC decrease).

Marginal Costs (MC — Marginal Cost)

MC = ΔTC / ΔQ — additional cost of producing one more unit of output.

MC is the most important indicator for making output decisions. It is MC that is compared with marginal revenue to determine the optimal production volume.

Detailed Numerical Table: Furniture Production

Analysis:

• AFC continuously decreases (100/1 = 100, 100/2 = 50, 100/3 = 33.3...)
• MC first decreases (50 → 35 → 25 — increasing returns), then increases (25 → 30 → 45 → 65 → 90 → 120 — decreasing returns)
• AC is minimal at Q = 5 (57 thousand rubles)—this is the efficient scale of the firm
• MC crosses AC at AC’s minimum (between Q = 4 and Q = 5)

Key Relationship: MC and AC

There is a fundamental mathematical relationship between marginal and average costs, similar to the average grade of a student:

• When MC < AC → AC decreases (each new unit is “cheaper than average” → pulls the average down). Like if a student got a grade above their current average GPA, the average GPA increases.
• When MC > AC → AC increases (each new unit is “more expensive than average” → pulls the average up)
• When MC = AC → AC is at its minimum (inflection point)

This means that the MC curve always crosses the AC curve at its minimum point—a critically important fact for graphical analysis.

<div style="text-align: center; margin: 20px 0;"> <svg width="100%" style="max-width: 600px;" viewBox="0 0 520 420" xmlns="http://www.w3.org/2000/svg"> <defs> <marker id="arrow-3-2" markerWidth="8" markerHeight="6" refX="8" refY="3" orient="auto"> <polygon points="0 0, 8 3, 0 6" fill="#333" /> </marker> </defs> <line x1="60" y1="20" x2="60" y2="360" stroke="#333" stroke-width="1.5" marker-end="url(#arrow-3-2)" /> <line x1="60" y1="360" x2="490" y2="360" stroke="#333" stroke-width="1.5" marker-end="url(#arrow-3-2)" /> <text x="25" y="190" font-family="sans-serif" font-size="13" fill="#333" transform="rotate(-90, 25, 190)" text-anchor="middle">Costs (&#8381;)</text> <text x="280" y="395" font-family="sans-serif" font-size="13" fill="#333" text-anchor="middle">Quantity (Q)</text> <path d="M 90,60 C 120,120 150,200 200,260 C 230,290 270,310 320,320 C 370,325 420,330 460,340" stroke="#9ca3af" stroke-width="1.5" fill="none" stroke-dasharray="6,4" /> <text x="465" y="337" font-family="sans-serif" font-size="12" fill="#9ca3af" font-weight="bold">AFC</text> <path d="M 90,280 C 130,230 170,200 220,195 C 260,192 300,200 340,220 C 380,245 420,280 460,310" stroke="#16a34a" stroke-width="2.5" fill="none" /> <text x="465" y="307" font-family="sans-serif" font-size="12" fill="#16a34a" font-weight="bold">AVC</text> <path d="M 90,180 C 130,140 180,120 240,115 C 280,113 320,120 360,140 C 400,165 440,200 470,240" stroke="#2563eb" stroke-width="2.5" fill="none" /> <text x="475" y="237" font-family="sans-serif" font-size="12" fill="#2563eb" font-weight="bold">ATC</text> <path d="M 90,310 C 120,240 150,180 180,160 C 200,150 210,155 220,195 C 225,210 230,220 240,240 C 260,270 270,280 280,290 C 290,295 300,290 310,280 C 315,275 320,268 330,255 C 335,248 340,235 350,220 C 355,208 360,195 365,180 C 375,150 385,120 400,90 C 415,60 430,40 450,25" stroke="#dc2626" stroke-width="2.5" fill="none" /> <text x="455" y="22" font-family="sans-serif" font-size="12" fill="#dc2626" font-weight="bold">MC</text> <circle cx="220" cy="195" r="4" fill="#dc2626" /> <text x="220" y="215" font-family="sans-serif" font-size="10" fill="#333" text-anchor="middle">MC=AVC</text> <circle cx="310" cy="118" r="4" fill="#dc2626" /> <text x="310" y="108" font-family="sans-serif" font-size="10" fill="#333" text-anchor="middle">MC=ATC</text> <text x="280" y="415" font-family="sans-serif" font-size="13" fill="#555" font-style="italic" text-anchor="middle">Fig. 1: Short-Run Cost Curves</text> </svg> </div>

Long-Run Average Costs (LRAC)

In the long run, all factors are variable, and the firm selects the optimal scale of production. The LRAC (Long-Run Average Cost) curve shows the minimum average cost at every output level, when the firm can freely choose the size of the factory.

LRAC is the “envelope” of a multitude of short-run AC curves for factories of different sizes. For each output, the firm selects the factory size that provides the lowest average cost.

The LRAC Curve Shape

The LRAC curve usually has a U-shape (or L-shape) and is divided into three sections:

1. Economies of Scale—Downward Sloping Section of the LRAC

When output scale increases, average costs fall. This happens for many reasons:

Technical economies: Large machines and equipment are often more productive per unit of output. A steel plant with a capacity of 10 million tons per year has much lower average costs than a plant with a capacity of 1 million tons. The reason is physical laws: volume of container increases proportionally to the cube of the linear dimensions, while the cost of its walls to the square.

Specialization economies: At a large enterprise, each worker performs a narrow specialized function, achieving high efficiency. At a small plant, one worker is forced to switch between different tasks, wasting time and not reaching mastery.

Financial economies: Large companies get loans at lower interest rates (banks consider them more reliable). Apple can borrow billions of dollars at 2-3% per annum, whereas small businesses pay 10-15%.

Bulk purchasing economies: When buying 10,000 tons of steel, the price per ton is much lower than when buying 10 tons. McDonald's, buying billions of rolls a year, gets a price much lower than an individual restaurant.

Marketing economies: The cost of a TV advertising campaign is the same whether the company sells 1,000 or 1,000,000 units. With large volumes, marketing expenses per unit of product are significantly lower.

Example: Samsung and microchip manufacturing. Samsung invested over $30 billion to build a single microchip plant. This plant produces millions of chips a year. Average cost per chip is a few dollars. If someone tried to build a small plant to produce a thousand chips, the average cost per chip would be thousands of dollars. Economies of scale in the semiconductor industry are so great that only a few companies in the world can compete (Samsung, TSMC, Intel).

2. Minimum Efficient Scale (MES)

This is the lowest output at which minimum LRAC is achieved. After this point, further increasing the scale does not reduce average costs.

MES determines the minimum size of a firm for competitiveness. In the automotive industry, MES is estimated at 200,000–400,000 cars per year—that’s why there are relatively few automakers worldwide (high MES creates barriers to entry). In hairdressing, MES is one barber—thus, there are thousands of barber shops.

3. Diseconomies of Scale—Upward Sloping Section of the LRAC

When output becomes too large, average costs start to rise. Reasons:

Coordination and management issues: As an organization grows, the number of management levels rises, communication becomes more complex. Information distorts as it passes through dozens of levels of hierarchy. Boeing faced serious quality problems producing the 737 MAX, partly due to the complexity of coordinating a huge organization with thousands of suppliers.

Employee demotivation: In a giant corporation, an individual employee may feel insignificant. Absenteeism and staff turnover are usually higher in large organizations. Google tries to combat this by dividing the company into small project teams (no more than 8–10 people) to maintain a startup atmosphere.

Inflexibility: Large organizations react more slowly to market changes. Kodak, despite its engineers inventing the digital camera in 1975, could not quickly restructure its huge film business and ultimately went bankrupt in 2012.

Practical Tasks

Task 1: Calculating Production Costs

Question: A firm hires workers in the short run. Capital is fixed. Wage per worker = £20. Fixed costs = £40.

(a) Calculate TVC, TFC, and TC at each output level. (b) Explain why marginal cost eventually rises.

Solution: (a) TFC = £40 at all output levels (fixed amount).

(b) Marginal costs rise due to the law of diminishing returns. As more workers are hired while capital is fixed, each additional worker adds less output (marginal product declines starting with the third worker). If each worker costs the same (£20), but each produces less, the cost per additional unit of output rises. For example, the 3rd worker produces 20 units for £20 (MC ≈ £1/unit), while the 5th worker only 10 units for £20 (MC = £2/unit).

Task 2: Fixed and Variable Costs

Question: Which of the following costs are fixed for a furniture workshop? A. Cost of wood B. Workers’ wages C. Rent for the workshop D. Cost of glue and screws E. Electricity costs for equipment

Solution: Answer: C — rent for the workshop. Rent does not depend on production volume: the workshop pays the same amount whether it produces 10 or 100 pieces of furniture. All other expenses (wood, wages, glue, electricity) increase with output—they are variable costs.