Costs of Production: Short Run and Long Run

The costs a firm faces determine its supply decisions, its profitability, and ultimately whether it survives. Economists distinguish carefully between short-run and long-run costs, because the behaviour of costs differs fundamentally depending on whether all factors of production can be varied. This lesson examines cost concepts, the law of diminishing returns, and the key cost curves that appear throughout microeconomics.

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The Short Run and the Long Run

In economics, the distinction between the short run and the long run is not based on calendar time but on the flexibility of factors of production:

Time Period	Definition	Example
Short run	At least one factor of production is fixed (typically capital — factories, machinery, land)	A bakery cannot build a new oven overnight
Long run	All factors of production are variable — the firm can change the scale of its entire operation	The bakery can relocate to larger premises, buy more ovens, hire more staff
Very long run	The state of technology changes	New baking technology is invented that transforms production

Exam Tip: Students commonly define the short run as "a short period of time" — this will lose marks. The short run is defined by the existence of a fixed factor, not by a specific time period. For a nuclear power station, the short run might be 15 years (the time to plan and build a new plant). For a market stall, it might be a few hours.

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Short-Run Costs

Fixed and Variable Costs

Cost Type	Definition	Examples	Behaviour
Total Fixed Cost (TFC)	Costs that do not vary with output in the short run	Rent, insurance, salaries of permanent staff, loan repayments	Constant — a horizontal line on a graph
Total Variable Cost (TVC)	Costs that vary directly with output	Raw materials, energy, wages of temporary staff, packaging	Increases with output
Total Cost (TC)	The sum of all costs	TC = TFC + TVC	Increases with output; the vertical distance between TC and TVC is always equal to TFC

Average and Marginal Costs

Cost Concept	Formula	Interpretation
Average Fixed Cost (AFC)	AFC = TFC ÷ Q	Falls continuously as output rises — the fixed cost is spread over more units
Average Variable Cost (AVC)	AVC = TVC ÷ Q	Typically U-shaped — falls at first, then rises due to diminishing returns
Average Total Cost (ATC or AC)	ATC = TC ÷ Q = AFC + AVC	U-shaped — the gap between ATC and AVC narrows as AFC falls
Marginal Cost (MC)	MC = ΔTC ÷ ΔQ	The cost of producing one additional unit — the most important cost concept for decision-making

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The Law of Diminishing Marginal Returns

The law of diminishing marginal returns (also called the law of variable proportions) is a short-run concept. It states that:

As increasing quantities of a variable factor (e.g., labour) are added to a fixed factor (e.g., capital), there comes a point beyond which the marginal product of the variable factor begins to decline.

Numerical Example: A Small Farm

Workers (L)	Total Product (TP)	Marginal Product (MP)	Average Product (AP)	Stage
0	0	—	—	—
1	10	10	10	Increasing returns
2	25	15	12.5	Increasing returns
3	45	20	15	Increasing returns
4	60	15	15	Diminishing returns begin
5	70	10	14	Diminishing returns
6	75	5	12.5	Diminishing returns
7	75	0	10.7	Zero marginal returns
8	70	−5	8.75	Negative returns

Why Diminishing Returns Occur

When a fixed factor (such as a factory floor) is combined with increasing units of a variable factor (such as workers), each additional worker has:

• Less capital (fewer machines, less space) to work with
• Greater coordination difficulties
• Increased overcrowding and congestion

The result is that each additional worker adds less to total output than the previous one.

Exam Tip: Diminishing returns is a short-run concept — it requires at least one fixed factor. Do not confuse it with diseconomies of scale, which is a long-run concept about what happens when the firm increases the scale of all its factors. The examiner penalises this confusion heavily.

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The Relationship Between Marginal and Average Costs

The relationship between marginal cost and average cost follows a fundamental mathematical rule:

• When MC < AC, average cost is falling — the marginal unit pulls the average down
• When MC > AC, average cost is rising — the marginal unit pushes the average up
• MC intersects AC at its minimum point