3.7.1. Short Run Costs

We have previously discussed the short run and the long run. In the short run, some of the factors of production cannot be varied, and therefore, remain fixed. The cost that a firm incurs to employ these fixed inputs is called the total fixed cost (TFC).

In economics, we distinguish between short run and long run based on the flexibility of inputs. In the short run, certain inputs, like machinery or land, are fixed, meaning their quantities cannot be changed. The costs associated with these fixed inputs are referred to as Total Fixed Costs (TFC). For example, if a factory has to pay rent on its building, that's a fixed cost that does not change with the level of output. So, no matter how many products the factory makes, it must pay the same amount of rent each month.

Think of a pizza restaurant. If the restaurant rents its space for $1,000 a month, that is a fixed cost. Whether the restaurant sells 10 pizzas or 100 pizzas, the rent remains the same.

To produce any required level of output, the firm, in the short run, can adjust only variable inputs. Accordingly, the cost that a firm incurs to employ these variable inputs is called the total variable cost (TVC).

In contrast to fixed costs, variable costs can change depending on the level of output. These costs are associated with the inputs that can be adjusted, such as labor or raw materials. The more output produced, the higher the Total Variable Cost (TVC). For instance, if the pizza restaurant decides to hire more chefs to handle a rush of orders, the wages for the additional chefs reflect a variable cost. The TVC increases with the scale of production.

Imagine the same pizza restaurant needs to buy more ingredients, like cheese and flour, when it decides to make more pizzas. The costs for these ingredients increase as production scales up, representing variable costs.

Adding the fixed and the variable costs, we get the total cost (TC) of a firm

TC = TVC + TFC.

The overall cost of production for a firm is calculated by combining both total fixed costs and total variable costs into what we call total costs (TC). This equation, TC = TVC + TFC, captures the complete financial picture of production. The total costs provide insight into how much it costs to produce a given level of output. An understanding of total cost is crucial for firms as they aim to maximize profit by balancing costs and revenues.

For our pizza restaurant, if the fixed cost is the monthly rent of $1,000, and the variable costs increase based on the number of pizzas made (say,$500 for ingredients and wages when making 100 pizzas), the total cost would be $1,500. This helps the restaurant owner decide how many pizzas to sell to make a profit.

The short run average cost (SAC) incurred by the firm is defined as the total cost per unit of output. We calculate it as

SAC = TC / q.

Average costs are important in determining efficiency in production. The short run average cost (SAC) is calculated by dividing total cost (TC) by the quantity of output (q). This provides an insight into how much it costs the firm to produce each individual unit of output, which is essential for pricing and profit strategies. Lower SAC can indicate efficiency, while higher costs per unit might necessitate adjustments in operations or pricing.

Using the pizza restaurant example, if the total cost of producing 100 pizzas is $1,500, then the average cost per pizza would be$15. This helps to set the selling price of each pizza to ensure profit margins.

The short run marginal cost (SMC) is defined as the change in total cost per unit of change in output

SMC = change in total cost / change in output.

The marginal cost is crucial for understanding the cost implications of increasing production. It represents the additional cost incurred from producing one more unit of output. If a firm knows its marginal costs, it can make informed decisions about whether to increase production based on profitability. SMC is calculated by observing the change in total cost that arises from a one-unit increase in output, highlighting the cost impact of scaling production up or down.

Returning to our pizza restaurant, if increasing production from 100 pizzas to 101 pizzas causes the total cost to rise from $1,500 to$1,515, the marginal cost of making that additional pizza is $15. This calculation helps ensure that the price set for each pizza covers the marginal cost, allowing the firm to remain profitable.

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