Question

Discuss the differences in technology and costs between the short-run and long-run. 750 words

Answer 1

STC TYC Costs (Rs.) LL -TFC Output (units) Figure 14.3 Short-run Costa

Difference in technology is defined very broadly to include all of the accumulated knowledge and technical skills that are used in the production of goods and services. As we will see, the unidirectional logic that is so central to neoclassical thinking applies in this case in that technology is used to determine the cost structure that firms face.

We begin with a distinction between two periods. The short run is a period in which at least one factor of production is fixed. If a pizzeria uses only capital (K) and labor (L), for example, we might expect labor to be a variable input whereas capital is its fixed input. That is, it may be possible for the firm to hire anywhere from 0 to a very large (unspecified) number of workers. At the same time, the restaurant itself, which includes its dining area, kitchen, and other facilities, is fixed in size. If the firm is not able to build a new restaurant or to add on to the existing restaurant, the firm is operating in the short run. If it takes 6 months to construct a new restaurant, then the short run in this specific industry is 6 months. The long run then refers to a period during which all factors of production are variable. In this example, the long run refers to a period that is longer than 6 months because both capital and labor are variable.

It is worth noting that the specific periods corresponding to the short run and the long run vary by industry. It may take two years to construct a new production plant in one industry and only six months to construct a new factory in a second industry. The amount of time simply depends on how long it takes for all inputs to become variable. It should also be emphasized that production technology remains fixed in both the short run and the long run. The knowledge and skills related to production do not change in this analysis, which is a key entry point of neoclassical theory. Also, consistent with the neoclassical approach is the assumption of a fixed capital endowment in the short run, which is another key entry point.

We will now continue with the example of a pizzeria in the short run. To represent the firm’s short run production technology, we will introduce a few key short run product concepts. The first concept is total product (TP). The total product refers to the total physical output produced during a given period, in this case a specific number of pizzas. In earlier chapters, we referred to total output as Q, which has the same meaning. Therefore, we can write the following:

An additional product concept that is critical for representing production technology in neoclassical theory is the concept of marginal product (MP). When an additional worker is hired, that additional worker increases total pizza production by a specific amount. This amount is the marginal product of that worker. For example, if the third worker increases total pizza production from 11 to 14 pizzas, then the marginal product of the third worker is 3 pizzas. Formally, we write the marginal product in the following way:

Finally, the concept of average product (AP) is important as well. In this example, the average product of labor refers to the average number of pizzas produced per worker. For example, if the total product is 30 pizzas and 10 workers are employed, then the average product is 3 pizzas per worker. It is important to understand the difference between average product and marginal product. Whereas marginal product only considers the addition to the total product of the last worker hired, average product spreads out the entire product evenly over the number of employed workers.

It may be noted at the outset that, in cost ac­counting, we adopt functional classification of cost. But in economics we adopt a different type of clas­sification, viz., behavioural classification-cost beha­viour is related to output changes.

In the short run the levels of usage of some input are fixed and costs associated with these fixed inputs must be incurred regardless of the level of output produced. Other costs do vary with the level of output produced by the firm during that time period.
A typical short-run total cost curve (STC) is shown in Fig. 14.3. This curve indicates the firm’s total cost of production for each level of output when the usage of one or more of the firm’s resources remains fixed.

When output is zero, cost is positive because fixed cost has to be incurred regardless of output. Examples of such costs are rent of land, deprecia­tion charges, license fee, interest on loan, etc. They are called unavoidable contractual costs. Such costs remain contractually fixed and so cannot be avoided in the short run.

by going into liquidation. The total fixed cost (TFC) curve is a horizontal straight line. Total variable is the difference between total cost and fixed cost. The total variable cost curve (TVC) starts from the origin, because such cost varies with the level of output and hence are avoidable. Examples are electricity tariff, wages and compensation of casual workers, cost of raw materials etc.

In Fig. 14.3 the total cost (OC) of producing Q units of output is total fixed cost OF plus total vari­able cost (FC).

Clearly, variable cost and, therefore, total cost must increase with an increase in output. We also see that variable cost first increase at a decreasing rate (the slope of STC decreases) then increase at an increasing rate (the slope of STC increases). This cost structure is accounted for by the law of Variable Proportions.

The main difference between long run and short run costs is that there are no fixed factors in the long run; there are both fixed and variable factors in the short run. In the long run the general price level, contractual wages, and expectations adjust fully to the state of the economy.