Short run average cost

What Is Short Run Average Cost?

Short run average cost (SRAC) is the total cost of production per unit of output when at least one factor of production remains fixed. This concept is fundamental to Microeconomics, as it helps firms analyze their cost structure and make optimal production decisions within a limited timeframe. In the short run, businesses operate with certain inputs, such as factory size or essential machinery, that cannot be readily changed. Other inputs, like labor and raw materials, are considered variable costs and can be adjusted to alter output levels.

The short run average cost helps firms understand the efficiency of their current operations. As production increases, the fixed costs are spread over a larger number of units, typically leading to a decrease in average cost per unit initially. However, due to the law of diminishing returns, adding more variable inputs to a fixed capacity eventually leads to less efficient production and an increase in the short run average cost.

History and Origin

The concept of average cost, including its short-run variant and the characteristic U-shaped curve, emerged as a key element of microeconomic theory in the early 20th century. While often attributed primarily to Alfred Marshall or Jacob Viner, economic historians Jan Horst Keppler and Jérôme Lallement highlight that the development of this concept was a shared endeavor, with significant contributions from economists like Enrico Barone, F.Y. Edgeworth, and Piero Sraffa. These thinkers explored the complexities of how firms manage costs and production, laying the groundwork for the modern theory of the firm. ⁴The U-shaped average cost curve, representing initial cost reductions followed by increases due to fixed constraints, became a widely accepted graphical representation of a firm's cost structure in the short run.

Key Takeaways

Short run average cost (SRAC) measures the total cost per unit of output when at least one production input is fixed.
It is a crucial metric for firms to assess operational efficiency and make production decisions in the short term.
The SRAC curve typically exhibits a U-shape, reflecting the spreading of fixed costs at low output levels and the impact of diminishing returns at higher output levels.
Understanding SRAC is vital for pricing strategies, resource allocation, and determining profit maximization within existing capacity.
SRAC includes both average fixed costs and average variable costs.

Formula and Calculation

The short run average cost (SRAC) is calculated by dividing the total cost of production by the quantity of output produced.

The formula is expressed as:

SRAC = \frac{SRTC}{Q}

Alternatively, since short run total cost (SRTC) comprises short run fixed costs (SRFC) and short run variable costs (SRVC), the formula can also be stated as:

SRAC = \frac{SRFC + SRVC}{Q} = \frac{SRFC}{Q} + \frac{SRVC}{Q} = ASRFC + ASRVC

Where:

(SRAC) = Short Run Average Cost
(SRTC) = Short Run Total Cost
(Q) = Quantity of output produced
(SRFC) = Short Run Fixed costs
(SRVC) = Short Run Variable costs
(ASRFC) = Average Short Run Fixed Cost (also known as Average Fixed Cost, AFC)
(ASRVC) = Average Short Run Variable Cost (also known as Average Variable Cost, AVC)

The calculation helps firms determine the total cost incurred for each unit produced, assisting in strategic planning and pricing decisions.

Interpreting the Short Run Average Cost

Interpreting the short run average cost involves understanding how a firm's per-unit production costs change as output varies within its existing fixed capacity. The SRAC curve is typically U-shaped. At low levels of output, the average fixed cost (fixed costs spread over few units) is very high. As output increases, the average fixed cost per unit declines rapidly, pulling down the overall short run average cost. This is often accompanied by increasing efficiency from the better utilization of fixed inputs and specialization of labor.

However, beyond a certain output level, the law of diminishing returns sets in. As more variable inputs are added to a fixed amount of capital (e.g., more workers in a finite factory space), the marginal productivity of these additional inputs begins to decline. This causes marginal costs to rise, eventually pushing the average variable cost and, consequently, the short run average cost upward. The lowest point on the U-shaped SRAC curve represents the most efficient scale of production for the firm in the short run, where the marginal cost curve intersects the SRAC curve.

Hypothetical Example

Consider "Bake-It-Easy," a small bakery with one fixed oven (a fixed cost). The monthly rent for the bakery and depreciation of the oven amounts to $1,000 (fixed costs). Variable costs include ingredients, hourly wages for bakers, and utility costs that fluctuate with production.

Month 1: Low Production
- Output (Q): 100 cakes
- Fixed Costs (SRFC): $1,000
- Variable Costs (SRVC): $500 (for ingredients, labor, utilities for 100 cakes)
- Total Cost (SRTC): $1,000 + $500 = $1,500
- Short Run Average Cost (SRAC): $1,500 / 100 cakes = $15.00 per cake
Month 2: Optimal Production
- Output (Q): 500 cakes (assuming this is near the point where the fixed oven and bakers are most efficiently utilized)
- Fixed Costs (SRFC): $1,000
- Variable Costs (SRVC): $2,000
- Total Cost (SRTC): $1,000 + $2,000 = $3,000
- Short Run Average Cost (SRAC): $3,000 / 500 cakes = $6.00 per cake
Month 3: Over-Production (Diminishing Returns)
- Output (Q): 700 cakes (requiring bakers to work overtime, crowded space, potential errors)
- Fixed Costs (SRFC): $1,000
- Variable Costs (SRVC): $4,000 (higher wages, more errors, less efficient use of ingredients)
- Total Cost (SRTC): $1,000 + $4,000 = $5,000
- Short Run Average Cost (SRAC): $5,000 / 700 cakes = $7.14 per cake (rounded)

This example illustrates how the short run average cost initially declines as fixed costs are spread over more units but then increases as the bakery faces diminishing returns from trying to produce too much with its fixed oven and limited space, leading to higher per-unit variable costs. This analysis helps Bake-It-Easy identify its breakeven point and optimal production capacity in the short run.

Practical Applications

Short run average cost analysis has several practical applications for businesses and in the broader economic landscape:

Pricing Decisions: Firms use short run average cost to set prices that cover their production costs and contribute to profitability. While market demand heavily influences pricing, understanding the cost per unit helps in determining a sustainable price floor or evaluating the feasibility of competitive pricing strategies.
Production Planning: Businesses rely on SRAC to identify the most efficient level of output given their current fixed assets. This helps in making day-to-day decisions about how much to produce to minimize average costs and maximize short-run profits. Firms aim to produce at the output level where marginal cost equals marginal revenue.
Resource Allocation: By analyzing how SRAC changes with varying levels of variable inputs, firms can optimize their allocation of resources, such as labor and raw materials, to achieve production targets cost-effectively. ³This includes deciding on the optimal number of shifts or workers to employ.
Cost Control and Efficiency Benchmarking: Tracking SRAC over time allows management to monitor efficiency improvements or declines. Deviations from expected cost curves can signal issues in the production process or changes in input prices, prompting corrective actions.
Supply Chain Management: Understanding the SRAC informs decisions related to raw material procurement and inventory management. Firms can optimize order sizes and timing to ensure continuous production without incurring excessive costs due to underutilized capacity or shortages that disrupt the production flow and raise average costs.

Limitations and Criticisms

While the short run average cost concept is a cornerstone of microeconomic theory, it faces several limitations and criticisms when applied to real-world scenarios:

Assumptions of Fixed and Variable Costs: The strict distinction between fixed and variable costs can be an oversimplification. In reality, some costs might be semi-variable, meaning they have both fixed and variable components, or change in a step-wise fashion rather than smoothly. Additionally, the definition of the "short run" itself is not a fixed calendar period but depends on the industry and the flexibility of inputs, making it subjective.
²* Static Nature: The traditional SRAC curve assumes a static technology and stable input prices. In dynamic markets, technological advancements can rapidly shift cost curves downward, making past cost data less relevant. Similarly, volatile input prices can render a calculated SRAC quickly outdated.
Empirical Evidence vs. Theory: Empirical studies have sometimes shown that actual firm cost curves do not always exhibit the clear U-shape depicted in textbooks. Some research suggests that average costs might decline initially but then remain relatively constant over a significant range of output, rather than rising sharply due to diseconomies of scale. ¹This "L-shaped" or "saucer-shaped" curve is often observed in industries with substantial economies of scale that don't easily lead to rising average costs within the firm's typical operating range.
Ignores Qualitative Factors: SRAC focuses purely on monetary costs and output, often overlooking qualitative factors like product quality, worker morale, or environmental impact, which can also influence a firm's long-term sustainability and true "cost" of production.
Applicability to Short-Run Decisions Only: As its name suggests, short run average cost is best suited for short-term operational decisions. It provides limited insight into long-term strategic choices, such as expanding plant capacity or entering new markets, where all factors of production are variable and different cost structures (e.g., opportunity cost) become relevant.

Short Run Average Cost vs. Long Run Average Cost

The distinction between short run average cost (SRAC) and Long run average cost (LRAC) is crucial in managerial economics and concerns the flexibility of inputs.

The Short Run Average Cost refers to the per-unit cost of production where at least one input is fixed and cannot be changed. This typically means the firm is operating within a given plant size or production capacity. In the short run, a firm can only adjust its variable inputs (like labor and raw materials) to change output. The SRAC curve is U-shaped due to the interplay of spreading fixed costs and the law of diminishing returns.

Conversely, the Long Run Average Cost represents the per-unit cost of production when all inputs are variable. In the long run, a firm has sufficient time to change its scale of operations—it can build new factories, expand existing ones, or even exit an industry. The LRAC curve is an "envelope" of all possible SRAC curves, showing the lowest possible average cost of producing any level of output when all inputs are flexible. Its shape is influenced by returns to scale (economies and diseconomies of scale).

The primary difference lies in the nature of fixed inputs: SRAC considers some inputs as fixed, while LRAC considers all inputs as variable, allowing firms greater flexibility in optimizing their production scale.

FAQs

What causes the U-shape of the short run average cost curve?

The U-shape of the short run average cost curve is due to two main factors: initially, as output increases, fixed costs are spread over a larger number of units, causing the average fixed cost per unit to decline. This pulls the overall SRAC down. However, beyond a certain point, the law of diminishing returns sets in, meaning that adding more variable inputs to a fixed input (like a factory) yields progressively smaller increases in output. This causes the average variable cost and, consequently, the SRAC to rise.

How is short run average cost different from marginal cost?

Short run average cost is the total cost per unit of output produced. Marginal cost is the additional cost incurred by producing one more unit of output. While SRAC considers the average of all costs over all units, marginal cost focuses on the incremental cost of the last unit. The marginal cost curve intersects the SRAC curve at its minimum point, indicating the most efficient short-run production level.

Why is short run average cost important for businesses?

Short run average cost is vital for businesses as it helps them make informed operational decisions. It allows them to determine the cost-effectiveness of producing different quantities of goods or services, set competitive prices, allocate resources efficiently, and assess their current production efficiency. Understanding SRAC is key to maximizing profit maximization within existing operational constraints.

Does the short run average cost curve always rise after its minimum?

According to traditional economic theory, yes, the short run average cost curve rises after its minimum due to the law of diminishing returns. However, some empirical studies suggest that in the real world, average costs might remain relatively constant over a significant range of output after the initial decline, leading to more of an L-shaped or saucer-shaped curve in practice.

What are average fixed cost and average variable cost in relation to SRAC?

Short run average cost (SRAC) is the sum of average fixed cost (AFC) and average variable cost (AVC). Average fixed cost is the total fixed costs divided by the quantity of output, and it continuously declines as output increases. Average variable cost is the total variable costs divided by the quantity of output, and it typically declines initially due to increasing returns but then rises due to the law of diminishing returns. The combination of these two curves forms the U-shaped SRAC curve.