Production Cost in Short & Long Run

Introduction: 

In microeconomics, the long run is the conceptual time period in which there are no fixed factors of production as to changing the output level by changing the capital stock or by entering or leaving an industry. The long run contrasts with the short run, in which some factors are variable and others are fixed, constraining entry or exit from an industry. In macroeconomics, the long run is the period when the general price level, contractual wage rates, and expectations adjust fully to the state of the economy, in contrast to the short run when these may not fully adjust.

In the long run, firms change production levels in response to (expected) economic profits or losses, and the land, labor, capital goods and entrepreneurship vary to reach associated long-run average cost. In the simplified case of plant capacity as the only fixed factor, a generic firm can make these changes in the long run:

• Enter an industry in response to (expected) profits

• Leave an industry in response to losses

• Increase its plant in response to profits

• Decrease its plant in response to losses.

Long-run average-cost curve with economies of scale to Q2 and diseconomies of scale thereafter.

The long run is associated with the long-run average cost (LRAC) curve in microeconomic models along which a firm would minimize its average cost (cost per unit) for each respective long-run quantity of output. Long-run marginal cost (LRMC) is the added cost of providing an additional unit of service or commodity from changing capacity level to reach the lowest cost associated with that extra output. LRMC equalling price is efficient as to resource allocation in the long run. The concept of long-run cost is also used in determining whether the long-run expected to induce the firm to remain in the industry or shut down production there. In long-run equilibrium of an industry in which perfect competition prevails, the LRMC = Long run average LRAC at the minimum LRAC and associated output. The shape of the long-run marginal and average costs curves is determined by economies of scale.

The long run is a planning and implementation stage. Here a firm may decide that it needs to produce on a larger scale by building a new plant or adding a production line. The firm may decide that new technology should be incorporated into its production process. The firm thus considers all its long-run production options and selects the optimal combination of inputs and technology for its long-run purposes. The optimal combination of inputs is the least-cost combination of inputs for desired level of output when all inputs are variable.[3] Once the decisions are made and implemented and production begins, the firm is operating in the short run with fixed and variable inputs.

All production in real time occurs in the short run. The short run is the conceptual time period in which at least one factor of production is fixed in amount and others are variable in amount. Costs that are fixed, say from existing plant size, have no impact on a firm's short-run decisions, since only variable costs and revenues affect short-run profits. Such fixed costs raise the associated short-run average cost of an output level over the long-run average cost if the amount of the fixed factor is better suited for a different output level. In the short run, a firm can raise output by increasing the amount of the variable factor(s), say labor through overtime.

A generic firm already producing in an industry can make three changes in the short run as a response to reach a posited equilibrium:

• Increase production

• Decrease production

• Shut down.

In the short run, a profit-maximizing firm will:

• Increase production if marginal cost is less than marginal revenue (added revenue per additional unit of output;

• Decrease production if marginal cost is greater than marginal revenue;

• Continue producing if average variable cost is less than price per unit, even if average total cost is greater than price;

• Shut down if average variable cost is greater than price at each level of output.

The transition from the short run to the long run may be done by considering some short-run equilibrium that is also a long-run equilibrium as to supply and demand, then comparing that state against a new short-run and long-run equilibrium state from a change that disturbs equilibrium, say in the sales-tax rate, tracing out the short-run adjustment first, then the long-run adjustment. Each is an example of comparative statics. Alfred Marshall (1890) pioneered in comparative-static period analysis. He distinguished between the temporary or market period (with output fixed), the short period, and the long period. "Classic" contemporary graphical and formal treatments include those of Jacob Viner (1931), John Hicks (1939),and Paul Samuelson (1947).

The law of diminishing marginal returns to a variable factor applies to the short run.  It posits an effect of decreased added or marginal product of from variable factors, which increases the supply price of added output. The law is related to a positive slope of the short-run marginal-cost curve.

The usage of 'long run' and 'short run' in macroeconomics differs somewhat from the above microeconomic usage. J.M. Keynes (1936) emphasized fundamental factors of a market economy that might result in prolonged periods away from full-employment.  In later macro usage, the long run is the period in which the price level for the economy is completely flexible as to shifts in aggregate demand and aggregate supply. In addition there is full mobility of labor and capital between sectors of the economy and full capital mobility between nations. In the short run none of these conditions need fully hold. The price is sticky or fixed as to changes in aggregate demand or supply, capital is not fully mobile between sectors, and capital is not fully mobile to interest rate differences among countries & fixed exchange rates.

A famous critique of neglecting short-run analysis was by John Maynard Keynes, who wrote that "In the long run, we are all dead," referring to the long-run proposition of the quantity theory of, for example, a doubling of the money supply doubling the price level.

Is a direct labor rate a variable cost or a fixed cost?

Labor is always a variable cost, even if it is contracted labor. Fixed cost is defined as any expenses you would still have if you shut everything down. For example, if a factory shuts down, they would still have payments on their equipment. Variable costs are costs that increase or decrease with production. So labor, raw materials, etc are variable costs. This holds true in both the short & long term, despite what others have posted here.