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Short-Run Costs and Output Decisions
(Part A)
by
Charles Lamson
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The next several posts continue our examination of the decisions that firms make in their quest for profits. Firms in perfectly competitive industries make three specific decisions (Figure 1). These decisions are:
 Remember though that all types of firms make these decisions, not just those in perfectly competitive industries. We continue to use perfectly competitive firms as a teaching device, but much of the material in the next several posts applies to firms in noncompetitive industries as well. We have assumed so far that firms are in business to earn profits and that they make choices to maximize those profits. (Remember that profit refers to economic profit, the difference between revenues and costs---full economic costs.) Because firms in perfectly competitive markets are price-takers (companies that must accept the prevailing prices in the market of its products, its own transactions being unable to affect the market price) in both input and output markets, many decisions depend on the prices over which firms have no control. Like households, firms also face market constraints. In parts 30-33 of this analysis, we focused on the production process. The next several posts focus on the costs of production. To calculate costs, a firm must know two things: the quantity and combination of inputs it needs to produce its product and how much those inputs cost. [Do not forget that economic costs include a normal return to capital (the average rate of return that a firm would receive in an industry when conditions of perfect competition prevail)---the opportunity cost of capital.]  Take a moment and look at the circular flow diagram from Part 30 of this analysis and reintroduced below, Figure 2. There you can see exactly where we are in our study of the competitive market system. The goal of the next few posts also is to look behind the supply curve in output markets. It is important to understand, however, that producing output implies demanding inputs at the same time. You can also see in Figure 1 two of the information sources that firms use in their output supply and input demand decisions: firms look to output markets for the price of output and to input markets for the prices of capital and labor.   Costs in the Short Run Our emphasis in the next few posts is on costs in the short run only. Recall that the short run is that period during which two conditions hold: (1) existing firms face limits imposed by some fixed factor of production, and (2) new firms cannot enter, and existing firms cannot exit, an industry. In the short run, all firms (competitive and noncompetitive) have costs that they must bear regardless of their output. In fact, some costs must be paid even if the firm stops producing---that is, even if output is zero. These kinds of costs are called fixed costs, and firms can do nothing in the short run to avoid them or to change them. In the long run, a firm has no fixed costs, because it can expand, contract, or exit the industry. Firms do have certain costs in the short run that depend on the level of output they have chosen. These kinds of costs are called variable costs. Fixed costs and variable costs together make up total costs: TC = TFC + TVC where TC denotes total costs, TFC denotes total fixed costs, and TVC denotes total variable costs. We will return to this equation after discussing fixed costs and variable costs in detail.  Fixed Costs In discussing fixed costs, we must distinguish between total fixed costs and average fixed costs. Total Fixed Cost (TFC) Total fixed cost is sometimes called overhead. If you operate a factory, you must heat the building to keep the pipes from freezing in the winter. Even if no production is taking place, you may have to keep the roof from leaking, pay a guard to protect the building from vandals, and make payments on a long-term lease. There may also be insurance premiums, taxes, and city fees to pay, as well as contract obligations to workers. Fixed costs represent a larger portion of total costs for some firms than for others. Electric companies, for instance, maintain generating plants, thousands of miles of distribution wires, poles, transformers, and so forth. Usually, such plants are financed by issuing bonds to the public---that is, by borrowing. The interest that must be paid on these bonds represents a substantial part of the utilities' operating cost and is a fixed cost in the short run, no matter how much (if any) electricity they are producing. For the purposes of our discussion in the next several posts, we will assume that firms use only two inputs: labor and capital. Although this may seem unrealistic, virtually everything that we will say about firms using these two factors can easily be generalized to firms that use many factors of production. Recall that capital yields services over time in the production of other goods and services. It is the plant and equipment of a manufacturing firm; the computers, desks, chairs, doors, and walls of a law office; it is the software of a web-based firm, and the boat that Bill and Colleen from Part 5 of this analysis built on their desert island. It is sometimes assumed that capital is a fixed input in the short run and that labor is the only variable input. To be a bit more realistic, however, we will assume that capital has both a fixed and a variable component. After all, some capital can be purchased in the short run.  Consider a small consulting firm that employs several economists, research assistants, and secretaries. It rents space in an office building and has a five-year lease. The rent on the office space can be thought of as a fixed cost in the short run. The monthly electric and heating bills are also essentially fixed (although the amounts may vary slightly from month to month). So are the salaries of the basic administrative staff. Payments on some capital equipment---a large copy machine, for instance---can also be thought of as fixed. The same firm also has costs that vary with output. When there is a lot of work, the firm hires more employees at both the professional and research assistant levels. The capital used by the consulting firm may also vary, even in the short run. Payments on the computer system do not change, but the firm may rent additional computer time when necessary. It can buy digital personal computers, network terminals, or databases quickly, if needed. It must pay for the copy machine, but the machine costs more when it is running than when it is not.  Total fixed costs (TFC) are those costs that do not change with output, even if output is zero. Column 2 of Table 1 presents data on the fixed costs of a hypothetical firm. Fixed costs are $1,000 at all levels of output (q). Figure 2(a) shows total fixed cost as a function of output. Because TFC does not change with output, the graph is simply a straight horizontal line at $1,000. The important thing to remember here is that firms have no control over fixed costs in the short run. For this reason, fixed costs are sometimes called sunk costs.   *MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 151-154* end |
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