On the basis of time, market is divided into short-run and long-run. The short-run is a period of time in which output can be increased or decreased by changing only variable factors. In short run there is the distinction between variable factors and fixed factors. Fixed factors like factory building capital equipments etc. can not be varied for bringing about a change in output. In short period fixed factors like installation machinery, building of factors shed, etc. can not added as the time period is very short.
Thus it is not adequate to have fullest adjustment of supply to change in demand. Output is produced only by the extensive use of the existing plants and equipments. No increase in short-run output can be made by expanding the existing plants and equipments.
Thus a firm in short-run can not expand existing plants nor give up the existing one. It is worth nothing that in short period output can charge in part by varying the variable factors only. Thus in short run a firm produces output at a higher point on its short-run marginal cost curve. No new firms can enter into the industry during this period in case the demand for the commodity went up because the rise in demand is likely to be short-lived.
On the other hand, the long run is defined as a period in which quantities of all factors are variable. No factor is fixed. The difference between variable and fixed factors disappears in the long run as there is sufficient time at hand to effect change in output to the change in demand. In the long run output can be expanded not only by increasing labour and raw-materials but also by expanding the size of plants and equipments.
The term plants and equipments stand for fixed factors. Thus in the long run firms adjust the supply of the commodity fully to the changed demand. The adjustment of supply to demand is brought about by the firms by altering the capital equipment itself. The firms, under long run produce at another cost curve called long period curve. In long period a firm is at will to produce or to leave the industry.
He produces by both expanding fixed factors and altering variable factors only. In the long period supply can be adjusted fully to changes in demand by varying the size of capital equipment.
Keeping fixed and variable factors in the short period and the variable factors in long period, the cost of production incurred on them is to be divided into fixed cost and variable cost. The total cost of production includes both fixed and variable costs. Fixed costs are independent of output.
Fixed costs remain fixed regardless of change in volume of output. Fixed cost is a definite amount which must be spent in the short period. Whether there is production or no production fixed cost must be incurred. Thus fixed costs are those which are incurred in hiring fixed factors whose amount cannot be altered in the short run. Variable costs are changeable. These costs are incurred on the variable factors.
Variable factors increase or decrease with the increase and decrease in the volume of production. If a firm is closed down in the short run, it will not use variable factors and hence variable costs are not incurred. Fixed cost is otherwise called supplementary cost and variable cost is called prime cost or direct cost.
Total cost of production is the sum total of total fixed costs and total variable costs. Total cost in the short period is influenced by the total variable cost as total fixed cost is a fixed amount and never changes with the change in production. Thus the component TVC changes with the change in output and it also causes the total cost to change.
When the total cost of production is divided by the total output produced, we get Average total unit cost. Average total unit cost is the cost per unit of output. Average cost is the sum total of average variable cost and average fixed costs. Average cost diminishes with every increase in output up to a certain point, and thereafter it tends to rise upward. The shape of Average total unit cost depends on the behaviour of AVC and AFC. Average fixed cost is the fixed cost per unit of output.
Being a fixed amount it gets distributed over a wide range of output. AFC curve therefore tends to fall but it never touches OX-axis. It takes the shape of a rectangular hyperbola. AVC is the variable cost per unit of output. AVC falls in the beginning, reaches a minimum and thereafter starts rising with the increase in output.
Marginal cost is addition to the total cost caused by producing one more unit of output. It is the cost of producing the final or the marginal unit of commodity. It is the addition to the total cost of producing n units instead of n-1 units where n is any given number, symbolically Men = TCn - TCn- l Marginal cost is the change In total cost as a result of a unit change in output. MC = ATC/ AQ. The total cost curve is shaped by Marginal Cost. The slope of the Total cost is nothing but the marginal cost. The concept of total cost, AFC, AVC and ATVC are clearly given in the table given below.
In the table it shown that AFC becomes smaller and smaller. The vertical distance between the Average cost and the average variable cost curves goes on diminishing. When AFC approaches the X-axis, the average variable cost curve approaches the average total cost curve (ATVC). The relationship between AC and AFC and AVC is expressed in the following diagram.
In the above diagram, ATVC curve depends on the behaviour of the average variable cost curve and average fixed cost curve. In the beginning AVC and AFC curves fall, the ATVC curve therefore falls sharply in the beginning. When AVC curve begins to rise but AFC curve is falling sharply, the ATVC curve continues to fall. During this stage this so happens because AFC curve weighs more than rise in the AVC curve.
But with further rise in output, there is sharp rise in AVC which more than off sets the fall in AFC. Thus the ATVC curve rises after a point.
Thus the average total cost curve like the AVC curve first falls reaches minimum and then rises. The average total cost curve is therefore ‘v’ shaped.
Long run average cost curve depicts the least possible average cost for producing all possible levels of output. The long run average cost curve will be a smooth and continuous curve which is drawn tangent to each of the short-run average cost curves. Thus every point on the long-run average cost curve is a tangency point with some short run average cost curve. LAC is nothing but the locus of all these tangency points.
If a firm desires to produce particular output in the long-run it will choose a point on the long run average cost curve and build up a plant and operate on the corresponding short-run average cost curve. LAC curve is flatter than the short-run cost curves. It is also called envelope curve as it embraces all the short run average cost curves. It is also called planning curve because it represents the cost output policy with regard to its scale of operation over a long period of time.
Like short-run average cost curve, long run average cost, curve is also 'U' shaped? In the beginning since there is increasing returns to scale the LAC falls an output is increased and likewise, it is because of the decreasing returns to scale that the long-run average cost rises beyond a certain point.