Question

Why can short-run average cost never be less than longrun average cost for a given level of output?

Short answer

The short-run average cost can never be less than the long-run average cost for a given output level because, in the long-run, all factors of production are variable. This lets a firm optimize its entire production process to reduce costs, something not possible in the short run where some factors are fixed.

Step-by-step solution

Conceptual Understanding

Firstly, it's important to clarify the difference between short-run and long-run in economics. In the short-run, some factors of production are fixed, meaning the firm doesn't have full flexibility to tweak its production process. In contrast, in the long-run, all factors of production are variable, giving the firm complete flexibility to adjust its production process to achieve a minimized cost of production.

Short-run Average Cost

In the short-run, companies are often limited by fixed assets such as factories, equipment, and initially subscribed capital, which might not be optimal for the particular level of output. Thus, the short-run average cost is the cost incurred given these constraints and for the decided level of output.

Long-run Average Cost

On the other hand, in the long-run, the situation is different because firms have the opportunity to adjust all of their factors of production. They can invest in or divest from assets to achieve an optimal production scale for the given level of output. That's why in the long-run, firms can achieve a lower or equal average cost than in the short-run.

Cost Comparison

To make the comparison between short-run and long-run average costs, one would find that given the lack of constraints, a firm is always able to match or reduce its cost of production in the long run. This is because a firm in the long-run has the opportunity to opt for the production level where the average cost is minimum, which is not necessarily the case in the short run. Hence, the average cost in the short-run can never be lower than in the long-run for a given level of output.

Key concepts

Short-Run Average Cost

When discussing economics, understanding the concept of short-run average cost (SRAC) is fundamental. SRAC represents the total fixed and variable costs divided by the number of units produced, but within a certain time frame where some production factors remain unchanged.

In the short-run, decisions are made under certain constraints like existing machinery, technology, and workforce levels. For example, if a company has a factory that can only produce a certain amount of widgets per day, the average costs of production are calculated based on that maximum output level.

In such cases, businesses cannot immediately adjust all their resources to match the demand or optimize production costs fully, which often results in a higher average cost compared to the long-run situation where adjustments can be made.

Factors of Production

The factors of production encompass all resources used in the creation of goods or services. They are traditionally categorized into four broad groups: land (all natural resources), labor (workforce), capital (machinery, factories, equipment), and entrepreneurship (the drive to combine the first three factors and take on the risk of starting and running a business).

These factors are variable in the long-run, meaning businesses can adjust quantities or change their quality according to their strategies. A deep understanding of how to best combine these factors is crucial in achieving cost efficiency and cannot be overstated when it relates to the profitability and competitive edge of a business.

Cost Minimization

Cost minimization is a fundamental goal for all businesses, with the intention of producing the maximum amount of output at the lowest possible cost. This strategy drives financial efficiency and competitive pricing.

Within the long-run perspective, firms aim to find the most cost-effective combination of factors of production, which often involves investment in technology, adjusting the scale of production, or refining operational processes. Despite this being a theoretical concept at heart, practical examples abound: automating a production line or outsourcing non-core activities are both measures aimed at reducing long-run average costs.

Production Process Flexibility

Flexibility in the production process is crucial for responding to changes in the market and demand. In the long-run, firms are not bound by current levels of production or existing setups, giving them the agility to adapt by acquiring new technologies, entering or exiting markets, or innovating in product offerings.

While flexibility in the short-run is limited due to fixed factors, a flexible long-run approach allows for the strategic and efficient planning that leads to lower average costs over time. Companies that continually reassess and adapt their production processes are better positioned to optimize costs and stay ahead of the competition.