Long-run production costs refer to the costs over the length of time in which all the costs of the firm are variable costs.
The main difference between short-run costs and long-run costs is the existence of fixed costs. In the short run, there is at least one fixed cost. In the long run, all costs are variable. An example shows why.
A bakery rents premises on a busy street where every other shop is let for the year. Its own lease also runs for a year, and until then nothing can be changed. During that year, the short run, the rent is a fixed cost. Once the lease ends, the bakery can choose to expand, for example by renting two premises. Looking beyond the one-year lease is the long run, in which the rent too becomes a variable cost.
To keep costs as low as possible while producing as much as possible, the firm needs to keep track of its costs. Here we assume that the firm uses only two factors of production, capital and labour. The long-run production cost function is concerned with finding the right mix of inputs as a function of rent and wage.
The long-run total cost function represents the lowest total cost of producing different levels of output when all inputs are variable. In the long run, total cost includes any outlay that may be required to produce at a certain level of output or in order to produce at a lower per-unit cost.
Average total cost is an important measure because it gives the cost of production per unit. It is calculated by dividing the total cost by the quantity of output:
Average Cost = Total Cost/Quantity
Key terms
- Minimum Efficient Scale (MES)
- The lowest level of output at which long-run average cost reaches its minimum.
- Long-run total cost
- The lowest total cost of producing each level of output when all inputs can be varied.