Long run costs have no fixed factors of production, while short run costs have fixed factors

and variables that impact production.

In economics, “short run” and “long run” are not broadly defined as a rest of time. Rather,
they are unique to each firm.

Long run costs are accumulated when firms change production levels over time in response to
expected economic profits or losses. In the long run there are no fixed factors of production.
The land, labor, capital goods, and entrepreneurship all vary to reach the the long run cost of
producing a good or service. The long run is a planning and implementation stage for
producers. They analyze the current and projected state of the market in order to make
production decisions. Efficient long run costs are sustained when the combination of outputs
that a firm produces results in the desired quantity of the goods at the lowest possible cost.
Examples of long run decisions that impact a firm’s costs include changing the quantity of
production, decreasing or expanding a company, and entering or leaving a market.

Short run costs are accumulated in real time throughout the production process. Fixed costs
have no impact of short run costs, only variable costs and revenues affect the short run
production. Variable costs change with the output. Examples of variable costs include
employee wages and costs of raw materials. The short run costs increase or decrease based on
variable cost as well as the rate of production. If a firm manages its short run costs well over
time, it will be more likely to succeed in reaching the desired long run costs and goals.

The main difference between long run and short run costs is that there are no fixed factors in
the long run; there are both fixed and variable factors in the short run. In the long run the
general price level, contractual wages, and expectations adjust fully to the state of the
economy. In the short run these variables do not always adjust due to the condensed time
period. In order to be successful a firm must set realistic long run cost expectations. How the
short run costs are handled determines whether the firm will meet its future production and
financial goals.

Cost curve: This graph shows the

relationship between long run and
short run costs.
  In the short run, there are both fixed and variable costs.
 In the long run, there are no fixed costs.
 Efficient long run costs are sustained when the combination of outputs that a firm
produces results in the desired quantity of the goods at the lowest possible cost.
 Variable costs change with the output. Examples of variable costs include employee
wages and costs of raw materials.
 The short run costs increase or decrease based on variable cost as well as the rate of
production. If a firm manages its short run costs well over time, it will be more likely to
succeed in reaching the desired long run costs and goals.

 variable cost: A cost that changes with the change in volume of activity of an
organization.
 fixed cost: Business expenses that are not dependent on the level of goods or services
produced by the business.

Increasing, constant, and diminishing returns to scale describe how quickly output rises as
inputs increase.

In economics, returns to scale describes what happens when the scale of production increases
over the long run when all input levels are variable (chosen by the firm). Returns to scale
explains how the rate of increase in production is related to the increase in inputs in the long
run. There are three stages in the returns to scale: increasing returns to scale (IRS), constant
returns to scale (CRS), and diminishing returns to scale (DRS). Returns to scale vary between
industries, but typically a firm will have increasing returns to scale at low levels of production,
decreasing returns to scale at high levels of production, and constant returns to scale at some
point in the middle.

Long Run ATC Curves: This

graph shows that as the output
(production) increases, long run
average total cost curve decreases
in economies of scale, constant in
constant returns to scale, and
increases in diseconomies of
scale.
The first stage, increasing returns to scale (IRS) refers to a production process where an
increase in the number of units produced causes a decrease in the average cost of each unit. In
other words, a firm is experiencing IRS when the cost of producing an additional unit of
output decreases as the volume of its production increases. IRS may take place, for example,
if the cost of production of a manufactured good would decrease with the increase in quantity
produced due to the production materials being obtained at a cheaper price.

The second stage, constant returns to scale (CRS) refers to a production process where an
increase in the number of units produced causes no change in the average cost of each unit. If
output changes proportionally with all the inputs, then there are constant returns to scale.

The final stage, diminishing returns to scale (DRS) refers to production for which the average
costs of output increase as the level of production increases. The DRS is the opposite of the
IRS. DRS might occur if, for example, a furniture company was forced to import wood from
further and further away as its operations increased.

Key Points

 In economics, returns to scale describes what happens when the scale of production
increases over the long run when all input levels are variable (chosen by the firm ).
 Increasing returns to scale (IRS) refers to a production process where an increase in
the number of units produced causes a decrease in the average cost of each unit.
 Constant returns to scale (CRS) refers to a production process where an increase in
the number of units produced causes no change in the average cost of each unit.
 Diminishing returns to scale (DRS) refers to production where the costs for
production do not decrease as a result of increased production. The DRS is the
opposite of the IRS.

Key Terms

 return to scale: A term referring to changes in output resulting from a proportional

change in all inputs (where all inputs increase by a constant factor).
 average cost: In economics, average cost or unit cost is equal to total cost divided by
the number of goods produced.

 Economies of scale occurs when more units of a good or service can be produced on
a larger scale with (on average) fewer input costs.
 External economies of scale can also be realized whereby an entire industry benefits
from a development such as improved infrastructure.
 Dis-economies of scale can also exist, which occurs when inefficiencies exist within
the firm or industry, resulting in rising average costs.
When more units of a good or service can be produced on a larger scale, yet with (on average)
fewer input costs, economies of scale are said to be achieved.

Alternatively, this means that as a company grows and production units increase, a company
will have a better chance to decrease its costs. According to this theory, economic growth
may be achieved when economies of scale are realized.

Economist Adam Smith identified the division of labor and specialization as the two key
means to achieving a larger return on production. Through these two techniques, employees
would not only be able to concentrate on a specific task but with time, improve the skills
necessary to perform their jobs. The tasks could then be performed better and faster. Hence,
through such efficiency, time and money could be saved while production levels increased.

Just like there are economies of scale, diseconomies of scale also exist. This occurs when
production is less than in proportion to inputs. What this means is that there are inefficiencies
within the firm or industry, resulting in rising average costs.

Economist Alfred Marshall made a distinction between internal and external economies of
scale. When a company reduces costs and increases production, internal economies of scale
have been achieved. External economies of scale occur outside of a firm, within an industry.

Thus, when an industry's scope of operations expands due to outside developments, external
economies of scale might result. For example, the creation of a better transportation network
might result in a subsequent decrease in cost for a company as well as its entire industry.
When external economies of scale occurs, all firms within the industry benefit.

The key to understanding economies of scale and diseconomies of scale is that the sources
vary. A company needs to determine the net effect of its decisions affecting its efficiency, and
not just focus on one particular source.

While a decision to increase its scale of operations may result in decreasing the average cost
of inputs (volume discounts), it could also give rise to diseconomies of scale. For example, a
company's expanded distribution network might be inefficient if not enough transport trucks
were invested in as well.

When making a strategic decision to expand, companies need to balance the effects of
different sources of economies of scale and diseconomies of scale, so that the average cost of
all decisions made is lower, resulting in greater efficiency all around. (For related reading, see
"Some of the Variables Involved in Economies of Scale")