Timothy Van Zandt - Insead

Chapter 6
Short-Run Costs and Prices
6.1 Motives and objectives
Broadly
Production is a dynamic process. As market conditions change, the firm adjusts production,
perhaps expanding output when demand rises and reducing output when demand falls. The
firm must change the inputs used for production, but some inputs are fixed in the short run.
This constraint causes costs to be higher in the short run than in the long run; in particular,
the cost reduction by decreasing output is smaller and the extra cost from increasing output
is higher. This leads the firm to respond less aggressively to changing market conditions in
the short run than in the long run.
So far, we have studied only long-run production decisions, when all outputs can be varied
and the firm can shut down. In this chapter, we consider short-run production decisions
when some inputs are fixed and their cost cannot be eliminated even by shutting down. We
reconsider competitive supply decisions in the short-run horizon and then compare these
with long-run decisions.
More specifically
We have the following objectives concerning short-run production and cost:
1. to compare short-run and long-run cost by examining the production function;
2. to see how short-run cost depends on the status-quo input mix;
3. to define the short-run fixed cost as the cost that cannot be eliminated in the short run
even by shutting down;
4. to state and provide intuition for the law of decreasing marginal return, and to see that
it results in increasing marginal cost in the short run.
While we develop those ideas about cost and paint the big picture about the firm’s planning
horizons, we will consider the decisions of both a perfectly competitive firm (as described
in the long run in Chapter 5) and a firm with market power (as described in the long
run in the Preliminaries chapter and in Chapter 7).
Then we make the following detailed comparisons between short-run and long-run decisions
by perfectly competitive firms.
1. Given a change in the market price, a firm’s output decision is less responsive in the
Firms, Prices, and Markets ©August 2012 Timothy Van Zandt