Q21 — Traditional Theory of Cost: Short-run and Long-run Costs

Introduction

The traditional theory of cost, as presented in your prescribed text Microeconomics by T.R. Jain & V.K. Ohri (Panjab University, B.Com Semester I), explains the behaviour of cost of production in the short run and long run with the help of a family of U-shaped cost curves. The traditional analysis distinguishes between:

Short-run cost curves — when some factors are fixed and some are variable; and
Long-run cost curves — when all factors are variable and the firm can change plant size.

A complete answer must clearly define short-run and long-run, derive the shapes of the various cost curves from the underlying law of variable proportions and economies/diseconomies of scale, and show how traditional cost curves are related to each other.

1. Short Run and Long Run in Cost Analysis

In the traditional theory, the distinction between short run and long run is not in terms of calendar time, but in terms of flexibility of factors:

Short run: A period during which at least one factor (e.g. plant, machinery, building) is fixed, while other factors (labour, raw materials, power) are variable.
Long run: A period long enough for the firm to vary all factors, including plant size. There are no fixed factors.

In the short run, the firm faces both fixed and variable costs and therefore separate short-run cost curves (TFC, TVC, TC, AFC, AVC, AC, MC). In the long run, all costs are variable and the firm chooses among different plant sizes, giving rise to a family of short-run average cost curves and a single long-run average cost curve (LAC) as their envelope.

2. Traditional Short-run Costs: TFC, TVC and TC

2.1 Total Fixed Cost (TFC)

Total Fixed Cost is the cost of fixed factors of production which does not change with the level of output. Whether the firm produces nothing or produces at full capacity, it must incur these costs.

Examples: rent of building, interest on fixed capital, insurance, salaries of permanent staff, etc.

In the traditional theory, the TFC curve is a horizontal straight line parallel to the X-axis, showing the same fixed cost at every level of output.

2.2 Total Variable Cost (TVC)

Total Variable Cost is the cost of variable factors of production, which varies directly with output. If output is zero, TVC is zero; as output increases, TVC increases.

Examples: wages of casual labour, cost of raw materials, power and fuel, packing expenses, etc.

2.3 Total Cost (TC)

Total Cost in the short run is the sum of TFC and TVC:

TC = TFC + TVC

Since TFC is constant and TVC rises with output, the TC curve starts from the level of TFC on the cost axis and rises as output increases. The shape of TC is thus determined by TVC.

Fig. 1 — Traditional Short-run Cost Curves: TFC is constant, TVC starts from origin and rises with output; TC is the vertical summation of TFC and TVC.

3. Traditional Short-run Average and Marginal Cost Curves

3.1 Average Fixed Cost (AFC)

AFC is fixed cost per unit of output:

AFC = TFC / Q

As output increases, TFC is spread over more units, so AFC continuously falls and approaches zero but never becomes zero. The AFC curve is therefore downward sloping and hyperbolic.

3.2 Average Variable Cost (AVC)

AVC is variable cost per unit of output:

AVC = TVC / Q

In the traditional theory, the AVC curve is U-shaped. At first, due to better utilisation of variable factors and increasing marginal returns, AVC falls. Beyond a certain point, due to the law of diminishing marginal returns, AVC starts rising.

3.3 Average Cost (AC) or Average Total Cost (ATC)

AC is total cost per unit of output:

AC = TC / Q = AFC + AVC

Since AC is the sum of a continuously falling AFC and a U-shaped AVC, the AC curve is also U-shaped in the traditional theory — it falls initially, reaches a minimum, and then rises.

3.4 Marginal Cost (MC)

MC is the addition to total cost when one more unit of output is produced:

MC = ΔTC / ΔQ = ΔTVC / ΔQ

MC depends only on TVC, since TFC does not change with output. In the traditional theory, MC is also U-shaped. It falls at first due to increasing marginal returns (rising MP) and then rises due to diminishing marginal returns (falling MP).

Fig. 2 — Traditional Short-run Cost Curves: AFC falls continuously; AVC and AC are U-shaped; MC is U-shaped and cuts AVC and AC at their minimum points.

3.5 Relationship between AC and MC in the Traditional Theory

The traditional cost theory emphasises the precise relation between AC and MC:

When MC < AC, AC is falling.
When MC > AC, AC is rising.
When MC = AC, AC is at its minimum point.

This is because AC is an average, while MC is the increment. If the additional cost of the last unit (MC) is less than the existing average, the average falls; if it is more, the average rises.

4. Basis of Short-run Cost Curves: Law of Variable Proportions

The U-shapes of AVC, AC and MC in the traditional theory are derived from the Law of Variable Proportions (already studied in Question 16). As more units of a variable factor are combined with a fixed factor:

Initially, increasing returns cause rising marginal product → falling MC and AC.
Later, diminishing returns cause falling marginal product → rising MC and AC.

Thus, the traditional short-run cost curves are simply the monetary reflection of physical law of variable proportions.

5. Traditional Long-run Costs: LAC as an Envelope of SAC Curves

In the long run, no factor is fixed. The firm can choose among different plant sizes or scales of operation. Each plant size has its own short-run average cost (SAC) curve. The traditional theory assumes a family of U-shaped SAC curves corresponding to different plant sizes:

Smaller plants efficient at low outputs,
Medium plants efficient at moderate outputs, and
Larger plants efficient at high outputs.

5.1 Long-run Average Cost (LAC)

The Long-run Average Cost curve shows the minimum average cost at which each level of output can be produced when the firm can adjust all factors, including plant size. In traditional analysis:

LAC is U-shaped, but flatter than individual SAC curves.
LAC is the envelope of the SAC curves — it is tangent to each SAC at one point.
Initially, LAC falls due to economies of scale, reaches a minimum, and then rises due to diseconomies of scale.

5.2 Long-run Marginal Cost (LMC)

The LMC curve is derived from LTC in the same way as MC is derived from TC. In the traditional theory:

LMC is also U-shaped.
LMC lies below LAC when LAC is falling and above LAC when LAC is rising.
LMC intersects LAC at its minimum point, exactly as MC cuts AC in the short run.

Fig. 3 — Traditional Long-run Average Cost (LAC): LAC is the envelope of a family of U-shaped SAC curves. It falls due to economies of scale, reaches a minimum (optimum scale) and then rises due to diseconomies.

6. Basis of Traditional LAC Shape: Economies and Diseconomies of Scale

The U-shape of the LAC curve in the traditional theory is explained by economies and diseconomies of scale (already discussed in Question 19):

At low levels of output, as the scale of the firm expands, internal and external economies (technical, managerial, marketing, financial, risk-bearing, etc.) dominate → LAC falls.
At some intermediate range, economies of scale are exactly balanced by diseconomies, giving a region of constant returns where LAC may be roughly flat.
At very large scale, diseconomies of scale (managerial difficulties, congestion, coordination problems, rising input prices) dominate → LAC rises.

The minimum point of LAC corresponds to the optimum size of the firm in traditional theory — the most efficient scale of operation.

7. Comparison between Short-run and Long-run Costs in Traditional Theory

Basis	Short-run Costs (Traditional)	Long-run Costs (Traditional)
Nature of Factors	Some factors fixed, some variable.	All factors variable; no fixed factors.
Types of Cost	Fixed and variable; TFC, TVC, TC.	Only variable (in long-run sense); all costs can be adjusted.
Key Curves	AFC, AVC, AC, MC (all short-run).	LAC and LMC derived as envelope over SAC and SMC curves.
Source of U-shape	Law of variable proportions (increasing then diminishing returns).	Economies and diseconomies of scale (increasing, constant, decreasing returns to scale).
Flexibility	Firm cannot change plant size; only utilisation changes.	Firm can choose among different plant sizes to minimise cost at each output.
Relevance	Useful for day-to-day output decisions for a given plant.	Useful for planning the optimum scale of plant in the long run.

8. Note on Traditional vs Modern Cost Theory (Brief)

Your syllabus primarily emphasises the traditional theory, with clearly U-shaped cost curves. Modern empirical studies often find that costs may remain constant over a wide range of output or even show “L-shaped” patterns. However, for Panjab University examinations at B.Com Semester I level, you are expected to present the traditional U-shaped short-run and long-run cost curves as given in T.R. Jain & V.K. Ohri.

9. Importance of the Traditional Theory of Cost

The traditional theory of cost occupies a central position in microeconomics:

(a) Basis of Price and Output Determination
The equilibrium of a firm under different market forms (perfect competition, monopoly, monopolistic competition) is derived from the condition MC = MR. Without clear short-run and long-run cost curves, the theory of price determination cannot be understood.

(b) Determination of Optimum Scale of Firm
The minimum point of the LAC curve indicates the optimum size at which a firm should operate in the long run. This guides long-term investment and capacity planning.

(c) Cost Control and Managerial Decisions
Distinguishing between fixed and variable costs helps management in analysing break-even point, shutdown decisions, and cost-control strategies, especially in the short run.

(d) Policy Implications
For regulated industries and public utilities, knowledge of long-run cost conditions (economies of scale) is essential for designing pricing and subsidy policies.

(e) Examination Importance
The question “Explain the traditional theory of cost or costs in the short and long run” is a standard 15-marks theory question in Panjab University B.Com Semester I. A well-structured answer covering short-run and long-run cost curves with neat diagrams and clear linkage to laws of production is highly scoring.

Exam Tip (Pattern for 15 Marks): For full marks, write your answer in this order: (i) define short run and long run; (ii) explain TFC, TVC, TC with Fig. 1; (iii) derive AFC, AVC, AC, MC with Fig. 2 and explain their U-shapes and AC–MC relation; (iv) define LAC and LMC and show LAC as the envelope of SACs with Fig. 3; (v) briefly relate short-run curves to law of variable proportions and long-run curves to economies/diseconomies of scale; (vi) give a short comparison table between short-run and long-run costs; and (vii) conclude with importance. This structure matches exactly the expectations of Panjab University examiners.

Conclusion

To summarise, the traditional theory of cost explains the behaviour of costs in the short run and long run with the help of a set of U-shaped cost curves. In the short run, the presence of fixed and variable costs gives rise to TFC, TVC, TC, AFC, AVC, AC and MC, whose shapes are governed by the law of variable proportions. In the long run, when all factors are variable, the firm chooses among alternative plant sizes; the envelope of the short-run average cost curves is the long-run average cost curve (LAC), whose U-shape reflects economies and diseconomies of scale. Together, these cost curves form the backbone of the traditional theory of the firm and are a core component of the B.Com (Sem I) Microeconomics syllabus of Panjab University.

These notes form part of a carefully curated set of important questions which have frequently appeared in past university examinations and therefore carry a high probability of being reflected, in whole or in part, in future question papers. However, they are intended as high-quality academic support material only and should not be treated as a guarantee or assurance of any specific questions being asked in forthcoming exams.