Short-run vs. Long-run Adjustments

Introduction

Key Concepts

Definitions of Short-run and Long-run

In microeconomic theory, the time horizon considered determines whether a market adjustment is viewed as short-run or long-run. The short-run is defined as the period in which at least one input, typically capital, is fixed. Firms can only adjust variable inputs, such as labor, in response to changes in demand or production costs. Conversely, the long-run is the period sufficiently extended for all inputs to become variable, allowing firms to alter their production capacity by adjusting both labor and capital.

Short-run Adjustments

Short-run adjustments refer to the changes firms make to their production processes when facing fluctuations in market conditions, while some factors remain fixed. Common short-run adjustments include altering the number of workers, modifying production hours, or changing the intensity of resource utilization. These adjustments help firms respond to immediate changes in demand without the need for significant capital investment.

For example, a restaurant experiencing a sudden increase in customer demand might hire additional staff or extend operating hours to accommodate the surge. However, the restaurant cannot rapidly expand its physical space or invest in new kitchen equipment in the short run.

Long-run Adjustments

In the long run, firms have the flexibility to adjust all factors of production, including capital. This allows for more substantial changes such as expanding production facilities, investing in new technology, or entering new markets. Long-run adjustments enable firms to achieve economies of scale, reduce per-unit costs, and enhance competitiveness.

Continuing with the restaurant example, in the long run, the establishment might decide to open additional locations, renovate existing premises to increase seating capacity, or invest in advanced kitchen appliances to improve efficiency and reduce costs.

Cost Structures in Short-run and Long-run

Cost structures differ significantly between the short run and the long run. In the short run, firms face both fixed and variable costs. Fixed costs, such as rent and salaries of permanent staff, remain constant regardless of output levels. Variable costs, like hourly wages and utility bills, fluctuate with production volume.

In contrast, the long-run cost structure comprises only variable costs, as firms can adjust all inputs. This flexibility allows firms to optimize their production processes and achieve lower average costs through economies of scale. The long-run average cost (LRAC) curve typically exhibits a U-shape, reflecting economies and eventually diseconomies of scale as production expands.

Production Functions and Adjustments

The production function illustrates the relationship between inputs and the maximum output that can be produced. In the short run, the production function is limited by the fixed inputs, leading to diminishing marginal returns as variable inputs are increased. Mathematically, this can be represented as:

Where:

• Q = Quantity of output
• L = Quantity of labor (variable input)
• K = Quantity of capital (fixed input)

In the long run, since all inputs are variable, the production function can adjust to changes in both labor and capital, allowing firms to explore various combinations of inputs to achieve optimal production efficiency.

Supply Curve in Short-run vs. Long-run

The supply curve represents the relationship between the price of a good and the quantity supplied by firms. In the short run, the supply curve is typically upward sloping, reflecting the principle of increasing marginal costs. As firms increase production, the cost of producing additional units rises, necessitating higher prices to supply more.

In the long run, the supply curve can be more elastic. With the ability to adjust all inputs, firms can respond more effectively to price changes, leading to a greater quantity supplied over a wider range of prices. Additionally, the long-run supply curve for a perfectly competitive industry may be horizontal at the minimum point of the long-run average cost curve, indicating constant returns to scale.

Market Entry and Exit

Market adjustments also involve the entry and exit of firms. In the long run, high profits attract new firms into the market, increasing supply and driving down prices. Conversely, persistent losses lead to firms exiting the market, reducing supply and allowing prices to rise. These dynamics ensure that, in the long run, industries tend to reach a state of zero economic profit.

In the short run, entry and exit are limited due to factors like sunk costs and contractual obligations. Firms can only adjust their production levels without altering the number of competitors in the market.

Elasticity of Supply

Elasticity of supply measures the responsiveness of the quantity supplied to changes in price. In the short run, supply is generally less elastic because firms cannot quickly alter production capacities. Limited flexibility in adjusting fixed inputs means that short-run supply is constrained.

In the long run, firms can adjust all inputs, making supply more elastic. The ability to enter or exit the market and to adjust production capacities allows for a more significant response to price changes, resulting in greater elasticity.

Examples of Short-run and Long-run Adjustments

To illustrate, consider the automobile industry:

• Short-run Adjustment: If there's a sudden increase in demand for electric cars, manufacturers might increase labor shifts or extend working hours to boost production. However, expanding factory space or investing in new production lines would not be feasible immediately.
• Long-run Adjustment: Over time, manufacturers can invest in new factories, adopt advanced technologies, and scale up their production capacities to meet sustained higher demand for electric vehicles.

Mathematical Representation

The distinction between short-run and long-run adjustments can be formalized using cost functions. The short-run total cost (STC) is the sum of fixed costs (FC) and variable costs (VC):

In the long run, all costs are variable, so the long-run total cost (LRTC) equals the long-run variable cost (LVC):

This equation highlights that in the long run, firms have the flexibility to adjust all inputs, eliminating the presence of fixed costs.

Implications for Firm Behavior

Understanding short-run and long-run adjustments helps explain firm behavior in different market conditions. In the short run, firms focus on optimizing existing resources to respond to immediate changes. In the long run, strategic decisions about capacity expansion, technology adoption, and market entry or exit shape the industry's structure and competitive landscape.

For instance, during periods of technological advancement, firms that effectively make long-run adjustments by adopting new technologies can gain a competitive edge, leading to increased market share and profitability.

Comparison Table

Summary and Key Takeaways