Thursday, November 26, 2009

What is the Short Run!

The short-run is a much used concept in Economics. However when one investigates what it is actually supposed to mean it appears so nebulous as to be virtually meaningless.

One context where is it widely used is in relation to costs of production. Here the distinction is made as between the short run and long run based on fixed and variable costs.

Fixed costs relate to financial commitments that occur at certain discrete time intervals and are therefore not related directly to changes in the output level.

For example a retail firm could enter into a leasing agreement on a premises for a period of 3 years. Therefore the rent on the premises would have to be paid for this period of time irrespective of trading conditions.

The implication therefore is that in the case of - say - a sharp downturn in sales that cost adjustments would have to be confined to variable costs e.g. raw material inputs and labour.

However though there is a certain truth to this, in practice it is not so clear cut. Fixed costs may not be entirely fixed. Thus in the present climate of recession many tenants are seeking to renegotiate lower rental terms on lease agreements (with varying degrees of success).

Also there are a whole series of fixed costs which come for renewal at varying periods of time. So there is therefore not just one short run period (which varies from sector to sector) but in fact a number of vaguely defined overlapping short runs occurring as certain payments fall due for payment.

There is also another source of confusion as the short run is sometimes referred to the period in which the overall scale (or size of the business cannot be changed.

For example a retail business might be operating out of a certain sized premises on a lease agreement.

Now if business is good and the owners wish to move to a larger premises they may feel obliged to wait till the present lease agreement expires. However in the meantime other fixed cost payments may come up for renewal e.g. insurance, interest payments to banks, depreciation etc.

So, the long run in this sense i.e. where the scale of a business can be changed does not equate in any exact way with the previous definition (where certain fixed cost commitments occur not directly related to the level of trading).

The short run is also used in another vague sense to refer to somewhat different circumstances.

For example it is accepted that it may make sense for a firm to trade at a loss in the short run (provided that variable costs are covered). So, many hotels in Ireland are in this position at present due to the severity of the current recession. The rationale for doing this is based on the hope that trading conditions will eventually pick up with acceptable profit margins once again attainable.

However the short run here has no clear time scale. Some hotels with deeper financial pockets would be able to ride out the recession for a considerable period of time. For others more deeply in debt, inevitable closure would occur at an earlier stage. Indeed these calculations can be complicated further by the fact that in certain cases the banks may not want hotels to close because of the slump in property prices thereby enabling them to keep operating (without even variable costs being fully covered).

The short run is used yet again in another economics context (which bears no direct relationship to previous meanings).

For example in speaking of perfect competition, economists distinguish as between the short run and long run.

The idea here is that certain firms could steal a march on rival firms e.g. through greater efficiency thereby making supernormal profits. However in a highly competitive sector one would expect other firms to keep catching up thus eliminating excess profit margins. So in the long run only "normal" profits would be made. However clearly this meaning of the "short-term" while again extremely vague in practical terms bears no direct relationship to previous definitions based on the distinction between fixed and variable costs.

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