Theory of cost final


Published on

Micro Economics

Published in: Business
1 Like
  • Be the first to comment

No Downloads
Total Views
On Slideshare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Theory of cost final

  1. 1. Cost of production - Aggregate of price paid for the factors used in producing a commodity. Cost concepts : 1. Used for accounting purposes. 2. Analytical, used in economic analysis.
  2. 2.  Opportunity cost and Actual cost  Opportunity cost is the income foregone for the current best use of a resource.  Business Costs and full costs – Actual cost or real cost i.e. all payments and contractual obligations made by the firm and is used for calculating business profits
  3. 3.  Accounting costs are the costs most often associated with the costs of producing.  Economic costs are not only the costs of producing a good, it also includes the opportunities forgone by producing this product.  Example: If a firm is producing Computers then the accounting costs are the costs incurred for producing the computers. Economic costs include the cost of producing the computers as well as opportunity cost. Suppose, If this firm could lease its office and the plant for say $100,000 then that is the oppurtunity cost.
  4. 4.  Explicit and Implicit costs – Explicit is the actual money expenses recorded in the books of accounts. Cost not appearing in the accouning system are implicit costs. E.g. opportunity costs. Explicit + Implicit costs = Economic costs
  5. 5. Total Cost (TC)  Total Fixed Cost (TFC)  Total Variable cost (TVC)  Average Fixed cost (AFC)  Average Variable cost (AVC)  Average total cost (ATC)  Marginal cost (MC) 
  6. 6. Fixed and variable costs  Total, Average and marginal costs.  Short run and long run costs  Incremental and sunk costs  Historical and replacement costs  Private and social costs 
  7. 7. Total fixed cost is the cost associated with the fixed input. EXAMPLE:- charges such as contractual rent , insurance fee , maintenance cost , property tax, interest on the borrowed funds etc.
  8. 8. $ TFC Quantity
  9. 9. AFC = TFC/Q AFC is the fixed cost per unit of output. As output increases , the total fixed cost spreads over more & more units & therefore avg. fixed cost becomes less & less.
  10. 10. $ AFC Quantity
  11. 11. Total variable cost is the cost associated with the variable input. EXAMPLE: it includes payment to labour employed , the prices of the raw material , fuel & power used etc.
  12. 12. $ TVC Quantity It is often drawn like a flipped over S, first getting flatter & flatter, & then steeper & steeper. This shape reflects the increasing & then decreasing marginal returns we discussed in the section on production.
  13. 13. AVC = TVC/Q AVC is the variable cost per unit of output.
  14. 14. Suppose X is the amount of variable input & PX is its price. Then, AVC = TVC/Q = (PXX)/Q = PX(X/Q) = PX [1/(Q/X)] = PX [1/AP]. So since AP had an inverted U-shape, AVC must have a U-shape.
  15. 15. $ AVC Quantity
  16. 16. $ TC TC = TFC + TVC The TC curve looks like the TVC curve, but it is shifted up, by the amount of TFC. TFC Quantity
  17. 17. $ ATC AVC Quantity Like AVC, ATC is U-shaped, but it reaches its minimum after AVC reaches its minimum. This is because ATC = AVC +AFC & AFC continues to fall & pulls down ATC.
  18. 18. Marginal Cost (MC) Marginal cost measures the additional cost of inputs required to produce each successive unit of output MC = ΔTC/ ΔQ Alternatively, MC = dTC/dQ . MC is the first derivative of the TC curve or the slope of the TC curve.
  19. 19. Suppose the firm takes the prices of inputs as given. Then, MC = ∆TC/∆Q = PX ∆X/ ∆Q = PX [1/(∆Q/∆X)] = PX [1/MP]. So since MP had an inverted U-shape, MC must have a U-shape.
  20. 20. $ MC Quantity
  21. 21. $ MC ATC AVC Quantity
  22. 22. Assumptions :  Labour (variable) and capital (fixed) are two factor inputs.  Price of labor : Rs.10/unit  Price of capital : Rs.25/unit
  23. 23. Units of capital 4 Units of labour 0 TP TFC TVC TC 0 100 0 100 4 1 2 100 10 110 4 2 5 100 20 120 4 3 10 100 30 130 4 4 15 100 40 140 4 5 18 100 50 150 4 6 20 100 60 160 4 7 21 100 70 170
  24. 24. FC remains constant at all levels of output  TVC varies with output  TVC does not change in the same proportion  TC varies in the same proportion as the TVC. 
  25. 25. The graph above is also a result of linear cost function i.e. TC = a + bQ a = TFC, Q = quantity produced, TC = total cost b = change in TVC due to change in Q AC= a/Q + b MC = b AVC = b
  26. 26. Q TFC TVC TC AFC AVC ATC MC 0 100 0 100 - - - 1 100 25 125 100 25 125 25 2 100 40 140 50 20 70 15 3 100 50 150 33.3 16.6 50 10 4 100 60 160 25 15 40 10 5 100 80 180 20 16 36 20 6 100 110 210 16.3 18.3 35 30 7 100 150 250 14.2 21.4 35.7 40 8 100 300 400 12.5 37.5 50 150 9 100 500 600 11.1 55.6 66.7 200 10 100 900 1000 10 90 100 400
  27. 27. AFC decreases as the output increases.  AVC first decreases and then increases as the output increases.  ATC first decreases , remains constant and then increases as the output increases.  MC first decreases and then increases as the output increases.  When the average cost is minimum, MC=AC 
  28. 28. AVC is U shaped indicating its three phases i) Decreasing ii) Constant iii) increasing.  Corresponds to the law of variable proportions. ATC : vertical summation of AFC and AVC curves. It is U shaped indicating that if the output is increased, initially the average cost decreases, remains constant and then starts rising .
  29. 29. ATC = AFC + AVC  ATC falls in the beginning since AFC and AVC both decrease.  At a certain point, even though AVC starts rising, ATC continues to fall because of predominance of falling AFC curve over the rising AVC curve.  With further expansion of output, AVC takes over AFC and hence ATC starts rising. 
  30. 30. The point at which the rise of AVC nullifies the falling AFC, ATC is constant.  The distance between ATC and AVC narrows down as the curve moves up.  Economic reason – Fixed cost is important for a firm till the normal capacity is exhausted. Beyond that, more and more variable inputs are added to increase output . 
  31. 31.  There is also a relationship between marginal costs and average total costs. ◦ Average total cost is equal to total cost divided by the number of units produced. ◦ Marginal cost is the change in total cost due to a one-unit change in the production rate. 34
  32. 32.  When marginal costs are less than average variable costs, the latter must fall.  When marginal costs are greater than average variable costs, the latter must rise. 35
  33. 33.  When AC is minimum, MC is equal to AC .  At this point , MC cuts AC from below.  This is the optimization point of cost to output in the short run .
  34. 34.  Question ◦ What do you think—is there a predictable relationship between the production function and AVC, ATC, and MC? 37
  35. 35.  Answer ◦ As long as marginal physical product rises, marginal cost will fall, and when marginal physical product starts to fall (after reaching the point of diminishing marginal product), marginal cost will begin to rise. 38
  36. 36.  Firms’ short-run cost curves are a reflection of the law of diminishing marginal product.  Given any constant price of the variable input, marginal costs decline as long as the marginal product of the variable resource is rising. 39
  37. 37.  At the point at which diminishing marginal product begins, marginal costs begin to rise as the marginal product of the variable input begins to decline. 40
  38. 38.  If the wage rate is constant, then the labor cost associated with each additional unit of output will decline as long as the marginal physical product of labor increases. 41
  39. 39. / / / 42
  40. 40. 43
  41. 41. 44
  42. 42. 45
  43. 43. LTC LTC Long Run Total Cost All inputs are variable in the long run. There are no fixed costs. Total Product LONG-RUN TOTAL COST CURVE Q
  44. 44. The LAC curve is an envelop curve of all possible plant sizes. Also known as “planning curve”  It traces the lowest average cost of producing each level of output.  It is U-shaped because of  ◦ Economies of Scale ◦ Diseconomies of Scale
  46. 46. COST SAC1 0 LAC Q q0
  47. 47. Building a larger sized plant (size 2) will result in a lower average cost of producing q0 COST SAC1 LAC SAC2 0 Q q0
  48. 48. Likewise, a larger sized plant (size 3) will result to a lower average cost of producing q1 COST SAC1 LAC SAC2 SAC3 0 Q q0 q1
  49. 49. Envelope curve • LRAC can never cut SRAC but it will be tangential to each SRAC at some point. • Average cost can not be higher in the long run than in the short run; •Explanation; 1.Any adjustment which will reduce costs possible to be made in the short run must also be possible in the long run 2.It is not always possible in the short run to produce a given output in the cheapest possible way as all the factors are not variable.
  50. 50. Long run average cost curve properties  U-shaped curve. Based on assumption of unchanging technology. LRAC is flatter curve than the SRAC.  In economics ,we define long period as that during which size of the organization can be altered to meet changed conditions. Normally;  Output increases and average costs also increases  But in long run, size of the firm Can be increased therefore Variable costs are likely to rise less sharply. Hence a flatter curve. Minimum efficient scale is the lowest output level for which LRAC is minimized
  51. 51. COST LAC SAC1 SAC2 Diseconomies of Scale Economies of Scale 0 Q1 LONG-RUN AVERAGE COST CURVE Q
  53. 53.  Long-run Average Cost (LAC) curve ◦ is U-shaped. ◦ the envelope of all the short-run average cost curves; ◦ driven by economies and diseconomies of size.  Long-run Marginal Cost (LMC) curve ◦ Also U-shaped; ◦ intersects LAC at LAC’s minimum point.
  54. 54. MC = ΔTC/ΔQ or MC = dTC/dQ
  55. 55. MC < ATC when ATC is decreasing, MC > ATC when ATC is increasing, & MC = ATC when ATC is at its minimum.
  56. 56. long run MC & short run marginal cost will be equal at that output. That is, the LR MC & SR MC will intersect at that output.
  57. 57.  The condition for optimisation is the same as Short run curve.  LAC= LMC= SAC= SMC  LAC and SAC are at their minimum.
  58. 58.  In the long run, all inputs are variable. ◦ What makes up LRAC?
  59. 59. Labor Specialization: Jobs can be subdivided and workers performing very specialized tasks can become very efficient at their jobs. Managerial Specialization: Management can also specialize in a larger firm (in areas such as marketing, personnel, or finance). Equipment that is technologically efficient but only effectively utilized with a large volume of production can be used.
  60. 60. The Long-Run Cost Function • Reasons for Economies of Scale… Increasing returns to scale Specialization in the use of labor and capital • • • • Economies in maintaining inventory Discounts from bulk purchases Lower cost of raising capital funds Spreading promotional and R&D costs Management efficiencies
  61. 61. ADVANTAGES AND DISADVANTAGES OF LARGE SCALE PRODUCTION Specialization Rent Economy of labour Overhead charges Economics of buying and selling
  62. 62. Reduction in costs when the scale of production increases is called ECONOMIES OF SCALE INTERNAL ECONOMIES EXTERNAL ECONOMIES
  63. 63. INTERNAL ECONOMIES Technological Economies in Production Advantages Advantages of Large scale production provides opportunities for technological advances Large scale production workers of varying skills & qualifications are employed which facilitates division of labour as per specialization divisions of labour .. Large scale selling & Specializationproducts of firms own Economies in Marketing .. Large scale purchase of raw materials & other inputs .. Advertising cost .. Large scale distribution Improves the overall performance of the firm
  64. 64. .. Specialization in managerial activities Managerial Economies .. Mechanization of managerial functions .. Efficient management of the transport function Transport & Storage Economies .. Proper utilization of storage facilities .. Improves managerial efficiency .. Helps in reducing transportation and storage costs
  65. 65. CAUSES OF INTERNAL ECONOMIES SIZE LIMITING PROCESS TECHNIQU E SPECIALI - Big Machine Mergers Superior Technique Division of Labour Bigger capacity lowe Energy less labour Spreading of costs Shorter period of time Increase in efficiency
  66. 66. MANAGERIAL ECONOMICS Aggregation Financial economies Managerial economies Credit facilities COMMERCIAL ECONOMIES Wide Market RISK BEARING ECONOMIES Diversification Encourages investment Spreading Risks
  67. 67. CAUSES OF EXTERNAL ECONOMIES CONCENTRATIO N Advantages of locality INFORMATION DISINTEGRATIO N Knowledge sharing Breaking up processes Common Pool of Knowledge of locality Reduced transportation cost The benefits which companies derive from trade publications and technical journals By virtue of location, common pool of research can be created and benefits can be shared Breaking up of processes which can be handled by specialist firms
  68. 68. Expansion of the management hierarchy leads to problems of communication, coordination, and bureaucratic red tape, and the possibility that decisions will fail to mesh. (“The left hand doesn’t seem to know what the right hand is doing.”) The result is reduced efficiency. In large facilities, workers may feel alienated and may shirk (not work as much as they should). Then additional supervision may be required and that adds to costs.
  69. 69. The Long-Run Cost Function • Reasons for Diseconomies of Scale… Decreasing returns to scale Input market imperfections e.g. wage rate driven up Management coordination and control problems Disproportionate rise in transportation costs Disproportionate rise in staff and indirect labour
  70. 70.  In the long run, a firm exercises its choice with regard to the size of the plant and scale of production, on the basis of long run average cost.  Selection of the optimal plant size according to the expected demand.  Avoid unnecessary costs due to inappropriate plant size.
  71. 71. The reasons for the LAC curve being L shaped are as follows :  Technological progress :In economics theory,technological is assumed to be constant.But technology changes in real life.Due to this,the average cost decline and does not rise
  72. 72.  Learning by doing :The LAC curve completely slopes completely downwards due to learning by doing.Since the efficiency of firm increases due to continuous work,it is able to reduce cost.As the output is increased,there is not only the increase in knowledge of many things,there is also an improvement in the management of plant.Due to this LAC curve is L shaped
  73. 73.  Management technique :According to the modern management theory,appropriate administrative structure is available to operate the plant of each size.There exists appropriate management technique in different levels of management.The management technique is available in large and small size.The cost of different management first fall up to certain plant size.The managerial cost slowly increases to very large level of output.
  74. 74. Break even point (BEP) is located at that level of output or sales at which net income or profit is zero.  BEP is located at that level of output at which the price or AR is equal to AC.  Contribution margin = Price – AVC  Formula for calculating BEP= TFC/ P- AVC where P- AVC 
  75. 75. BEP in terms of sales value BEP = FC/ Contribution ratio Contribution ratio = TR-TVC/ TR  BEA can be used for determining ‘safety margin’ regarding the extent to which the firm can permit a decline in sales without causing losses.  Safety Margin = Sales- BEQ/ Sales *100 
  76. 76. BEA can be useful in determining the target profit sales volume.  Target profit sales vol = TFC- Target profit / Contri. Margin 