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  • 1. In This Lecture…  Concepts of Costs: Economic Costs, Accounting Costs, Sunk Costs  Short-run and Long-run Costs: Total, Average and Marginal Costs  Cost Schedules, Cost Curves, Characteristics and their Relationships
  • 2. Business Firm An entity that employs factors of production (resources) to produce goods and services to be sold to consumers, other firms, or the government.
  • 3. Why Do Business Firms Arise in the First Place? Firms are formed when benefits can be obtained from individuals working as a team.
  • 4. Economic Cost Economic cost is the cost to a firm for utilizing economic resources in production, including opportunity cost.
  • 5. Accounting Cost Accounting cost is that cost which includes actual expenses plus depreciation charges for capital equipment.
  • 6. Sunk Cost A cost incurred in the past that cannot be changed by current decisions and therefore cannot be recovered.
  • 7. Explicit and Implicit Cost  Explicit Cost - A cost incurred when an actual (monetary) payment is made.  Implicit Cost - A cost that represents the value of resources used in production for which no actual (monetary) payment is made.
  • 8. Production and Cost: Short and Long Run  Short Run - A period of time in which some inputs in the production process are fixed.  Long Run - A period of time in which all inputs in the production process can be varied (no inputs are fixed).
  • 9. Short-run Cost  The short-run costs are the costs over the period during which some factors are in fixed supply – like plant, machinery etc.  It is a sum total of fixed cost and variable cost incurred by the producer in producing the commodity.
  • 10. Long-run Cost  The long-run costs are the costs over the long period enough to permit changes in all factors of production.  It is a sum total variable cost incurred by the producer in producing the commodity.
  • 11. Fixed and Variable Costs  Fixed Costs – The cost incurred in those inputs whose quantity cannot be changed as output changes.  Variable Costs – the cost incurred in those inputs whose quantity can be changed as output changes.
  • 12. Costs in Short-run  Fixed Costs (FC) - Costs that do not vary with output; the costs associated with fixed inputs.  Variable Cost (VC) - Costs that vary with output; the costs associated with variable inputs.  Total Cost (TC) - The sum of fixed costs and variable costs. TC = TFC + TVC  Marginal Cost (MC) - The change in total cost that results from a change in output: MC = ΔTC/Δ Q.
  • 13. Fixed Cost / Overhead Cost  Fixed Costs (FC) - Costs that do not vary with output; the costs associated with fixed inputs.  Overhead expenses, Wages/Salaries, Depreciation of Machinery, Insurance Amount etc. Output TFC 0 1 2 3 4 10 10 10 10 10
  • 14. Fixed Cost / Overhead Cost Cost 20 15 10 5 TFC O 1 2 3 4 Output  Total Fixed Cost Curve (TFC Curve) – Horizontal line
  • 15. Total Variable Cost/ Prime Cost  Variable Cost (VC) - Costs that vary with output; the costs associated with variable inputs.  Cost of direct labor, Running expenses like cost of raw materials, fuels etc. Output TVC 0 1 2 3 4 0 10 18 30 45
  • 16. Total Variable Cost/ Prime Cost Cost 40 TVC 30 20 10 0 1 2 3 4 Output  Total Variable Cost Curve (TVC Curve) – Inverse Sshaped Curve
  • 17. Total Cost  Total Cost (TC) - The sum of fixed costs and variable costs. TC = TFC + TVC  It is the aggregate of all costs of producing any given level of output Output TFC TVC TC 0 1 2 3 4 10 10 10 10 10 0 10 18 30 45 10 20 28 40 55
  • 18. Total Variable Cost/ Prime Cost Cost 50 TC TVC 40 30 20 TFC 10 TFC 0 1 2 3 4 Output  Total Cost Curve (TC Curve) – Inverse S-shaped Curve
  • 19. Fixed Cost vs. Variable Cost Fixed Cost (FC) 1. 2. 3. 4. 5. 6. FC are incurred in fixed FOP. FC do not change with the change in output. FC cannot be changed during short-run. FC can never be zero even at zero level of output. Production at the loss of FC may continue. TFC curve is parallel to x-axis. Variable Cost (VC) 1. 2. 3. 4. 5. 6. VC are incurred in variable FOP. VC changes with the change in the level of output. VC can be changed during short-run. VC can be zero at zero level of output. Production at the loss of VC will not continue. TVC curve is inverse S-shaped.
  • 20. Average Fixed, Variable and Total Cost  Average Fixed Cost (AFC) - Total fixed cost divided by quantity of output: AFC = TFC / Q.  Average Variable Cost (AVC) - Total variable cost divided by quantity of output: AVC = TVC / Q.  Average Total Cost (ATC), or Unit Cost Total cost divided by quantity of output: ATC = TC / Q.
  • 21. Average Fixed Cost, Average Varible Cost & Average Cost
  • 22. Average Fixed Cost, Average Variable Cost & Average Cost
  • 23. Average Fixed Cost, Average Variable Cost & Average Cost
  • 24. Average Fixed Cost, Average Varible Cost & Average Cost
  • 25. Average Fixed Cost, Average Varible Cost & Average Cost
  • 26. Average Fixed Cost, Average Variable Cost & Average Cost
  • 27. Average Cost Curve is U-shaped  Basis of AFC : AC includes AFC and AFC falls continuously with increase in output. Once AVC reaches its minimum point and starts rising, its rise is initially offset by the fall in AFC. Hence, AC continues to fall. After a certain point the rise in AFC becomes greater than the fall in AFC and AC starts rising
  • 28. Average Cost Curve is U-shaped  Basis of Law of Variable Proportion : According to this Law initially when variable factor is combined with the fixed factor, production increases at an increasing rate implying AC falls till the best combination of fixed and variable factors is attained. Beyond this point, AC starts to rise.
  • 29. AFC, AVC and AC Curves Cost AC AVC A C B A1 C1 B1 AFC A2 O A4 C2 B2 C3 Output  Short run AC curve is a vertical summation of AFC and AVC curves.  AVC = A2A4, AFC = A1A4. AC = AVC + AFC = A2A4 + A1A4 = AA4
  • 30. AC and AVC Curve  AVC is a part of AC as AC = AVC + AFC  The minimum point of AC will always be to the right of minimum point of AVC  Both AVC and AC are U-shaped curves  The difference between AC and AVC decreases with the rise in the level of output as AC is the aggregation of AVC and AFC; and, AFC falls continuously as output increases. AVC and AC never meets each other as AFC is a rectangular hyperbola and can never touch x-axis
  • 31. Marginal Cost  Marginal Cost (MC) - The change in total cost that results from a change in output: MC = ΔTC/Δ Q.  Short run MC can be estimated from TVC as well MC = TCn – TCn-1 = (TFCn + TVCn) - (TFCn-1 + TVCn-1) = (TFCn + TVCn) - (TFCn + TVCn-1) = TVCn - TVCn-1
  • 32. Marginal Cost Output TFC TVC TC MC 0 1 2 3 4 10 10 10 10 10 0 10 18 30 45 10 20 28 40 55 10 8 12 15
  • 33. Marginal Cost Cost MC O Output  MC curve is U-shaped curve due to Law of Variable Proportion
  • 34. MC and AC Cost O MC a b AC Output
  • 35. MC and AC  Both MC and AC are derived from TC. MC= ΔTC/ΔQ and AC = TC/Q  Both AC and MC curves are U-shaped, reflecting the law of variable proportion.  When AC is falling MC is below AC  When AC is rising MC is above AC  When AC is neither falling or rising AC=MC  There is a range over which AC is falling but MC is rising (ab)  MC curve cuts AC from its minimum point.
  • 36. MC and AVC Cost MC AC AVC AFC O a b Output
  • 37. MC and AVC  Moth MC and AVC are derived from TVC. MC= ΔTVC/ΔQ and AVC = TVC/Q  Both AVC and MC curves are U-shaped, reflecting the law of variable proportion.  When AVC is falling MC is below AVC  When AVC is rising MC is above AVC  When AVC is neither falling or rising AVC=MC  There is a range over which AVC is falling but MC is rising (ab)  MC curve cuts AVC from its minimum point.  The minimum point of AVC curve occurs to the right of the minimum point of MC curve.
  • 38. Production and Costs in the Long Run  In the short run, there are fixed costs and variable costs; therefore, total cost is the sum of the two.  A period of time in which all inputs in the production process can be varied (no inputs are fixed). In the long run, there are no fixed costs, so variable costs are total costs.
  • 39. Long-Run Average Total Cost (LRATC) Curve A curve that shows the lowest (unit) cost at which the firm can produce any given level of output. A firm attempts to maximize long run profits by selecting a short scale of plant that minimizes its costs.
  • 40. Long-Run Average Total Cost Curve (LRATC )  There are three short-run average total cost curves for three different plant sizes.  If these are the only plant sizes, the longrun average total cost curve is the heavily shaded, blue scalloped curve.
  • 41. Long-Run Average Total Cost Curve (LRATC )  The long-run average total cost curve is the heavily shaded, blue smooth curve.  The LRATC curve is not scalloped because it is assumed that there are so many plant sizes that the LRATC curve touches each SRATC curve at only one point.
  • 42. Economies of Scale  Economies of Scale exist when inputs are increased by some percentage and output increases by a greater percentage, causing unit costs to fall.  Constant Returns to Scale exist when inputs are increased by some percentage and output increases by an equal percentage, causing unit costs to remain constant.  Diseconomies of Scale exist when inputs are increased by some percentage and output increases by a smaller percentage, causing unit costs to rise.
  • 43. Why Economies of Scale? Up to a certain point, long-run unit costs of production fall as a firm grows. There are two main reasons for this:  Growing firms offer greater opportunities for employees to specialize.  Growing firms can take advantage of highly efficient mass production techniques and equipment that ordinarily require large setup costs and thus are economical only if they can be spread over a large number of units.
  • 44. Why Diseconomies of Scale? In very large firms, managers often find it difficult to coordinate work activities, communicate their directives to the right persons in satisfactory time, and monitor personnel effectively.
  • 45. Economies of Scale The lowest output level at which average total costs are minimized.
  • 46. LAC and LMC Costs LMC O X Increasing Returns to Scale LAC Output Decreasing Returns to Scale Constant Returns to Scale
  • 47. LAC and LMC  Both LMC and LAC curves are flatter Ushaped curves are compared to SMC and SAC  LMC cuts LAC at its minimum point  When LAC is falling LMC is below it  When LAC is rising LMC is above it  When LAC is neither falling or rising LMC = LAC
  • 48. Shifts in Cost Curves A firm’s cost curves will shift if there is a change in: Taxes Input prices Technology.