Costs of production

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  • 1. The costs of Production What does supply curve represent? How does a firm take its supply decisions?
  • 2. Before we start this chapter let us ask ourselves one question? Why do organizations do business? -The Answer is obvious, for profit. - How do you earn profit? - By selling goods and services. - By selling goods and services, what do you get? - Revenue or Profit? - Revenue of Course. - Then how do you get profit? - By Deducting Total Costs from Total Revenue.
  • 3. Hence we study this chapter that will teach us the costs of production and the various kinds of costs of production. Understanding what revenue is, is a trivial. Simply P X Q. But understanding all costs of production is a complicated affair. Hence keep your ears, eyes and brains open.
  • 4. Total COST IS Total DETERMINANT OF A FIRM’S Revenue, A KEYcost and Total ProfitA FIRMS PRICING AND PRODUCTION DECISIONS. The total amount the firm Total Revenue: receives for its output. Total Cost: Total amount a firm pays for its inputs. Total Profit = Total Revenue- Total Cost Total revenue= P x Q. If Dhruvraj produces 10000 units and sells them at Rs.2. Total revenue is 20,000.
  • 5. Do You think that the costs you incur in your business has an opportunity cost?
  • 6. Costs as opportunity costs Suppose Onkar pays Rs.1,000 for flour, that Rs.1000 is an opportunity cost because Onkar can no longer use that amount to buy something else. Similarly when Onkar pays for labor, is a part of the companies cost. Because these costs require the company to pay some money, they are called explicit costs. But some opportunity costs do not require a cash outlay and are called implicit costs. The total costs would include both EXPLICIT COSTS AND IMPLICIT COSTS. This distinction helps us understand how economists and accountants analyze a business. Economists consider both the explicit and implicit costs to study a firms production and pricing decisions while accountants consider only explicit costs.
  • 7. The Cost of capital as an opportunity costs. An important implicit cost of any business is the opportunity cost of the financial capital that has been invested in the business. Suppose Siddhi uses 3,00,000 of her savings to start a business. Instead if Siddhi had left the same amount with the savings account that could earn her 5% interest, the opportunity cost would be the interest of 15,000 that she could have earned by depositing the money in the bank. This income of 15,000 is one of the implicit costs for Siddhi. Suppose Siddhi does not have the entire 3,00,000 to do the business. She has only 2,00,000 and the rest 1,00,000 she borrows from a bank, and has to pay 10% interest. What is the total cost of siddhi as an economist’s point of view and from an accountant’s point of view?
  • 8. Economic Profit Versus Accounting Profit Because economists and accountants treat costs differently, they also treat profits differently. Economists treat economic profit as the difference between total revenue minus total costs ( Explicit and Implicit costs ). Accountants treat accounting profit as the difference between total revenue minus explicit costs.
  • 9. The Production FUNCTION The Production function shows the relationship between quantity of inputs and quantity of output. The Pr One of the ten principles of economics is that rational people always think about margin. A firm would be interested in knowing that with an additional unit of input how much output can it increase. The production function is used to understand the decisions of a firm with regards to the output it wants to produce and the inputs it will use.
  • 10. A Production function and Total Cost Number of Workers Output (Quantity of cookies produced per hour) Marginal Product of Labor Cost of Factory Cost of Total Cost of Workers Inputs ( 10 / hour) 0 0 - 30 0 30 1 50 50 30 10 40 2 90 40 30 20 50 3 120 30 30 30 60 4 140 20 30 40 70 5 150 10 30 50 80 6 155 5 30 60 90
  • 11. Quantity Produced As the number of workers increase the output increases but only upto a certain extent after which the marginal product falls, this shoes the principle of diminishing marginal product. 160 140 120 100 80 60 Production Function 40 20 0 1 2 3 4 5 6 Number of Workers
  • 12. Total Cost As the quantity rises so does the cost. 80 70 60 50 40 Total Cost Curve 30 20 10 0 20 40 60 80 100 120 140 160 Quantity Produced
  • 13. The various measures of cost
  • 14. The various measures of cost The firms total cost can be divided into FIXED COSTS AND VARIABLE COSTS. Fixed Cost: These are costs that do not vary with output. They have to be incurred when there is no production. Eg. Rent, Book keepers salary etc. Variable Cost: These are costs that vary with output. As the production increases, even these costs increase. Eg, Raw material cost, cost of electricity etc.
  • 15. 16 14 TC 12 C O S T 10 8 6 4 2 0 1 2 3 4 5 6 QUANTITY OF OUTPUT 7 8 9 10 11
  • 16. The various measures of cost AVERAGE AND MARGINAL COSTS As an owner of a firm one has to decide what will the total produce be. A key part of this decision is how will costs vary with production. While deciding this two questions have to be asked? What will be my cost of producing one unit of output? What will be the change in cost for increasing the output by one unit? The answer of the first question is ATC. ATC = TC/Q or ATC= AFC + AVC ( Where AFC= FC/Q and AVC= VC/Q) The answer of the second question is MC. MC= Δ TC / Δ Q
  • 17. Cost Curves and their Shapes As in the previous chapters we analyzed the supply and demand curves to analyze the behavior of markets, we will use the cost curves to analyze the behavior of firms. On the X axis we have the quantity of output produced, and on the Y axis we have the Costs. Cost curves shown ahead have three common features, which we will examine: 1) The shape of the Marginal Cost Curve 2) The shape of the Average Total Cost Curve 3) The relationship between ATC and MC.
  • 18. The shape of the MC curve: The rising Marginal Cost According to the law of Diminishing Marginal Product: When Production is low the MARGINAL PRODUCT is large ( Because of full capacity utilization) , and the MARGINAL COST is less.( Less production less workers). When production is increased the MARGINAL PRODUCT is less. ( Because of limited capacity), and the MARGINAL COST increases due to increase in production.
  • 19. The shape of the ATC curve: The U-shaped ATC The ATC is u-shaped. Please note that ATC is a sum of AFC and AVC. Hence it reflects the behavior of both these curves. The AFC is high when the quantity produced is less, because the FIXED COST gets spread over less number of units. But when the quantity produced rises the AFC falls. Hence initially the ATC is high. ( Because AFC is high) The AVC is low initially as the quantity produced is less, but when the quantity produced rises the AVC rises. Hence later the ATC rises. ( Because AVC is high )
  • 20. Relationship Between MC AND ATC. When MC is less than ATC, ATC is falling. When MC is greater than ATC, ATC rises. This is true for all firms and not a coincidence. To understand this consider your Scoring system of your examination, where ATC is the average percentage and MC is the score of every subject. Now when the score of your subjects ( MC ) is less then Your Average percentage falls. And vice-versa. There is another point to be noted and i.e the MC curve intersects the ATC at its minimum point. Because at low levels of output MC is below ATC, hence ATC is falling. At higher levels of output ie after intersection MC rises above ATC, hence ATC is rising. Hence the point of intersection is where ATC is lowest.
  • 21. From a firms total cost, we can we can derive several related measures of cost. Quantity of furniture Onkar might produce 0 TC 3 FC 3 VC AFC AVC ATC 0 - - MC .30 1 3.30 3 .30 3 .30 3.30 .50 2 3.80 3 .80 1.50 .40 1.90 .70 3 4.50 3 1.50 1.00 .50 1.50 .90 4 5.40 3 2.40 .75 .60 1.35 1.10 5 6.50 3 3.50 .60 .70 1.30 1.30 6 7.80 3 4.80 .50 .80 1.30 1.50 7 9.30 3 6.30 .43 .90 1.33 1.70 8 11.00 3 8.00 .38 1.00 1.38 1.90 9 12.90 3 9.90 .33 1.10 1.43 2.10 10 15.00 3 12.00 .30 1.20 1.50
  • 22. 3.5 3 2.5 MC C 2 O S T 1.5 ATC AVC 1 0.5 AFC 0 1 2 3 4 5 6 QUANTITY OF OUTPUT 7 8 9 10 11
  • 23. Till Now we have studied that a firm faces diminishing marginal returns hence we see marginal cost rising all the time. But in reality a firm faces Diminishing marginal returns only after a level. Hence initially the MARGINAL PRODUCT is high and MARGINAL COST is falling. ( Hence a change in the diagram) and after the firm starts facing diminishing marginal returns the MC rises. The cost curves share three properties that we need to remember: 1) Marginal cost eventually increases with increase in output.( Because of law of diminishing returns which firms face only after some time.). 2) The ATC is U-shaped. 3) The MC curve cuts the ATC at the minimum level of ATC.
  • 24. In the short run, Because of the Law of diminishing returns if a firm wants to increase its production from 1,000 to 1,200 unit the MC rises as the MP is less as production increase due to limited capacity. And so the ATC also rises from 10,000 to 12,000.In the short run a firm cannot increase its capacity. But in the long run since the capacity can be increased the ATC will remain at 10,000, as MP goes up AND MC comes down. Therefore the ATC in the long run is lower than the ATC in the short run. Total Cost ATC in Short run 12,000 10,000 ATC in long run 1,000 1,200 Quantity of output
  • 25. Economies of Scale And Diseconomies of Scale As we have just seen that the ATC curve in the long run declines as output increases, it shows us economies of scale. When ATC rises as output increases there is said to be diseconomies of scale. When ATC does not vary with output there is said to be Constant returns to Scale.
  • 26. Economies of Scale And Diseconomies of Scale Economies of scale arise usually when the outputs increase at a faster rate than the inputs. It means if output increases more than inputs the cost gets spread to a higher number of units. It occurs at small levels of output. Diseconomies of scale arises when inputs rise faster than outputs. It occurs at large level of output.
  • 27. What causes economies and diseconomies: Economies and Diseconomies of scale occur due to two reasons: Mainly because of technological and financial reasons. At technological level it takes place because as output increases a greater division of labor takes place and specialization takes place. At financial level, as output increases purchases of raw materials are done in bulk and hence the firm receives quantity discounts, which can be passed on to the consumer. Economies of Scope takes place when the production of two different units brings down the cost of production. Eg. A small communter airline can easily extend to cargo services.
  • 28. ECONOMIES OF SCALE: Suppose if a firm produces 100 units its cost of production is 1,00,000. And when it increases the production to 1000 units the total cost will come down to 8,00,000. It happens due to specialization and finance. When a firm increases its production, workers specialize in their jobs, they become experts and hence now they are able to produce more, hence there cost will come down. If the firm increases its production, now it purchases raw materials in bulk and hence it can avail quantity discounts and hence cost will come down.
  • 29. DISECONOMIES OF SCALE: In the above example now the firm increases its production to 2,000 units how much should its cost increase to 20,00,000. (When production was 1,000 units the cost was 8,00,000). This happens because now as the production increases coordination problems start happening. But SIR YOU SAID THAT IN THE LONG RUN A FIRM CAN INCREASE ITS CAPACITY. THEN WHY IS THE COST INCREASING. ??? MY ANSWER TO YOU STUDENTS IS YES, CAPACITY CAN INCREASE BUT UPTO AN EXTENT, BUT BEYOND THAT IT CANNOT.
  • 30. The Various types of Cost FC- Fixed Cost VC- Variable Cost TC- Total Cost = FC+VC AFC- Average Fixed Cost = FC/Q AVC- Average Variable Cost= VC/Q ATC- Average total Cost= TC/Q OR AFC+ AVC AC= Average Cost- Cost of Producing One Unit of Output MC= Marginal cost- Change in Cost for producing one extra unit of output AR= Average Revenue- Revenue of one unit of output MR= Marginal Revenue- Change in Revenue for selling one extra unit of output
  • 31. In the chapter Cost of Production we studied all types of Cost because they will help us in understanding the pricing and production decisions of firms in competitive markets, monopoly, monopolistic competition and oligopoly.