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# Cost theory and analysis.pptx

Cost theory and analysis

Cost theory and analysis

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### Cost theory and analysis.pptx

1. 1. COST THEORY AND ANALYSIS MANAGERIAL ECONOMICS
2. 2. Costs Theory and Analysis  Short run – Diminishing marginal returns results from adding successive quantities of variable factors to a fixed factor  Long run – Increases in capacity can lead to increasing, decreasing or constant returns to scale
3. 3. Short Run Production Costs  Total variable cost (TVC)  Total amount paid for variable inputs  Increases as output increases  Total fixed cost (TFC)  Total amount paid for fixed inputs  Does not vary with output  Total cost (TC)  TC = TVC + TFC
4. 4. Short-Run Total Cost Schedules Output (Q) Total fixed cost (TFC) taka Total variable cost (TVC) Taka Total Cost Taka TC=TFC+TVC) 0 6,000 100 6,000 200 6,000 300 6,000 400 6,000 500 6,000 600 6,000 0 14,000 22,000 4,000 6,000 9,000 34,000 6,000 20,000 28,000 10,000 12,000 15,000 40,000
5. 5. Total Cost Curves
6. 6. Average Costs  TVC AVC Q  TFC AFC Q    TC ATC AVC AFC Q • ( AFC ) Average fixed cost • ( ATC ) Average total cost ( AVC ) Average variable cost •
7. 7. Short Run Marginal Cost  Short run marginal cost (SMC) measures rate of change in total cost (TC) as output varies       TC TVC SMC Q Q
8. 8. Average & Marginal Cost Schedules Output (Q) Average fixed cost (AFC=TFC/Q) Average variable cost (AVC=TVC/Q) Average total cost (ATC=TC/Q= AFC+AVC) Short-run marginal cost (SMC=TC/Q) 0 100 200 300 400 500 600 -- 15 12 60 30 20 10 -- 35 44 40 30 30 56.7 -- 50 56 100 60 50 66.7 -- 50 80 40 20 30 120
9. 9. Average & Marginal Cost Curves
10. 10. Short Run Average & Marginal Cost Curves
11. 11. Short Run Cost Curve Relations  AFC decreases continuously as output increases  Equal to vertical distance between ATC & AVC  AVC is U-shaped  Equals SMC at AVC’s minimum  ATC is U-shaped  Equals SMC at ATC’s minimum
12. 12. Short Run Cost Curve Relations  SMC is U-shaped  Intersects AVC & ATC at their minimum points  Lies below AVC & ATC when AVC & ATC are falling  Lies above AVC & ATC when AVC & ATC are rising
13. 13.  In the case of a single variable input, short-run costs are related to the production function by two relations Relations Between Short-Run Costs & Production   w w AVC SMC MP MP and w Where is the price of the variable input A
14. 14. Short-Run Production & Cost Relations
15. 15. Relations Between Short-Run Costs & Production  When marginal product (average product) is increasing, marginal cost (average cost) is decreasing  When marginal product (average product) is decreasing, marginal cost (average variable cost) is increasing  When marginal product = average product at maximum AP, marginal cost = average variable cost at minimum AVC
16. 16. Isocost  The combinations of inputs that cost the producer the same amount of money  For given input prices, isocosts farther from the origin are associated with higher costs.  Changes in input prices change the slope of the isocost line K L C1 C0 L K New Isocost Line for a decrease in the wage (price of labor).
17. 17. Cost Minimization  Marginal product per dollar spent should be equal for all inputs:  Expressed differently r MP w MP K L  r w MRTSKL 
18. 18. Cost Minimization Q L K Point of Cost Minimization Slope of Isocost = Slope of Isoquant
19. 19. 19 The Firm’s Expansion Path  An Expansion curve is formally defined as the set of combinations of capital and labor that meet the efficiency condition MPL/w = MPK/r, where w and r are wage rate and interest rate respectively.  The firm can determine the cost-minimizing combinations of K and L for every level of output  If input costs remain constant for all amounts of K and L the firm may demand, we can trace the locus of cost-minimizing choices  called the firm’s expansion path
20. 20. 20 The Firm’s Expansion Path L per period K per period q00 The expansion path is the locus of cost-minimizing tangencies q0 q1 E The curve shows how inputs increase as output increases
21. 21. Equation for Expansion Path  Production Function Q = 100K0.5L0.5 The marginal product functions are MPL =50 MPK = 50 Efficiency Condition is MPL/ MPK = w/r Solving for K K = (w/r).L The production function re-written as Q = 100((w/r)L)0.5 L0.5 Or Q = 100L(w/r)0.5
22. 22. Example  Determine the efficient input combination for producing 1000 units of output if w = 4, r = 2.  Answer: 1000 = 100L(4/2)0.5  Or L = 7.07  K = (4/2) 7.07 = 14.14  The input combination ( K=14.14 and L = 7.07) is the most efficient way to produce 1000 units of output.
23. 23. 23 The Firm’s Expansion Path  The expansion path does not have to be a straight line  the use of some inputs may increase faster than others as output expands  depends on the shape of the isoquants  The expansion path does not have to be upward sloping  if the use of an input falls as output expands, that input is an inferior input
24. 24. Revenue  Total revenue – the total amount received from selling a given output  TR = P x Q  Average Revenue – the average amount received from selling each unit  AR = TR / Q  Marginal revenue – the amount received from selling one extra unit of output  MR = TRn – TR n-1 units
25. 25. Profit  Profit = TR – TC  The reward for enterprise  Profits help in the process of directing resources to alternative uses in free markets  Relating price to costs helps a firm to assess profitability in production
26. 26. Profit  Normal Profit – the minimum amount required to keep a firm in its current line of production  Abnormal or Supernormal profit – profit made over and above normal profit  Abnormal profit may exist in situations where firms have market power  Abnormal profits may indicate the existence of welfare losses  Could be taxed away without altering resource allocation
27. 27. Profit  Sub-normal Profit – profit below normal profit  Firms may not exit the market even if sub-normal profits made if they are able to cover variable costs  Cost of exit may be high  Sub-normal profit may be temporary (or perceived as such!)
28. 28. Profit  Assumption that firms aim to maximise profit  May not always hold true – there are other objectives  Profit maximising output would be where MC = MR