Business Economics 07 Theory of Cost

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Business Economics 07 Theory of Cost

  1. 1. Cost
  2. 2. Objectives <ul><li>to introduce and discuss nature of costs </li></ul><ul><li>to outline short-run costs and examine the determinants </li></ul><ul><li>to understand the process of constructing LATC </li></ul><ul><li>to outline how and why costs change in the long-run </li></ul><ul><li>to examine the importance of cost to the organization </li></ul>vg/lv/p-ii-6
  3. 3. Cost Concepts <ul><li>Opportunity cost (normal profit) - cost measured in term of the next best alternative foregone </li></ul><ul><li>Economic costs – payment made to all the resources employed in the production of a good </li></ul><ul><li>Explicit costs – the payments to outside suppliers of inputs </li></ul>VG/lv/P-II-6
  4. 4. <ul><li>Implicit costs – costs which do not involve a direct payment of money to a third party, but which nevertheless involve a sacrifice of some alternatives </li></ul><ul><li>Historical costs – the original amount the firm paid for factors it now owns </li></ul><ul><li>Replacement costs – what the firm would have to pay to replace factors, it currently owns </li></ul>
  5. 5. VG/lv/P-II-6 Factors hired Cost (Rs.) seed 750.00 labor 1900.00 tractor 2000.00 fertilizer 1100.00 tube well 1250.00 Explicit cost 7000.00 Self-owned factor Opportunity Cost (Rs.) family labor 3500.00 land 5000.00 Implicit cost 8500.00 Economic cost 15500.00
  6. 6. Cost function <ul><li>Influenced by </li></ul><ul><li>the character of the underlying production function </li></ul><ul><li>markets inputs supply functions </li></ul><ul><li>c = ƒ (Q, E, P r , G ---- ) </li></ul><ul><li>Where C = cost </li></ul><ul><li>Q = output </li></ul><ul><li>E = efficiency </li></ul><ul><li>Pr = price of resources </li></ul><ul><li>G = government policy </li></ul>VG/lv/P-II-6
  7. 7. Cost-output relationships in the short run <ul><li>The family of total cost concepts </li></ul><ul><ul><li>Total fixed cost (TFC) – the sum total of the explicit costs of all the fixed inputs plus the implicit costs associated with the firm’s operations. </li></ul></ul><ul><ul><li>examples – salaries of top management officials, property taxes, interest, depreciation charges, rents on office space, insurance premiums. </li></ul></ul>
  8. 8. <ul><li>where p i = prices of specified fixed inputs </li></ul><ul><li> x i = quantity of fixed inputs </li></ul><ul><li> n = number of various kinds of fixed inputs </li></ul><ul><li>Total variable cost (TVC)- sum of the amounts a firm spends for variable inputs employed in the production process </li></ul><ul><li>examples – raw material outlays, power and fuel charges, transportation cost </li></ul>VG/lv/P-II-6 TFC =
  9. 9. m TVC =  Pj Xj j =1 Where Pj = prices of specified variable inputs Xj = quantity of variable inputs m = number of variable inputs Total cost = TFC + TVC Q = 0, TVC = 0 , TC = TFC
  10. 10. The family of unit costs <ul><li>Average fixed cost (AFC) </li></ul><ul><li>AFC = TFC/Q = P fi (FI/Q) </li></ul><ul><li>The reduction of AFC by producing more is called “spreading the overhead” </li></ul><ul><li>AP fi = Q/FI </li></ul>
  11. 11. Unit costs <ul><li>Average variable cost (AVC) </li></ul><ul><li>AVC = TVC/Q = P vi (VI/Q) </li></ul><ul><li>Since AP vi = Q/VI therefore </li></ul><ul><li>AVC = P vi (1/AP vi ) </li></ul><ul><li>Average total cost (ATC) </li></ul><ul><li>ATC = TC/Q </li></ul><ul><li>ATC = TC/Q = TFC/Q +TVC/Q </li></ul><ul><li>ATC = AFC + AVC </li></ul>
  12. 12. Marginal cost <ul><li>MC = ΔTC/ΔQ = ΔTVC/ΔQ </li></ul><ul><li>ΔTVC = P vi (ΔVI) </li></ul><ul><li>MC = P vi (ΔVI/ΔQ) = P vi (1/MP) </li></ul>
  13. 13. Cost behavior with increasing and diminishing returns to variable inputs TP = Q = a + bx +cx 2 – dx 3 AP vi = b + cx – dx 2 MP vi = b + 2cx – 3dx 2 TFC = a TVC = bQ – CQ 2 + dQ 3 TC = TFC + TVC = a + bQ – cQ 2 + dQ 3 VG/lv/P-II-6
  14. 15. Cost concepts VG/lv/P-II-6 Q TC TFC+TVC TFC TVC ATC AFC+AVC AFC TFC/Q AVC TVC/Q MC = Δ TC/ △ Δ Q <ul><li>1 </li></ul>107.00 85 22 107.00 85.00 22.00 22.00 2. 126.00 85 41 63.00 42.50 20.04 19.00 3. 143.00 85 58 47.66 28.33 19.33 17.00 4. 159.00 85 74 39.75 21.25 18.50 16.00 5. 174.00 85 89 34.80 17.00 17.80 15.00 6. 189.00 85 104 31.50 14.17 17.33 15.00 7. 205.00 85 120 29.28 12.14 17.14 16.00 8. 223.00 85 138 27.88 10.63 17.25 18.00 9. 243.00 85 158 27.00 9.44 17.56 20.00 10. 266.00 85 181 26.60 8.50 18.10 23.00 11. 293.00 85 208 26.64 7.73 18.91 27.00 12. 325.00 85 240 27.08 7.08 20.00 32.00 13. 363.00 85 278 27.92 6.54 21.38 38.00 14. 408.00 85 323 29.14 6.07 23.07 45.00 15. 461.00 85 376 30.74 5.67 25.07 53.00
  15. 16. Results of empirical studies of short-run cost functions Source: A.A. Walters, “production and cost functions”, Econometrica, Vol. 31, No.1 (January 1963), pp.1-66 VG/lv/P-II-6 Name Type of Industry Finding Lester (1946) Manufacturing AVC decreases up to capacity level of output Hall and Hitch (1939) Manufacturing Majority have decreasing MC. Johnston (1960) Electricity multiple-product food processing “ Direct” cost is a linear function of output, and MC is constant. Dean (1936) Furniture Constant MC which failed to rise Dean (1941) Leather belts No significant increases in MC Dean (1941) Hosiery Constant MC which failed to rise. Dean (1942) Department store Declining or constant MC , depending on the department within the store. Ezekiel and Wylie (1941) Steel Declining MC but large variation. Yntema (1940) Steel Constant MC Johnston Electricity ATC falls, then flattens, tending toward constant Mc up to capacity. Mansfield & Wein (1958) Railways Constant MC
  16. 17. <ul><li>Reasons for increasing MC & AC </li></ul><ul><li>wage premium for overtime </li></ul><ul><li>intensive use of equipments induces more breakdowns </li></ul><ul><li>leaves less time for maintenance </li></ul><ul><li>hiring standards to be lowered </li></ul><ul><li>less efficient resources </li></ul>vg/lv/p-ii-6
  17. 18. Case - McGraw Hill’s annual survey of manufacturing firms <ul><li>What percentage of production capacity is currently being used? </li></ul><ul><li>At what percentage they would prefer to operate? </li></ul>
  18. 19. 0 100% OF CAPACITY 90% 50% cost AFC AVC MC AC 100% OF CAPACITY 90% 0 50% cost McGraw Hill Study TFC TVC TC
  19. 20. Cost-output relationship in the long run <ul><li>Objective </li></ul><ul><li>Q at lowest cost, </li></ul><ul><li>Find the ‘right size’ scale </li></ul><ul><li>Increasing returns to scale – cost increases less than proportionately – factor price increase </li></ul><ul><li>Constant returns to scale – LTC increases in the same proportion </li></ul><ul><li>Decreasing returns to scale – LTC increases at an increasing rate </li></ul>VG/lv/P-II-6
  20. 21. <ul><li>Large scale – aircraft, electricity, automobile, steel, oil refining, paper, glassware, aluminum. etc. </li></ul><ul><li>Small scale – garments, shoes, furniture printing, publishing, farming etc. </li></ul>
  21. 22. Cost behavior and plant size <ul><li>Long run minimum average cost (LRAC) or least unit cost attainable for a given output rate when the firm has time to change the rate of usage of any and all inputs and firm enjoys economies of scales more than it suffers from diseconomies of scale </li></ul>VG/lv/P-II-6
  22. 23. LRAC <ul><li>Economies negligible </li></ul><ul><li>Economies never exhausted – natural monopoly – barriers – public utilities </li></ul><ul><li>Minimum efficient scale – beyond which AC is constant, least volume of output at which LAC is minimum. </li></ul>VG/lv/P-II-6
  23. 24. Minimum efficient scale C F Pratten’s Study (1988) <ul><li>Many firms especially in manufacturing experience substantial economies of scale </li></ul><ul><li>AC falls as Q increases or may remain constant </li></ul><ul><li>MES – is the size beyond which no significant additional economies achieved </li></ul><ul><li>Pratten – ½ MES is the scale above which any possible doubling in scale would reduce AC by less than 5% leading to MES </li></ul>
  24. 25. Q MES 1/3 1/2 1 AC 0 cost Pratten’s Study
  25. 26. Cost disadvantage of plants that are 50% of MES Industry Cost disadvantage (%) Industry Cost disadvantage (%) Flour mill 3.0 Synthetic rubber 15.0 Bread baking 7.5 Detergents 2.5 Paper printing 9.0 Bricks 25.0 Sulphuric acid 1.0 Machine tools 5.0
  26. 27. Reasons for economies of scale at the plant level <ul><ul><li>Economies of mass production – greater specialization, learning by doing </li></ul></ul><ul><ul><li>Learning cure- separate out technical breakthroughs, input-cost inflation, output scale effect </li></ul></ul><ul><ul><li>Learning rate = (1 – AC 2 /AC 1 ) . 100 </li></ul></ul><ul><ul><li>(1 – 90/100) . 100 = 10% </li></ul></ul><ul><ul><li>Continuous process utilizing by products </li></ul></ul><ul><ul><li>Marketing economies – quantity discounts </li></ul></ul><ul><ul><li>Transport economies </li></ul></ul>
  27. 28. Reasons for diseconomies of scale at the plant level <ul><ul><li>Increasing transportation cost </li></ul></ul><ul><ul><li>Inefficient supervision and coordination </li></ul></ul><ul><ul><li>Labor unions </li></ul></ul>
  28. 29. Cost behavior and firm size <ul><ul><li>Reasons for economies of scale at the firm level </li></ul></ul><ul><li>common management economies </li></ul><ul><li>mass marketing economies – nationwide distribution systems and sales promotion campaigns </li></ul><ul><li>R&D, designing new products </li></ul><ul><li>greater market visibility and recognition </li></ul><ul><li>financial economies </li></ul><ul><li>economies of scope </li></ul><ul><li>diversification as an asset in surviving fundamental market changes </li></ul><ul><li>control over costs, selling price, production technology, source of financial capital, relationship with govt. </li></ul><ul><li>. </li></ul>VG/lv/P-II-6
  29. 30. <ul><li>Diseconomies of scale at the firm level </li></ul><ul><ul><li>Increasing difficulties and costs of managing ever-larger enterprise </li></ul></ul>
  30. 31. Results of empirical studies of long-run cost function Source – A.A. Walters, “ production and cost functions,” Econometrica, vol. 31, no.1 (January 1963), pp. 1-66 VG/lv/P-II-6 Name Type of Industry Finding Bain (1956) Manufacturing Small economies of scale for Multiplant firms. Holton (1956) Retailing LRAC is L-shaped. Alpert (1959) Metal Economies of scale up to an output of 80,000 lbs per month; constant returns to scale and horizontal LRAC thereafter. Moore (1959) Manufacturing Economies of scale prevail quite generally. Lomax (1951) and Gribbin (1953) Gas (Great Britain) LRAC of production declines as output rises. Loxam (1952) and Johnston (1960) Electricity (Great Britain) LRAC of production declines as output rises. Johnston (1960) Life assurance LRAC declines. Johnston (1960) Road passenger transport (Great Britain) LRAC either falling or constant. Nerlove (1961) Electricity (U.S.) LRAC (excluding transmission costs) declines and then shows signs of increasing.
  31. 32. Case - Economies of scale <ul><li>Survey by NCAER </li></ul><ul><li>Pre investment survey group reported </li></ul><ul><li>manufacturing cost of writing and printing paper declines from Rs. 1489 (in 100 tonne per day plant) to Rs. 1238 (200 t. per day) and further to Rs. 1104 (300 t. per day) per t. </li></ul>VG/lv/P-II-6 Sources – State Bank of India Monthly Review, November. 1975, pp. 416 -17 size of plant (t. per day) fixed investments (per t.) cost of raw material (per t.) operating cost (per t.) 100 4473 324 1307 200 4070 263 1116 300 3945 258 1056
  32. 33. Case - Economies of scale <ul><li>Economic and Scientific Research Foundation found that single cement plant producing 3,200 tpd required 46% less capital investment than 8 plants of 400 tpd. Cost of production was lower by Rs.100 per t. in 3,200 tpd plant. </li></ul><ul><li>during 1960s – 600 tpd 1200 tpd 32,00 tpd </li></ul><ul><li>Source -The Economic Times – March 14,1983 </li></ul><ul><li>-The Cement Industry, K S Rajan, Economic Times, May 3, 1979,p 5. </li></ul>
  33. 34. Output elasticity of total cost- Responsiveness of TC to the change in total production . If e TC , Q <1 Economies of scale e tc , Q >1 Diseconomies of scale VG/lv/P-II-6

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