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Lecture 5 cost analysis
1. 1
COSTS OF PRODUCTION
Dr.Sunitha.S
Assistant Professor
School of Management Studies,
National Institute of Technology (NIT) Calicut
2. Explicit & Implicit Cost
2
Explicit cost refers to the making of actual payments in
the process of production.
Whereas Implicit cost implies that although the work gets
done yet there is no corresponding payment for it in terms of
money.
3. Private and Social Cost
3
Private costs are those that accrue directly to the
individuals or firms engaged in relevant activity.
External costs on the other hand are are passed on to persons
not involved in the activity in any direct way (ie they are
passed to society at large)
4. Sunk Cost
4
A sunk cost is an expenditure that has been made and cannot
be recovered.
Since it cannot be recovered, it should be ignored while
taking economic decisions.
Eg: a firm buys a highly specialized machine for a plant. It can
be used only what it was designed for. That is, it cannot be put
in alternative uses. Its opportunity cost is zero.
5. Money cost
5
Money cost refers to the payments made to the factors of
production in terms of money proper in return for their
services enjoyed by the producer in his process of
production. For e.g. payments made for purchasing raw
material, rent of land, wages for labour.
6. Opportunity Cost (Alternative or
Transfer Cost)
6
“The opportunity cost of anything produced can thus be defined as
the next best alternative that can be produced instead by the same
factors or by an equivalent group of factors costing the same
amount of money.”
Resources are limited and therefore they cannot be used for
more than one purpose at the same time. E.g. If land is used for
building a house, the same land cannot be used for agricultural
purpose. In general terms, if a resource can produce either ‘A’ or
‘B’, then the opportunity cost of producing ‘A’ is the loss of ‘B’.
9. Short-Run & Long-Run
9
“Time concepts” rather than fixed periods.
Short-run:
One or more production input is fixed:
Increasing cropland?
One crop or livestock production cycle.
Long-run:
The quantity of all necessary production inputs can
be changed.
Expand or acquire additional inputs.
10. Fixed Costs
(Overhead costs)
10
Result from owning a fixed input or resource.
Incurred even if the resource isn’t used.
Don’t change as the level of production changes
(in the short run).
Exist only in the short run.
Not under the control of the manager in the
short run.
The only way to avoid fixed costs is to sell the
item.
12. Important Fixed Costs
12
Total fixed cost (TFC):
All costs associated with the fixed input.
Average fixed cost per unit of output:
AFC = TFC
Output
13. Variable Costs
13
Can be increased or decreased by the manager.
Variable costs will increase as production increases.
Variable costs exist in the short-run
and long-run:
In fact, all costs are considered to be
variable costs in the long run.
14. Variable Costs
14
Total Variable cost (TVC) is the summation of
the individual variable costs.
VC = (the quantity of the input) X (the input’s
price).
15. Variable Costs
15
Total variable cost (TVC):
All costs associated with the variable input.
Average variable cost per unit of output:
AVC = TVC
Output
16. Total Cost
16
The sum of total fixed costs and total
variable costs:
TC = TFC + TVC
In the short run TC will only
increase as TVC increases.
19. Typical Total Cost Curves
(selected attributes)
19
TFC is constant and unaffected by output level.
TVC is always increasing:
First at a decreasing rate.
Then at an increasing rate.
TC is parallel to TVC:
TC is higher than TVC by a distance equal to TFC.
27. Economies of Scale
27
Economies arise from the firm increasing its plant size.
Classified into
Real economies
Benefits that cannot be measured in monetary terms which
accrue to the firm when it expands its scale of operations eg:
goodwill of a firm
Pecuniary economies
These are benefits /economies accruing to the firm due to discounts that
it can obtain due to its large scale operations.
28. Diseconomies of scale
28
Losses or increase in costs of production for a firm when it
expands its scale of operation.
30. Production and Cost in the Long
Run
The key difference between the short run and the long run
is that there are no diminishing returns in the long run.
Diminishing returns occur because workers
share a fixed facility. In the long run the firm can
expand its production facility as its workforce
grows.
Short run average cost curves are U shaped
owing diminishing marginal returns while long
run average cost curves are U shaped due to
economies of scale.
31. Deriving long-run average cost curves: factories of
fixed size
fig
SRAC3
Costs Output
O
SRAC5
SRAC4
5 factories
2 factories
3 factories4 factories
1 factory
SRAC1 SRAC2
32. Deriving long-run average cost curves: factories of
fixed size
fig
SRAC1
SRAC2 SRAC4
SRAC3
SRAC5
LRAC
Costs Output
O
33. Deriving long-run average cost curves: factories of
fixed size
fig
SRAC1
SRAC2 SRAC4
SRAC3
SRAC5
LRAC
Costs Output
O
34. Deriving a long-run average cost curve: choice of
factory size
fig
LRAC
Costs Output
O
Thank You
35. A typical long-run average cost curve
Economies Constant
LRAC
of scale
costs
fig Output OCosts
Diseconomies
of scale
