Micro Economics cost of production analysis. Short Run and Long Run costs

1. COST OF PRODUCTION
Prof. Prabha Panth,
Osmania University,
Hyderabad

2. Costs
• A Rational Firm tries to minimise its costs of
production.
• Costs include “Explicit Costs” and “Implicit Costs.”
• Explicit or Money costs: actual money expenditure
on factors of production, raw material, etc.
• Implicit or Real costs: includes the value of the
inputs owned by the firm, and used by it for
production.
• Implicit costs are not in money terms.
• They are the “Opportunity Costs”, the value of the
opportunities or alternatives given up to produce this
product, instead of another.
17/04/2016 Prabha Panth 2

3. Money Costs:
Fixed and Variable Costs
• Output is produced with the help of fixed and
variable inputs.
• The cost of hiring/using these are the fixed and
variable costs to the firm.
• Fixed Costs: on fixed inputs that cannot be
changed in the short run.
o Includes: rent, interest and normal profits.
• Variable Costs: on inputs that change as output
increases.
o Includes wages, raw material costs, other costs such
as on power, water, transport, etc.
17/04/2016 Prabha Panth 3

4. Short Run Costs of a Firm
• Total cost (TC) = Total Fixed Cost + Total Variable
Cost.
• Total Fixed Cost (TFC): in the short run, cost of
fixed factors remain constant.
Fixed costs do not change with increase in
output.
• Total Variable Cost (TVC): change as output
increases.
• As output does not increase at a constant rate in
the short run, TVC also does not increase at a
constant rate as Q increases.
17/04/2016 Prabha Panth 4

5. Q (Kgs) TFC (Rs) TVC (Rs) TC (Rs)
0 60 0 60
1 60 30 90
2 60 40 100
3 60 45 105
4 60 55 115
5 60 75 135
6 60 120 180
17/04/2016 Prabha Panth 5

6. Total Cost Curves
Costs
0
Quantity of
output
Total Fixed
Cost=TFC
Total Variable Cost=TVC
Total Cost=TC
TFC
F
17/04/2016 Prabha Panth 6

7. TC, TFC and TVC
• Fixed costs have to be paid even when no
output is produced.
oSo TFC starts from F, when Q = 0.
oIt remains constant as Q increases.
oFor instance, rent or interest is not increased
depending on output produced.
oSo TFC is a straight line parallel to X – axis.
17/04/2016 Prabha Panth 7

8. TC, TFC and TVC
• Total Variable Cost: is zero, when Q =0. It increases
as Q increases. But not at a constant rate.
• Initially it increases at a decreasing rate, then at a
constant rate, and finally at an increasing rate.
• This is because of the operation of the Law of
Variable Proportions.
• Initially, when the fixed and variable proportions
become optimum, costs increase slowly.
• In the third stage of production, fixed factors become
a constraint, and costs increase rapidly.
• This gives the peculiar shape of the TVC. (Inverted S-
shape).
17/04/2016 Prabha Panth 8

9. Total Cost
• TC = TFC + TVC,
• When Q = 0, TVC = 0, but TFC = 0F. So TC also
starts at F, and not from the origin as TVC.
• As Q increases, TVC also increases, but TFC
remains constant.
• So the shape of the TC resembles the TVC, as
Q increases,
• But it lies above the TVC, the difference being
TFC.
17/04/2016 Prabha Panth 9

10. • Average Cost: AC = TC/Q
• TC = TFC + TVC
• Average Fixed Cost, AFC, i.e. Total Fixed Cost/Q.
• Average Variable Cost, AVC = Total Variable Cost/Q
• Therefore AC = AFC + AVC
• Marginal Cost, MC = ∆TC/∆Q = ∆TVC + ∆TFC
∆Q
• As ∆TFC = 0, therefore MC = ∆TVC/ ∆Q = ∆TC/ ∆Q
AC = TC = TFC + TVC
Q Q Q
Average Costs
17/04/2016 Prabha Panth 10

11. Q
(Kgs)
TFC
(Rs)
TVC
(Rs)
TC (Rs) AFC AVC AC MC
0 60 0 60 -- -- -- --
1 60 30 90 60 30 90 30
2 60 40 100 30 20 50 10
3 60 45 105 20 15 35 5
4 60 55 115 15 13.75 28.75 10
5 60 75 135 12 15 27 20
6 60 120 180 10 20 30 45
17/04/2016 Prabha Panth 11

12. Costs
0
Output (Q)
AFC
AVC
ACMC
17/04/2016 Prabha Panth 12
THE SHORT
RUN COST
CURVES

13. Shapes of the Per unit cost curves
• Average Fixed Cost: AFC: always falls as Q
increases. Rectangular Hyperbola: area under
AFC is always constant. AFC × Q = TFC, at any
point on the curve.
• Average Variable Cost: AVC: U-shaped curve.
As Q increases, AVC first falls, reaches a
minimum, and then rises.
• This is due to the Law of Variable Proportions.
17/04/2016 Prabha Panth 13

14. Shapes of the Per unit cost curves
• Average Cost: AC: also U-shaped. AC = TC/Q. Or
sum of AFC+AVC, AC lies above AVC. Initially both
are falling, so AC also falls,
• Reaches a minimum, then as AVC rises, AC also
rises.
• Marginal Cost: MC: is the rate of change in TC due
to change in Q. Since TFC does not change, MC is
affected only by TVC.
• It is also U-shaped. It falls when AVC falls,
• It cuts AVC first at its minimum point, then AC at
its minimum point, and then rises steeply.
17/04/2016 Prabha Panth 14

15. Long Run Cost Curves
17/04/2016 Prabha Panth 15

16. The Long Run
• The Long Run refers to the period of time
when all factors are variable.
• When it is possible to increase the scale of
operation by investing in more machinery,
buildings, plant size, and so on.
• Thus the Long Run is a series of short runs.
• In the Long Run, as the scale of production
increases, it affects the Long Run Costs as
well.
17/04/2016 Prabha Panth 16

17. Long Run Costs
• The Long Run cost curves are a series of short
run cost curves.
• As output increases it is more economical to
increase the scale of production.
• By installing new plant, machinery, buildings,
more output can be produced with lower
costs.
• So the firms start expanding in the long run.
17/04/2016 Prabha Panth 17

18. Short Run and Long Run Costs
Costs
0 Q
SAC1
C0
Q1 Q2
C1
SAC2
C2
C3
SAC3
Q3
LRAC
17/04/2016 Prabha Panth 18

19. Returns to Scale
• Initially, in the long run, as the size of production
increases, the long run Average Costs start falling.
1. This is called the period of Decreasing Costs or
Increasing Returns to Scale. Due to:
o Cheaper inputs with bulk purchase,
o Availability of loans easier for large scale units,
o Cheaper transport, in railways, trucks,
2. After a certain scale is reached, AC does not
change with increase in Q. This is the period of
Constant Costs, or Constant Returns to Scale.
17/04/2016 Prabha Panth 19

20. Returns to Scale
3. Further expansion of the firm, leads to increase
in managerial costs, and external costs (pollution,
over crowding, etc.), competition for labour, raw
material, etc.. So LRAC starts rising.
• This is known as Increasing Costs, or Decreasing
Returns to Scale.
• When the firm expands, it goes through all the
three types of Returns to Scale – Decreasing
costs, Constant Costs and Increasing costs.
17/04/2016 Prabha Panth 20

21. Costs
0 Output
LRACLMAC
Q1
C1
DecreasingCostsorIncreasing
ReturnstoScale
Q2
C2
Constant Costs or Constant
Returns to Scale
IncreasingCostsor
DecreasingReturnsto
Scale
E
QE
Minimum LRAC, efficient
level of output
Returns to Scale
17/04/2016 Prabha Panth 21

22. Long Run Cost
• The LRAC is called the “envelope” curve, as
the SAC curves lie within it.
• It is the outer envelope of the SAC curves.
• An optimum firm will operate at the lowest
LRAC, at the point where LRAC = LRMC.
• This point of lowest LRAC indicates the
“efficiency” of the firm.
17/04/2016 Prabha Panth 22

23. Questions
• Short Answer Questions (one page answers):
1. Distinguish between Explicit and Implicit costs of
a firm.
2. Depict AFC, AVC, AC, and MC in a diagram, and
explain the reason for their shapes.
3. What are the main differences between the
Short run and the Long run Costs of a firm?
4. What is the point of efficient production? Depict
it with the help of a diagram.
17/04/2016 Prabha Panth 23

24. Questions
• Essay type Questions (3-5 page answers):
1. Explain how the Law of Variable Proportions affects
the shape of the SAC.
2. Draw the following cost curves, and state reasons for
their shapes: a) TFC, b) TVC, c)TC, d) AFC, e) AVC, f)
AC, and g) MC.
3. What is an “envelope curve”? How is it derived, and
what is its significance?
4. Explain what is meant by the following:
a) Decreasing Costs, b) Constant Costs, and c)
Increasing Costs. Draw diagrams to illustrate the
above concepts. Why do they occur?
17/04/2016 Prabha Panth 24