Cost of production - Aggregate of price paid for the factors used in producing a commodity.

Cost concepts :1.Used for accounting purposes.2.Analytical, used in economic analysis.

Opportunity cost and Actual cost

Opportunity cost is the income foregone for the current best use of a resource.

Business Costs and full costs – Actual cost

or real cost i.e. all payments and contractual obligations made by the firm and is used for calculating business profits

Accounting costs are the costs most often associated with the costs of producing.

Economic costs are not only the costs of producing a good, it also includes the opportunities forgone by producing this product.

Example: If a firm is producing Computers then the accounting costs are the costs incurred for producing the computers. Economic costs include the cost of producing the computers as well as opportunity cost. Suppose, If this firm could lease its office and the plant for say $100,000 then that is the oppurtunity cost.

Explicit and Implicit costs – Explicit is the actual money expenses recorded in the books of accounts.

Cost not appearing in the accouning system are implicit costs. E.g. opportunity costs.

Explicit + Implicit costs = Economic costs

Total Cost (TC) Total Fixed Cost (TFC) Total Variable cost (TVC) Average Fixed cost (AFC) Average Variable cost (AVC) Average total cost (ATC) Marginal cost (MC)

Fixed and variable costs Total, Average and marginal costs. Short run and long run costs Incremental and sunk costs Historical and replacement costs Private and social costs

Total fixed cost is the cost associated with the fixed input.

EXAMPLE:- charges such as contractual rent , insurance fee , maintenance cost , property tax, interest on the borrowed funds etc.

$

Quantity

TFC

AFC = TFC/Q

AFC is the fixed cost per unit of output.

As output increases , the total fixed cost spreads over more & more units & therefore avg. fixed cost becomes less & less.

$

Quantity

AFC

Total variable cost is the cost associated with the variable input.

EXAMPLE: it includes payment to labour employed , the prices of the raw material , fuel & power used etc.

It is often drawn like a flipped over S, first getting flatter & flatter, & then steeper & steeper.This shape reflects the increasing & then decreasing marginal returns we discussed in the section on production.

$

Quantity

TVC

AVC = TVC/Q

AVC is the variable cost per unit of output.

Suppose X is the amount of variable input & PX is its price.

Then, AVC = TVC/Q = (PXX)/Q

= PX(X/Q)

= PX [1/(Q/X)]

= PX [1/AP].

So since AP had an inverted U-shape, AVC must have a U-shape.

$

Quantity

AVC

Quantity

TC = TFC + TVC

The TC curve looks like the TVC curve, but it is shifted up, by the amount of TFC.

$TC

TFC

$

Quantity

ATC

Like AVC, ATC is U-shaped, but it reaches its minimum after AVC reaches its minimum.

This is because ATC = AVC +AFC & AFC continues to fall & pulls down ATC.

AVC

Marginal Cost (MC)

Marginal cost measures the additional cost of inputs required to produce each successive unit of output

MC = ΔTC/ ΔQ Alternatively, MC = dTC/dQ .MC is the first derivative of the TC

curve or the slope of the TC curve.

Suppose the firm takes the prices of inputs as given.

Then,MC = TC/Q

= PX X/ Q

= PX [1/(Q/X)]

= PX [1/MP].

So since MP had an inverted U-shape, MC must have a U-shape.

$

Quantity

MC

$

Quantity

MC ATC

AVC

Assumptions : Labour (variable) and capital (fixed) are two

factor inputs. Price of labor : Rs.10/unit Price of capital : Rs.25/unit

Units of capital

Units of labour

TP TFC TVC TC

4 0 0 100 0 100

4 1 2 100 10 110

4 2 5 100 20 120

4 3 10 100 30 130

4 4 15 100 40 140

4 5 18 100 50 150

4 6 20 100 60 160

4 7 21 100 70 170

FC remains constant at all levels of output TVC varies with output TVC does not change in the same

proportion TC varies in the same proportion as the

TVC.

The graph above is also a result of linear cost function i.e.

TC = a + bQa = TFC, Q = quantity produced, TC = total

costb = change in TVC due to change in QAC= a/Q + bMC = bAVC = b

Q TFC TVC TC AFC AVC ATC MC

0 100 0 100 - - -

1 100 25 125 100 25 125 25

2 100 40 140 50 20 70 15

3 100 50 150 33.3 16.6 50 10

4 100 60 160 25 15 40 10

5 100 80 180 20 16 36 20

6 100 110 210 16.3 18.3 35 30

7 100 150 250 14.2 21.4 35.7 40

8 100 300 400 12.5 37.5 50 150

9 100 500 600 11.1 55.6 66.7 200

10 100 900 1000 10 90 100 400

AFC decreases as the output increases. AVC first decreases and then increases as

the output increases. ATC first decreases , remains constant and

then increases as the output increases. MC first decreases and then increases as

the output increases. When the average cost is minimum, MC=AC

AVC is U shaped indicating its three phases i) Decreasing ii) Constant iii) increasing.

Corresponds to the law of variable proportions.

ATC : vertical summation of AFC and AVC curves.

It is U shaped indicating that if the output is increased, initially the average cost decreases, remains constant and then starts rising .

ATC = AFC + AVC ATC falls in the beginning since AFC and

AVC both decrease. At a certain point, even though AVC starts

rising, ATC continues to fall because of predominance of falling AFC curve over the rising AVC curve.

With further expansion of output, AVC takes over AFC and hence ATC starts rising.

The point at which the rise of AVC nullifies the falling AFC, ATC is constant.

The distance between ATC and AVC narrows down as the curve moves up.

Economic reason – Fixed cost is important for a firm till the normal capacity is exhausted. Beyond that, more and more variable inputs are added to increase output .

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There is also a relationship between marginal costs and average total costs.

◦ Average total cost is equal to total cost divided by the number of units produced.

◦ Marginal cost is the change in total cost due to a one-unit change in the production rate.

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When marginal costs are less than average variable costs, the latter must fall.

When marginal costs are greater than average variable costs, the latter must rise.

When AC is minimum, MC is equal to AC .

At this point , MC cuts AC from below.

This is the optimization point of cost to output in the short run .

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Question

◦ What do you think—is there a predictable relationship between the production function and AVC, ATC, and MC?

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Answer

◦ As long as marginal physical product rises, marginal cost will fall, and when marginal physical product starts to fall (after reaching the point of diminishing marginal product), marginal cost will begin to rise.

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Firms’ short-run cost curves are a reflection of the law of diminishing marginal product.

Given any constant price of the variable input, marginal costs decline as long as the marginal product of the variable resource is rising.

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At the point at which diminishing marginal product begins, marginal costs begin to rise as the marginal product of the variable input begins to decline.

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If the wage rate is constant, then the labor cost associated with each additional unit of output will decline as long as the marginal physical product of labor increases.

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/ / /

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44

45

Lon

g R

un

Tota

l C

ost

LTC

LTC

QTotal Product

All inputs are variable in the long run. There are no fixed costs.

LONG-RUN TOTAL COST CURVE

The LAC curve is an envelop curve of all possible plant sizes. Also known as “planning curve”

It traces the lowest average cost of producing each level of output.

It is U-shaped because of ◦ Economies of Scale◦ Diseconomies of Scale

LAC

SAC1

Q0

COST

SAC2

LONG-RUN AVERAGE COST CURVE

LAC

Q0

COST

SAC1

q0

LAC

Q0

COST

SAC1

q0

SAC2

Building a larger sized plant (size 2) will result in a lower average cost of producing q0

LAC

Q0

COST

SAC1

q0

SAC2

Likewise, a larger sized plant (size 3) will result to a lower average cost of producing q1

q1

SAC3

Envelope curve

• LRAC can never cut SRAC but it will be tangential to each SRAC at some point.

• Average cost can not be higher in the long run than in the short run;

•Explanation;1.Any adjustment which will reduce costs

possible to be made in the short run must also be possible in the long run

2.It is not always possible in the short run to produce a given output in the cheapest possible way as all the factors are not variable.

properties U-shaped curve.Based on assumption of unchanging technology.LRAC is flatter curve than the SRAC. In economics ,we define long period as that during which size of the organization can be altered to meet changed conditions.Normally; Output increases and average costs also increases But in long run, size of the firm Can be increased therefore Variable costs are likely to rise less sharply. Hence a flatter curve.

Long run average cost curve Minimum

efficient scale is the lowest output level for which LRAC is minimized

LAC

SAC1

Q0

COST

SAC2

LONG-RUN AVERAGE COST CURVE

Q1

Economies of Scale

Diseconomies of Scale

LAC

SAC1

Q0

COST

LONG-RUN AVERAGE and MARGINAL COST CURVES

Q1

LMC

SMC1

SMC2

SAC2

Long-run Average Cost (LAC) curve ◦ is U-shaped. ◦ the envelope of all the short-run average

cost curves; ◦ driven by economies and diseconomies of

size. Long-run Marginal Cost (LMC) curve

◦ Also U-shaped; ◦ intersects LAC at LAC’s minimum point.

MC = ΔTC/ΔQor MC = dTC/dQ

MC < ATC when ATC is decreasing,

MC > ATC when ATC is increasing, &

MC = ATC when ATC is at its minimum.

long run MC & short run marginal cost will be equal at that output.

That is, the LR MC & SR MC will intersect at that output.

The condition for optimisation is the same as Short run curve.

LAC= LMC= SAC= SMC LAC and SAC are at their minimum.

In the long run, all inputs are variable.◦ What makes up LRAC?

Labor Specialization: Jobs can be subdivided and workers performing very specialized tasks can become very efficient at their jobs.

Managerial Specialization: Management can also specialize in a larger firm (in areas such as marketing, personnel, or finance).

Equipment that is technologically efficient but only effectively utilized with a large volume of production can be used.

The Long-Run Cost Function

• Reasons for Economies of Scale…Increasing returns to scaleSpecialization in the use of labor and

capital• Economies in maintaining inventory• Discounts from bulk purchases• Lower cost of raising capital funds• Spreading promotional and R&D costs

Management efficiencies

ADVANTAGES AND DISADVANTAGES OF LARGE SCALE PRODUCTION

Specialization

Economy of labour

Economics of buying and

selling

Overhead charges

Rent

ECONOMIES OF SCALE

INTERNAL ECONOMIES

EXTERNAL ECONOMIES

Reduction in costs when the scale of production increases

is called

INTERNAL ECONOMIES

Economies in Production

Economies in

Marketing

Technological Advantages

Advantages of divisions of labour & Specialization

Large scale production provides opportunities for technological advances

Large scale production workers of varying skills & qualifications are employed which facilitates division of labour as per specialization

.. Large scale selling of firms own products

.. Advertising cost .. Large scale distribution

.. Large scale purchase of raw materials & other inputs

Improves the overall performance of the firm

Managerial Economies

Transport & Storage Economies

.. Specialization in managerial activities

.. Mechanization of managerial functions

.. Improves managerial efficiency

.. Efficient management of the transport function

.. Proper utilization of storage facilities

.. Helps in reducing transportation and storage costs

CAUSES OF INTERNAL ECONOMIES

SIZE Big Machine

Bigger capacity lower Energy less labour

LIMITING PROCESS

MergersSpreading of

costs

TECHNIQUE

Superior Technique

Shorter period of time

SPECIALI - ZATION

Division of Labour

Increase in efficiency

MANAGERIAL ECONOMICS

COMMERCIAL ECONOMIES

Aggregation

Financial economies

Wide Market

Credit facilities

Encourages investment

Managerial economies

RISK BEARING ECONOMIES Spreading

RisksDiversification

CAUSES OF EXTERNAL ECONOMIES

CONCENTRATION

Advantages of locality

Common Pool of Knowledge of localityReduced transportation cost

INFORMATION

DISINTEGRATION

Breaking up processes

The benefits which companies derive from trade publications and technical journalsBy virtue of location, common pool of research can be created and benefits can be shared

Knowledge sharing

Breaking up of processes which can be handled by specialist firms

Expansion of the management hierarchy leads to problems of communication, coordination, and bureaucratic red tape, and the possibility that decisions will fail to mesh. (“The left hand doesn’t seem to know what the right hand is doing.”) The result is reduced efficiency.

In large facilities, workers may feel alienated and may shirk (not work as much as they should). Then additional supervision may be required and that adds to costs.

The Long-Run Cost Function

• Reasons for Diseconomies of Scale…Decreasing returns to scaleInput market imperfections e.g. wage rate driven upManagement coordination and controlproblemsDisproportionate rise in transportation costsDisproportionate rise in staff and indirect labour

In the long run, a firm exercises its choicewith regard to the size of the plant andscale of production, on the basis of long runaverage cost. Selection of the optimal plant size accordingto the expected demand. Avoid unnecessary costs due to

inappropriateplant size.

The reasons for the LAC curve being L shaped are as follows :

Technological progress :In economics theory,technological is assumed to be constant.But technology changes in real life.Due to this,the average cost decline and does not rise

Learning by doing :The LAC curve completely slopes completely downwards due to learning by doing.Since the efficiency of firm increases due to continuous work,it is able to reduce cost.As the output is increased,there is not only the increase in knowledge of many things,there is also an improvement in the management of plant.Due to this LAC curve is L shaped

Management technique :According to the modern management theory,appropriate administrative structure is available to operate the plant of each size.There exists appropriate management technique in different levels of management.The management technique is available in large and small size.The cost of different management first fall up to certain plant size.The managerial cost slowly increases to very large level of output.

Break even point (BEP) is located at that level of output or sales at which net income or profit is zero.

BEP is located at that level of output at which the price or AR is equal to AC.

Contribution margin = Price – AVC Formula for calculating BEP=TFC/ P- AVC where P- AVC

BEP in terms of sales value BEP = FC/ Contribution ratioContribution ratio = TR-TVC/ TR BEA can be used for determining ‘safety

margin’ regarding the extent to which the firm can permit a decline in sales without causing losses.

Safety Margin = Sales- BEQ/ Sales *100

BEA can be useful in determining the target profit sales volume.

Target profit sales vol = TFC- Target profit / Contri. Margin