Cost Concepts & Its Analysis

7/29/2019 Cost Concepts & Its Analysis

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Cost concepts & its Analysis


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Certain concept of cost Opportunity cost is the cost concept most

relevant to economic decisions. The OC of anydecision is the value of the next best alternativethat must be foregone.

Explicit Cost are those costs that involve anactual payment to other parties

Implicit costs represent the value of foregone opportunities but do not involve anactual cash payment

Sunk cost are cost which cannot berecovered by renting or selling the productive

resources.


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Economic costs refers to the costs involved for all thefactors of production including those purchasedfrom outside as well as those owned by the firm. Inother words, it is the normal returns to themanagement which is necessary to keep theresources from shifting to other firms

Direct & Indirect costDirect cost are directly associated with the

production of a given product like labour cost , rawmaterial etc. Indirect cost are cost which cannot beseparated and are directly attributed to individualunits of production like depreciation of plant &

machinery, administrative charges etc


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Fixed & Variable costFixed cost are cost that do not vary with the

changes in the output of a product. These areassociated with the existence of a firms plantand therefore, must be paid even if the firms

level of output is zero.. Eg. Payment of interest, rent, salaries of top level management.

Variable costs are those which varies with the

level of output. Eg. Payment of raw materials, payment of wages


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Short-run Cost Functions In SR capital is fixed and labour is variable. Total cost = TC = TVC + TFC

or, TC = wL+ rK, rk is fixedor, TC = wLor, TC = TVC in short run

ATC = TC/Q

AVC = TVC/Q AFC = TFC/Q MC =d(TC)/dQ


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Deriving TC curve from TP curve


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TC, TVC & TFC Curves


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Deriving AC & MC curve from TC curve


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Relationship between the curves ATC = AFC + AVC = (TFC/Q) + (TVC/Q) When MCATC, then ATC is rising When MCAVC< then AVC is rising This implies that MC must intersect both ATC & AVC

at their minimum points ATC reaches its minimum point at a larger output than

AVC because ATC = AFC + AVC and so even when AVC has begun to rise, AFC is still declining, hencepulling ATC down.

Eventually, the increase in AVC will offset thedecrease in AFC and ATC will begin to increase.


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Economies of Scale(ES)

Internal economies of scale/ real economies of scale :This arise from an increase in the firms plant size. This

can be in achieved through :Production economies of scale- labour economies- Technical economies- Inventory economiesSelling economies are associated with the distribution of

the product of a firm. The most important of theseeconomies is advertising economies Advertisingexpenditure increase less than proportionately with ES.


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Managerial economies arises for mainly two reasons- Specialization of management-Mechanization of managerial functions

Transport & storage economies : it comes downwith increase in sales


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Pecuniary economies of scale/ external economiesof scale

These are economies accruing to the firm due to thediscounts it can obtain for its large scale operations.

They can be achieved by :

- Reduction in the prices of raw materials- Lower cost of external finance- Lower advertising rates

- Lower transport rates- Using the monopoly power and paying less to the

employees or using its prestigious position for

giving less payment to the employees


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Diseconomies of scaleThere is a limit to the gain achieved from large

scale of operations, which means that there isan optimum level of capacity and any increasein the scale beyond this level leads todiseconomies of scale

They can arise from managerial difficulties, lowemployee morale, higher input price etc.


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Long run cost functions

L= g1(Q)K = g2(Q)

C = Lw + Kr or, C = wg1(Q) + rg2(Q)or, C=C(Q)LRAC = C/Q ,LRMC = dC /dQ


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Long-run Cost curves LRAC = TC/Q , LRMC = d(TC) /dQ

Lo


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Equiliburium Condition LRAC = SRAC LRMC = SRMC

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Cost Concepts & Its Analysis