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Costs of Production

Mihir Mahapatra

PGDM 2011-13

July 2011


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Topics to be Discussed

Measuring Cost: Which Costs Matter?

How do Cost Curves Behave?

Cost in the Short Run

Cost in the Long RunHow to Minimize Cost?

How to draw Implications for BusinessStrategy?


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Topics to be Discussed

Production with Two Outputs:Economies of Scope

Dynamic Changes in Costs:The Learning Curve

Estimating and Predicting Cost


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Measuring Cost:

Which Costs Matter?

Accountants tend to take a retrospective view of

firms costs, whereas economists tend to take a

forward-looking viewAccounting Cost

capital equipment

Economic Cost

Cost to a firm of utilizing economic resources inproduction, including opportunity cost


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Costs as Opportunity Costs

Accountantsmeasure the explicit costs butoften ignore the implicit costs.

Economistsinclude all opportunity costswhen measuring costs.

Accounting Profit = TR - Explicit Costs

Economic Profit = TR - Explicit Costs -

Implicit Costs


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Explicit and Implicit costs

The firms costs include Explicit Costsand ImplicitCosts:

Explicit Costs: costs that involve a direct money

outlay for acquiring factors of production.Actual expenditure incurred by firm for hire, rent or

purchase of the inputs so as to undertake production.

(Exp: Wages to hire labour, rental price of capital, equipment and buildingsand purchase price of raw materials and semi finished products).

Implicit Costs: Costs that do not involve a direct

money outlay (Ex. Opportunity costs of the owners own inputs used

Implicit wages, implicit rent, cost of capital).


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Opportunity Cost

Economic costs distinguish between coststhe firm can control and those it cannot

Opportunity cost Cost associated with opportunities that are foregone when a

firms resources are not put to their highest-value use

Opportunity costof an action is the value of thenext best alternative forgone.

For an Input: What the input could have earnedfrom best alternative use (outside the firm).


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SUNK COST Although opportunity costs are hidden and should be taken into

account, sunk costs should not

Sunk Cost

EXPENDITURE THAT HAS BEEN MADE AND CANNOT BERECOVERED

Firm buys a piece of equipment that cannot be

conver e o ano er useCost that is committed but can not beavoided

Should not influence a firms future economic decisions


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Sunk Cost

From a firms point of view it is the cost thatarises when an investment in an asset can notbe recovered by subsequent resale.

Firm can neither sell nor lease it to any otherperson and even cannot be used for other

.

Investment is a SUNK COST when its

OPPORTUNITY COST is zero.


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Fixed Cost versus Sunk Cost

Fixed CostCost paid by a firm that is in business

regardless of the level of output

Fixed costs can be avoided if the firm goes outof business (say key executives will not beneeded

Sunk Cost

Cost that has been incurred and cannot be

recoveredEx: Cost of factory with specialized equipment which is of

no use in another industry

Exception: Something can be recovered if it is sold for scrap.


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Family of Total Costs...

Total Fixed Costs (TFC)

Total Variable Costs (TVC)

TC = TFC + TVC


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Short Run Costs

Fixed Costs:

Those costs that do not vary with theamount of output produced or level ofoutput.

period (time) for all fixed inputs (Land,Building, Capital Equipment).

Exp: Payment for renting the plant and equipment if firmowns it, insurance, property taxes, salaries (for topmanagement fixed by contract and to be paid during theperiod of contract irrespective of going for production or not)

-Annual allowances made for depreciation (wear and tear)and expenditure on maintenance


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Variable Cost

Those costs that do vary with

the amount of outputproduced.

ga ons o e rm per per o orall variable inputs (Exp. Payment for Raw materials and fuels,

expense on power and water supply, wages oflabour)


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Family of Average Costs. . .

Average Costs:Specific Cost / Output Level

Average Fixed Costs (AFC)

Average Variable Costs (AVC)

= Total Variable Cost / output (Q)

Average Total Costs (ATC)

= Total Cost / Output (Q)


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Marginal Cost:

How much does it cost to produce anadditional unit of output?

Marginal Cost (MC):The extra or additional cost of

.

MC = TC Q


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Determinants of Short Run Costs INCREASE in OUTPUT leads to INCREASE in TOTAL COST.

HOW does it MOVE?

Extent of Rise in Cost Depends on the nature of the PRODUCTION

PROCESS

Extent to which production involves DIMINSHING RETURNS to

If MARGINAL PRODUCT OF LABOUR DECREASES significantly as

more labor is hired

Costs of production increase rapidly

Greater and greater expenditures must be made to produce moreoutput


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Determinants of Short Run Costs

Assume Labour: onlyVariable Input

Assume the wagerate (w) is fixedrelative to the LwVC

hired

Variable costs is theper unit cost of extra

labor times theamount of extralabor: wL

QQ


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A Firms Short Run CostsInference: MC decreases initially with increasing returns (0 through 4 units of output)

MC increases with decreasing returns (5 through 11 units of output)


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Cost($ peryear)

300

400

VC

Variable cost

TC

Total costis the vertical

sum of FCand VC.

Outpu

100

200

0 1 2 3 4 5 6 7 8 9 10 11 12 13

increases with

production andthe rate varies with

increasing anddecreasing returns.

FC50

Fixed cost does notvary with output


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Capitalper

year

Isocost C2shows quantity

Q1 is an isoquant for output Q1.There are three isocost lines, of

which 2 are possible choices inwhich to produce Q1.

K2

Cost Minimizing Input Choice in Long Run:

Producing a Given Output at Minimum Cost

Labor per year

Q1

can be produced withcombination K2,L2or K3,L3.

However, both of theseare higher cost combinations

than K1,L1.

Q1

C0 C1 C2

AK1

L1

K3

L3L2


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Cost in the Long Run How does the isocost line relate to the

firms production process?

LMP K

KMPL

rw

LK =

=lineisocostofSlope

costminimizesfirmwhenr

wMP

MP

K

L =


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Capital is fixed at K1.To produce Q1, min cost at (K1,L1).

If increase output to Q2, min. costis K1 and L3 in short run.

Long Run versus Short Run Cost Curves

The Inflexibility of Short Run Production

Long-Run

Capitalper

year C

E

In Long R,can change

Labor per yearL2

Q2

K2

D F

Q1

A

BL1

K1

L3

PShort-RunExpansion Path

capital andmin costsfalls to K2and L2.

xpans on at :

Combination ofLabour & Capital

that firm chooses to

Minimize Cost at

each Level of

Output.


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Derivation of Expansion Path & Long Run Total Cost Curves


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Long-Run Average Cost (LAC)

Most important determinant of the shape of

the LR AC and MC curves is relationshipbetween scale of the firms operation andin uts re uired to minimize cost

Long Run Versus

Short Run Cost Curves

L R C


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Long-Run Costs

How does per unit costs behave as the firmEXPANDS all INPUTS, even plant size or scaleof operation?

The Long-Run Average Total Cost(LRATC)reflects the lowest possible unit cost relatedto different plant sizes and/or scales of

opera on.In long run no fixed factor, all factors are

variable.

LRATC=LVC or Average total and variable costscoincide.

The LRATC Curve is U-shaped


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Long Run Versus Short Run Cost

Curves Long-run marginal cost leads long-run

average cost: If LMC < LAC, LAC will fall

,

Therefore, LMC = LAC at the minimum of

LAC

In special case where LAC is constant,LAC and LMC are equal


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Long Run Average and Marginal Cost

Cost($ per unit

of output

LAC

LMC

Output

A


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U-Shaped LAC Curve Increasing Returns to scale Constant Returns to Scale

Diminishing Returns to Scale

Sources of Returns to ScaleEconomies of Scale

Diseconomies of Scale

Economies of Scale


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Economies of Scale Economies of Scale: Output can be doubled for less than a

doubling Cost- Pindyck et al.

LRATC DECREASEs as the Scale of Operation INCREASES.

Diseconomies of Scale (DRS): Doubling of Output requires more than a doubling of

Cost

LRATC INCREASES with the scale of operation.

U-shaped LAC reflects ECONOMIES of SCALE forrelatively low output levels and diseconomies of scalefor higher levels

Di ti ti b t IRS & E i f S l


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Distinction between IRS & Economies of Scale

Increasing Returns to ScaleOutput more than doubles when the QUANTITIES

of all inputs are doubled

Economies of ScaleDoubling of output requires LESS than a doubling

of COST

Ex: Milking cows by hand in large dairy firms.ConstantReturns to Scale but experience Economies of scale if milkedby machine (Pindyck et al.)

..Firms production process can exhibit constant returns to

scale, but still have economies of scale as well. Of course, firmcan enjoy both economies of scale and increasing returns toscale (Pindyck)


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Emergence of Economies of Scale?

As output increases, firms AC of producing islikely to decline to a point1.Production Economies

On a larger scale, workers can better SPECIALIZE..

DEVELOPMETN OF Skills, Time Saving etc

production more effectively

3.DISCOUNT for BULK PURCHASE of INPUTS (RawMaterials)

Firm may be able to get inputs at lower cost if can get quantitydiscounts. Lower prices might lead to different input mix.


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ECONOMIES of SCALE

-Change in TECHNOLOGY in the long run

-Changes in FACTOR PRICES

-Transport and Storage Economies(Average cost of Transport Relatively low for bulk transport and

bulk storage)

-Selling or Marketing Economies

(Lower Average cost of Advertising at large Scale)


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Economies of Scale

Managerial EconomiesArises Primarily due to Specialisation of Management &

Mechanisation of Managerial Function.

Division of Managerial Task-Specialization of Management-

Im rovement in Efficienc .

High Degree of Mechanisation (Telephone, computer) and

Decline in Cost

Decision Making Process Decentralized (increase in efficiency)


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Continues.

LOW COST OF FINANCELarger firm can borrow at lower interest rate andhave access to Financial Market

Exp: PRIME LENDING RATE of CommercialBanks.

be associated with organisation of Reputeor there is no LABOUR UNION(Low expenditureRelatively low cost)


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At some point, AC will begin to increase

1.FACTORY SPACE and MACHINERY may make it

more difficult for workers to do their jobs efficiently

2.Managing a larger firm may become more complex

INCREASES

3. Increase in INPUT PRICES resulting from increase in

Usage by the firm or Limited availability of Inputs

Di i f S l


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Management Limitations (diseconomies)Decisions are Delayed in large firms(information often consciously or unconsciously

distorted as it passes through various hierarchicallevels or stopped for different reasons at somestage)

DECISIONS OF TOP MANAGEMENT will not beoptimal if information is not accurate or comeswith time lag (by that time environment undergonea change)

CRITICS argue in the MODERN WORLD it does notPREVAIL. Do you agree?

L R C


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Economies of scale are measured interms of

COST-OUTPUT ELASTICITY (Ec)

Long Run Costs

of production resulting from a 1-per centincrease in output

ACMC

QQCCE

C=

=


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Long Run Costs EC is equal to 1, MC = AC

Costs increase proportionately with output

Neither economies nor diseconomies of scale EC < 1 when MC < AC

Both MC and AC are declining

EC > 1 when MC > AC

Diseconomies of scale Both MC and AC are rising

Long Run Average Cost Curve: Flatbottomed


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Long Run Average Cost Curve: Flatbottomed

Curve (a Special Case)

LRATC Curve

(Rs)

PerUnit

.

ofScale

. ofScale

Economies norDiseconomies ofScale

Scale of Operation (Q)


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E i /Di i f S C f M lti P d t Fi


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Economies/Diseconomies of Scope: Case of Multi-Product Firm

If Total Cost of jointly producing Cars and Trucks (T)is smaller than the cost incurred for producing carsand trucks independently by different firms

ECONOMIES OF SCOPE Exists if

TC(C,T) < [TC (C,0) + TC(0, T)]

Reasons: Automobiles and Trucks can be producedwith same metal sheet and engine assembly facilities.

Joint Production: Better utilization of ProductionFacilities and lower costs.


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Economies of Scope

Advantages

1.Both use capital and labor2.The firms share management resources

3.Both use the same labor skills and typesof machinery


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Economies of Scale and Economies of Scope

Economies of scale: Should a Public sectorcommercial bank merge with its competitor

(other PSBs)

Economies of Scope: Should Commercial

Bank offer Mutual Fund or Life insurancescheme?

Production with Two Outputs


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Economies of Scope There is no direct relationship between

economies of scope and economies ofscale

diseconomies of scale

May have economies of scale and not haveeconomies of scope

Production with Two Outputs Economies of


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The degree of economies of scope (SC) can be measured by

percentage of cost saved producing two or more products

jointly:)qC(q)C(q)C(q

SC, 2121 +

=

Production with Two Outputs Economies of

Scope

C(q1) is the cost of producing q1C(q2) is the cost of producing q2

C(q1,q2) is the joint cost of producing both products



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Economies of Scope With economies of scope, the joint cost is

less than the sum of the individual costs Interpretation:

> conom es o scope

If SC < 0 Diseconomies of scope

The greater the value of SC, the greater the

economies of scope

Dynamic Changes in Costs The Learning


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Dynamic Changes in Costs The LearningCurve

Firms may lower their costs not only due to

economies of scope, but also due to managers

and workers becoming more EXPERIENCED attheir JOBS

As management and labor gain experience withproduction, the firms MARGINAL and

AVERAGE COST may fall



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Curve Learning curve: Measures the impactworkers experience on the costs of

production Describes the RELATIONSHIP between a firms

needed to produce each unit of output

Learning curve information facilitates to take decision

whether production operation is profitable or not. Based on the information plan how much cumulative

output to be produced to reduce cost

The Learning Curve


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Hours of laborper machine

8

10

The Learning Curve

Hours of Labour needed

Per unit of output declines

With increase in cumulativeoutput

Cumulative number ofmachine produced10 20 30 40 500

2

4

6

D i Ch i C t Th L i C


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Dynamic Changes in Costs The Learning Curve

Reasons1.Workers SPEED OF WORK increases with

experience

2.Managers learn to SCHEDULE PRODUCTIONprocesses more efficiently (flow of material to

3.More FLEXIBILITY is allowed with experience; mayinclude more specialized tools and plant organization

4.Suppliers become more efficient in processingrequired material.often pass this advantage (lowermaterial cost) to company

Economies of Scale Versus Learning


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Economies of Scale Versus Learning

Cost(Rs per unit

of output)

Movement from A to B along AC1-Lower cost

due to Economies of Scale

Move from A (on AC1) to C (On AC2) leads to lower

Cost due to Learning

Output

AC1B

Economies of ScaleA

AC2

Learning C


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Sum up.. Relevance of studying cost of production Identify which cost matter

How to minimize cost in the short run andlong run

y s ong run - ape

Distinction between Economies of Scaleand Scope

Role of Learning Curve in Cost

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