theory of costs.ppt

7/21/2019 theory of costs.ppt

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THEORY OF COSTS

Short Run & Long Run

S.S. Hamila

Assistant Lecturer, SLIATE



Theory of costs

• Costs of a firm is incurred to establish theroduction unit and to urchase different

factors of roduction!

• Cost of a firm "TC# is classified into t$obroad categories % Fixed cost (TFC) and

Variable cost (TVC)!

i!e! TC = TFC + TVC• Ho$eer' nothing is fixed in the long run!





Theory of costs

Fi(ed cost does not change $ith theolume of roduction!

TFC

)

costs

*++

O



Theory of costs

Variable costs

Variable costs change in direct

proportion to the actiity of a businesssuch as sales or roduction olume! ,n

retail' the cost of goods is almost entirely

ariable! ,n manufacturing' direct material

costs' $ages' fuel costs are e(amles ofariable costs!



fig

TFC

Output(Q)

0

12!"

#$

TFC

(%)

12

1212121212

1212

Total costs for firm -



fig

TFC

Output(Q)

0

12!"

#$

TFC

(%)

12

1212121212

1212

TVC

(%)

0

101#212&!0

#0'1




fig

TVC

Output(Q)

0

12!"

#$

TFC

(%)

12

1212121212

1212

TVC

(%)

0

101#212&!0

#0'1

TFC




fig

TVC

TFC

Diminishing marginalreturns set in here




fig

TVC

Output(Q)

0

12!"

#$

TFC

(%)

12

1212121212

1212

TVC

(%)

0

101#212&!0

#0'1

TFC




fig

TVC

TFC

Output(Q)

0

12!"

#$

TFC

(%)

12

1212121212

1212

TVC

(%)

0

101#212&!0

#0'1

TC

(%)

12

222&!0"2

$210




fig

TC

Output(Q)

0

12!"

#$

TFC

(%)

12

1212121212

1212

TVC

(%)

0

101#212&!0

#0'1

TC

(%)

12

222&!0"2

$210

TVC

TFC




fig

TC

TVC

TFC





. Firm/s Short Run Costs



. Firm/s Short Run Costs



Cost Cures for a Firm

Output

Cost( per ear)

100

200

00

!00

0 1 2 ! " # $ & ' 10 11 12 1

VC

Variable costincreases *ithproduction and

the rate aries *ithincreasing ,

decreasing returns-

TC

Total costis the ertical

su. o/ FCand VC-

FC"0

Fixed cost does notar *ith output



erage /ixed cost

erage /ixed cost ".FC# 0 TFC1)$here TFC 0 fi(ed cost' ) 0 total number of

units roduced!

2nit fi(ed costs decline along $ith olume'follo$ing a rectangular hyerbola! .s a

result' the total unit cost of a roduct *illdecline as olu.e increases-



.erage Fi(ed costs

)

Costs

.FC

O



erage ariable cost

erage ariable cost ".3C# is the T3C of a firmdiided by the total units of outut ")#!

.3C 0 T3C1)

)

costs

Y

.3C

O



erage cost

erage cost ".C# is the TC of a firm diided bythe total units of outut ")#!

.C 0 TC1) 0 .FC 4 .3C

)

costs

5

.C

O



6arginal Cost

The additional cost incurred to roduce oneadditional unit of outut is called the

6arginal Cost "6C#!

6C 0 dC1d)



6C

The marginal cost cure is 2%shaed!

6arginal cost is relatiely high at small7uantities of outut % then as roduction

increases' it declines % then reaches a

minimum alue % then rises!

This shae of the marginal cost cure is

directly attributable to increasing' thendecreasing marginal returns "the la$ of

diminishing marginal returns#!

6 i l t

6 i l t



figOutut "Q#

C o s t s " 8 #

MC

x


6arginal costs6arginal costs



figOutut "Q#

C o s t s " 8 #

AFC

AVC

MC

x

AC

.erage and marginal costs



Long run cost cures

The ong run aerage cost "LR.C or L.C#

cure illustrates % for a gien 7uantity of

roduction % the aerage cost er unit

$hich a firm faces in the long run "i!e!$hen no factors of roduction is fi(ed#!



LR.C

LR.C cure is deried from a series of shortrun aerage cost cures!

,t is also called the 9Eneloe cure: since it

enelos all the short run aerage cost

cure!

The cure is created as an eneloe of an

infinite number of short%run aerage total

cost cures!



L.C

The LR.C cure is 2%shaed' reflectingeconomies of scale $hen it is negatiely%

sloed and diseconomies of scale $hen it

is ositiely sloed!

,n erfect cometition' the LR.C cure is

flat at the oint of e7uilibrium ; in this

stage the firm is en<oying constant returns

to scale!

L t



fig

Long%run aerage cost cures

OututO

C o s t s

LRAC

Economies of Scale

l t



fig

OututO

C o s t s

LRAC

Diseconomies of Scale

long%run aerage cost cures

long run aerage cost cures



fig

OututO

C o s t s

LRAC

Constant costs

long%run aerage cost cures



Long%run Costs

• Long%run aerage costs

; assumtions behind the cure

• factor rices are gien

• state of technology and factor 7uality are gien

• firms choose least%cost combination of factors

. t ical long r n a erage cost c r e



fig

. tyical long%run aerage cost cure

OututO

C o s t s

LRAC

. tyical long run aerage cost cure



fig

OututO

C o s t s

LRAC Economiesof scale

Constantcosts

Diseconomiesof scale

. tyical long%run aerage cost cure

Long run aerage and marginal costs



fig

Long%run aerage and marginal costs

OututO

C o s t s

LRAC LRMC

Economies of Scale




fig

OututO

C o s t s

LRAC

LRMC

Diseconomies of Scale





fig

OututO

C o s t s

LRMC

LRAC

Initial economies of scale,then diseconomies of scale


=eriing long run aerage cost cures> lants of fi(ed si?e



fig

=eriing long%run aerage cost cures> lants of fi(ed si?e

SRAC @

C o s

t s

Outut

O

SRAC A

SRAC B

" /actories

! /actories /actories

2 /actories

1 /actor

SRAC * SRAC

=eriing long%run aerage cost cures> factories of fi(ed si?e



fig

SRAC *

SRAC @

SRAC

SRAC A

SRAC B

LRAC

C o s

t s

Outut

O

=eriing long%run aerage cost cures> factories of fi(ed si?e

=eriing a long run aerage cost cure> choice of factory si?e



fi

LRAC

C o s

t s

O t t

O

=eriing a long%run aerage cost cure> choice of factory si?e

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theory of costs.ppt