9 costs class

In This Lecture…

Concepts of Costs: Economic Costs, Accounting Costs, Sunk Costs

Short-run and Long-run Costs: Total, Average and Marginal Costs

Cost Schedules, Cost Curves, Characteristics and their Relationships

Business Firm

An entity that employs factors of production (resources) to produce goods and services to be sold to consumers, other firms, or the government.

Why Do Business Firms Arise in the First Place?

Firms are formed when benefits can be obtained from individuals working as a team.

Economic Cost

Economic cost is the cost to a firm for utilizing economic resources in production, including opportunity cost.

Accounting Cost

Accounting cost is that cost which includes actual expenses plus depreciation charges for capital equipment.

Sunk Cost

A cost incurred in the past that cannot be changed by current decisions and therefore cannot be recovered.

Explicit and Implicit Cost

Explicit Cost - A cost incurred when an actual (monetary) payment is made.

Implicit Cost - A cost that represents the value of resources used in production for which no actual (monetary) payment is made.

Production and Cost:Short and Long Run

Short Run - A period of time in which some inputs in the production process are fixed.

Long Run - A period of time in which all inputs in the production process can be varied (no inputs are fixed).

Short-run Cost

The short-run costs are the costs over the period during which some factors are in fixed supply – like plant, machinery etc.

It is a sum total of fixed cost and variable cost incurred by the producer in producing the commodity.

Long-run Cost

The long-run costs are the costs over the long period enough to permit changes in all factors of production.

It is a sum total variable cost incurred by the producer in producing the commodity.

Fixed and Variable Costs

Fixed Costs – The cost incurred in those inputs whose quantity cannot be changed as output changes.

Variable Costs – the cost incurred in those inputs whose quantity can be changed as output changes.

Costs in Short-run

Fixed Costs (FC) - Costs that do not vary with output; the costs associated with fixed inputs.

Variable Cost (VC) - Costs that vary with output; the costs associated with variable inputs.

Total Cost (TC) - The sum of fixed costs and variable costs. TC = TFC + TVC

Marginal Cost (MC) - The change in total cost that results from a change in output: MC = ΔTC/Δ Q.

Fixed Cost / Overhead Cost

Fixed Costs (FC) - Costs that do not vary with output; the costs associated with fixed inputs.

Overhead expenses, Wages/Salaries, Depreciation of Machinery, Insurance Amount etc.

Output TFC

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1010101010

Fixed Cost / Overhead Cost

Cost 20

15

10 TFC 5

O 1 2 3 4 Output

Total Fixed Cost Curve (TFC Curve) – Horizontal line

Total Variable Cost/ Prime Cost

Variable Cost (VC) - Costs that vary with output; the costs associated with variable inputs.

Cost of direct labor, Running expenses like cost of raw materials, fuels etc.

Output TVC

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Cost 40

TVC

30

20

10

0 1 2 3 4 Output

Total Variable Cost Curve (TVC Curve) – Inverse S-shaped Curve

Total Cost

Total Cost (TC) - The sum of fixed costs and variable costs. TC = TFC + TVC

It is the aggregate of all costs of producing any given level of outputOutput TFC TVC TC

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1010101010

010183045

1020284055


Cost TC 50

TVC

40

30

20 TFC 10

TFC

0 1 2 3

4 Output

Total Cost Curve (TC Curve) – Inverse S-shaped Curve

Fixed Cost vs. Variable Cost

Fixed Cost (FC) Variable Cost (VC)

1. FC are incurred in fixed FOP.

2. FC do not change with the change in output.

3. FC cannot be changed during short-run.

4. FC can never be zero even at zero level of output.

5. Production at the loss of FC may continue.

6. TFC curve is parallel to x-axis.

1. VC are incurred in variable FOP.

2. VC changes with the change in the level of output.

3. VC can be changed during short-run.

4. VC can be zero at zero level of output.

5. Production at the loss of VC will not continue.

6. TVC curve is inverse S-shaped.

Average Fixed, Variable and Total Cost

Average Fixed Cost (AFC) - Total fixed cost divided by quantity of output: AFC = TFC / Q.

Average Variable Cost (AVC) - Total variable cost divided by quantity of output: AVC = TVC / Q.

Average Total Cost (ATC), or Unit Cost - Total cost divided by quantity of output: ATC = TC / Q.

Average Fixed Cost, Average Varible Cost & Average Cost

Average Fixed Cost, Average Variable Cost & Average Cost





Average Cost Curve is U-shaped

Basis of AFC : AC includes AFC and AFC falls continuously with increase in output. Once AVC reaches its minimum point and starts rising, its rise is initially offset by the fall in AFC. Hence, AC continues to fall. After a certain point the rise in AFC becomes greater than the fall in AFC and AC starts rising

Average Cost Curve is U-shaped

Basis of Law of Variable Proportion : According to this Law initially when variable factor is combined with the fixed factor, production increases at an increasing rate implying AC falls till the best combination of fixed and variable factors is attained. Beyond this point, AC starts to rise.

AFC, AVC and AC Curves Cost AC AVC A C B A1 C1

B1 AFC

A2 C2

O A4 B2 C3 Output

Short run AC curve is a vertical summation of AFC and AVC curves.

AVC = A2A4, AFC = A1A4. AC = AVC + AFC = A2A4 + A1A4 = AA4

AC and AVC CurveAVC is a part of AC as AC = AVC + AFCThe minimum point of AC will always be

to the right of minimum point of AVCBoth AVC and AC are U-shaped curvesThe difference between AC and AVC

decreases with the rise in the level of output as AC is the aggregation of AVC and AFC; and, AFC falls continuously as output increases. AVC and AC never meets each other as AFC is a rectangular hyperbola and can never touch x-axis

Marginal Cost

Marginal Cost (MC) - The change in total cost that results from a change in output: MC = ΔTC/Δ Q.

Short run MC can be estimated from TVC as well

MC = TCn – TCn-1

= (TFCn + TVCn) - (TFCn-1 + TVCn-1)

= (TFCn + TVCn) - (TFCn + TVCn-1)

= TVCn - TVCn-1

Marginal Cost

Output TFC TVC TC MC

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1010101010

010183045

1020284055

-108

1215

Marginal Cost

Cost MC

O Output

MC curve is U-shaped curve due to Law of Variable Proportion

MC and AC

Cost MC AC

O a b Output

MC and AC

Both MC and AC are derived from TC. MC= ΔTC/ΔQ and AC = TC/QBoth AC and MC curves are U-shaped,

reflecting the law of variable proportion.When AC is falling MC is below ACWhen AC is rising MC is above ACWhen AC is neither falling or rising AC=MCThere is a range over which AC is falling but

MC is rising (ab)MC curve cuts AC from its minimum point.

MC and AVC

Cost MC AC

AVC AFC O a b

Output

MC and AVC

Moth MC and AVC are derived from TVC. MC= ΔTVC/ΔQ and AVC = TVC/QBoth AVC and MC curves are U-shaped,

reflecting the law of variable proportion.When AVC is falling MC is below AVCWhen AVC is rising MC is above AVCWhen AVC is neither falling or rising

AVC=MCThere is a range over which AVC is falling

but MC is rising (ab)MC curve cuts AVC from its minimum point.The minimum point of AVC curve occurs to

the right of the minimum point of MC curve.

Production and Costs in the Long Run

In the short run, there are fixed costs and variable costs; therefore, total cost is the sum of the two.

A period of time in which all inputs in the production process can be varied (no inputs are fixed). In the long run, there are no fixed costs, so variable costs are total costs.

Long-Run Average Total Cost (LRATC) Curve

A curve that shows the lowest (unit) cost at which the firm can produce any given level of output.

A firm attempts to maximize long run profits by selecting a short scale of plant that minimizes its costs.

Long-Run Average Total Cost

Curve (LRATC ) There are three

short-run average total cost curves for three different plant sizes.

If these are the only plant sizes, the long-run average total cost curve is the heavily shaded, blue scalloped curve.

Long-Run Average Total Cost

Curve (LRATC ) The long-run average

total cost curve is the heavily shaded, blue smooth curve.

The LRATC curve is not scalloped because it is assumed that there are so many plant sizes that the LRATC curve touches each SRATC curve at only one point.

Economies of Scale Economies of Scale exist when inputs

are increased by some percentage and output increases by a greater percentage, causing unit costs to fall.

Constant Returns to Scale exist when inputs are increased by some percentage and output increases by an equal percentage, causing unit costs to remain constant.

Diseconomies of Scale exist when inputs are increased by some percentage and output increases by a smaller percentage, causing unit costs to rise.

Why Economies of Scale?

Up to a certain point, long-run unit costs of production fall as a firm grows. There are two main reasons for this:

Growing firms offer greater opportunities for employees to specialize.

Growing firms can take advantage of highly efficient mass production techniques and equipment that ordinarily require large setup costs and thus are economical only if they can be spread over a large number of units.

Why Diseconomies of Scale?

In very large firms, managers often find it difficult to coordinate work activities, communicate their directives to the right persons in satisfactory time, and monitor personnel effectively.

Economies of Scale

The lowest output level at which average total costs are minimized.

LAC and LMC Costs

LMC LAC

O X Output

Increasing Decreasing Returns to Scale Returns to

Scale Constant Returns to Scale

LAC and LMC

Both LMC and LAC curves are flatter U-shaped curves are compared to SMC and SAC

LMC cuts LAC at its minimum pointWhen LAC is falling LMC is below itWhen LAC is rising LMC is above itWhen LAC is neither falling or rising

LMC = LAC

A firm’s cost curves will shift if there is a change in:TaxesInput pricesTechnology.

Shifts in Cost Curves

Education

9 costs class