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Managerial

Economics

Chapter 4: Costs of Production

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Private & Social Cost

Private cos tsfor a producer of a good, service, or activityinclude the costs the firm pays to purchase capital

equipment, hire labor, and buy materials or other inputs.

While this is straightforward from the business side, it also is

important to look at this issue from the consumers'perspective. Field, in his 1997 text, Environmental

Economics provides an example of the private costs a

consumer faces when driving a car:1

The private costs of this (driving a car) include the fuel andoil, maintenance, depreciation, and even the drive time

experienced by the operator of the car.

Private costs are paid by the firm or consumer and must be

included in production and consumption decisions. In a

competitive market, considering only the private costs will

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External costs, on the other hand, are not

reflected on firms' income statements or in

consumers' decisions. However, external costs

remain costs to society, regardless of who pays for

them.

Consider a firm that attempts to save money by not

installing water pollution control equipment.Because of the firm's actions, cities located down

river will have to pay to clean the water before it is

fit for drinking, the public may find that recreational

use of the river is restricted, and the fishing industrymay be harmed.

When external costs like these exist, they must be

added to private costs to determine social costs

and to ensure that a socially efficient rate of output

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Social co stsinclude both the private costs and any

other external costs to society arising from the

production or consumption of a good or service. Social costs will differ from private costs, for

example, if a producer can avoid the cost of air

pollution control equipment allowing the firm's

production to imposes costs (health orenvironmental degradation) on other parties that are

adversely affected by the air pollution.

Remember too, it is not just producers that may

impose external costs on society. Let's also view

how consumers' actions also may have external

costs using Field's previous example on driving:2

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The social costs include all these private costs (fuel,

oil, maintenance, insurance, depreciation, and

operator's driving time) and also the cost

experienced by people other than the operator who

are exposed to the congestion and air pollution

resulting from the use of the car.

The key point is that even if a firm or individualavoids paying for the external costs arising from

their actions, the costs to society as a whole

(congestion, pollution, environmental clean up,

visual degradation, wildlife impacts, etc.) remain.Those external costs must be included in the social

costs to ensure that society operates at a socially

efficient rate of output.

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Accounting and Economic Costs

Accounting cost: take care of all the payments andcharges made by the entrepreneur to the suppliers ofvarious productive factorsknown as Explicit Cost E.g. Wages, Raw materials, fuel & power used, rent,

interest. Economic Cost: if the money invested in the business

invested else where, would fetch interest & dividends.Entrepreneurs time and effort would bring him salary.

EC includes (a) normal return on money capital invested bythe entrepreneur himself in his own business (b) thewages or salary not paid to the entrepreneur but couldhave been earned if the services had been soldsomewhere else.

EC includes Both Accounting & Implicit Cost

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Cost Estimation & Cost

Forecasting

In a long run, a firm has to aim at optimum profits if ithas to survive in the market.

In a competitive world, profit is an index of efficiency.

Profit is governed by two variables TC & TR. Hence behavior of costs along with changes in output

occupy an important position.

Present costs are known but this is not enough

Future behavior of costs also needs to be taken intoaccount since every firm plans for the future.

The broad head is forecasting under which one can

include demand, cost, sales forecasting, etc.

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Methods of CE & CF 1. Engineering method

Least cost combination of factor of production can be

technically provided y the engineers & hence the

name

Any given product uses certain inputs.Wherever these inputs can be substituted, they

provide opportunities of finding out the least cost

combination.

Given the prices of inputs and the quantities of each

used in the least cost combination, one can find out

the costs for estimated levels of output.

Cost forecasts therefore will have to be worked out on

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For example; IC-1, IC-2, IC-3 are Iso-costs.

Any point on each Iso-cost shows various

combinations of capital & labor within thesame cost.

If we suppose that IC-1=Rs. 10,000 then,

several combination of K(capital) + L (labor)given by all the points on IC-1 would together

cost Rs. 10,000/-

IQ-1, IQ-2,etc., are Iso-Quant meaning equalproduct curves.

Every point on the same curve would

represent the same quantity of output.

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If we suppose IQ-1 for 100 units, then, all

the points on IQ-1will show 100 units.

Points t-1 then shows the least costcombination of capital and labor since

only at this point, 100 units can be

produced at a cost of Rs. 10,000/-. In this way if we draw an Iso-Quant map

with Iso-costs, we get the path of

expansion as shown by the dotted line

OP.

Depending upon how much the firm

expects to produce, the cost as well as

the least cost factor combinations can be

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Limitation

This method takes into account current

factor prices(e.g. current wage rates,

interest rates).

If they change over time (as they always

do), the projection may go wrong. It

becomes necessary to estimate possible

changes also.

Another limitation is that this method isbased on the current state of technology.

If the technology changes in future, the

forecasts will go wrong and will have, to be

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Survivorship methodAdvocated by Prof. Stigler

for using this technique, all the firms in an industry are

divided into various groups and then, over a period of

time, the growth of each group is examined.

For E.g. in the Table:Group Share in Industry Output (%)

Base Year Current Year

Small 10 11

Medium 35 54

Large 53 35

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In this table a base year is taken to compare with the currentyear.

Let us say base year is 2001 and current year is 2010.

Then we find that over a period of 10 years, the share ofsmall firms in the total output of the industry has marginallyincreased from 10% to 11%.

The share of the large firms has considerably decreasedfrom 55% to 35%.

However, the share of the medium-sized firms has improvedfrom 35% to 54%.

It thus becomes obvious that the large-sized firms are themost inefficient because they find it difficult to survive.

While medium-sized firms are the most efficient as they

appear to grow in importance. Because survival is taken to indicate the cost-effectiveness

and efficiency, this method is known as Survivorship method.

The lowest average cost of the medium-sized firm is thentaken as a norm.

If a firm expects to survive (& flourish), it has to aim at theo timum size and corres ondin lowest cost.

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Limitation

This method is useful only where a very highdegree of competition exists.

There too, it only gives approximations of

size and costs It gives a broad range of output but does not

spell out the detailed cost-output relationship

in the form of a cost function

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Statistical method

A variety of statistical techniques can be used forforecasting costs.

What is required is the data regarding historical costs

and cost determinants.

For this purpose data of one firm can be used, or that of

all firms in an industry can be used.

All determinants of costs need to be carefully identified.

Effects of inflation should be properly handled. Once the function is formulated and data are ready, one

can use regression analysis for cost forecasting.

Similarly, simple moving averages can also be used.

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Limitation

Past or historical costs are the basis of theseforecasts.

They remain relevant so long as the cost function

remains the same. E.g. Change in rate of RM &

labor will necessitate to refine forecasts

Changes in technology are the most remarkable

feature of modern industrial economics. These

changes makes forecasts difficult

In case of new products, for want of historical

data, forecasts become difficult to arrive at.