Cost of Production

Marginalism

Independent variable to be changed by just one unit at a time to see impact on the dependent variable

In real world situations difficult to apply concept of Marginalism

Independent variable may be subject to chunk changes rather than unit changes

In such cases concept of marginalism is replaced by “Incrementalism”

Incrementalism Incremental is about change, not necessarily

one unit e.g. additional revenue due to a change in

packaging, advertizing - incremental revenue Additional cost of packaging, advertizing,

computerization- incremental costs Incrementalism is more general, marginalism is

more specific All marginal concepts are incremental concepts

but all incremental concepts may not be marginal concepts

Time Perspective Short Run

period of time in which some productive resources are fixed

Change in output can be achieved by changing the intensity of use of fixed factors

Long Run period of time in which all productive resources

(including machinery, buildings, other capital items) are variable

Change in output achieved by adjusting the scale of output, size of firm etc

Cost concepts relevant for Managerial Decisions & Corporate Planning

Historic costs Historic cost: the original amount the firm paid for

factors it now owns When firm has paid for a machine – it is historic cost -

is irrelevant Not using it will not bring the money back Money spent- sometimes referred to as “sunk costs” Sunk costs do not change so irrelevant for decision

making Replacement cost: what the firm would have to pay to

replace factors it currently owns

The Fallacy of Using Historic Costs: there’s no point crying over split milk

Incremental costs Incremental cost: change in total cost due to change in total output,

revenue etc Incremental Revenue: change in total revenue due to change in level of

output, prices etc Costs which would not be incurred if a particular project is not

undertaken Avoidable costs or added cost Differences in total costs resulting from a change in policy- Differential

costs Variable costs are generally incremental But all incremental costs are not variable, it may include fixed costs

also Incremental costs to be compared with incremental revenue – added

revenue due to change. This is called incremental income Incremental costs are relevant for decision making

Illustration of Incremental Income

Results of present operation

Expected operating results based on price decrease

Incremental revenue, cost & income

Sales less Variable cost

Rs 10,00,000

Rs 6,00,000

Rs14,00,000

Rs 8,40,000

Rs 4,00,000

Rs 2,40,000

Contribution Margin less Fixed costs

Rs 4,00,000

Rs 2,00,000

Rs 5,60,000

Rs 2,00,000

Rs 1,60,000

Rs ----------

Income Rs 2,00,000 Rs 3,60,000 Rs 1,60,000

Marginal cost and Incremental cost

Marginal cost deals with unit by unit change in output

Incremental cost is not restricted to a unit change

MC is amount added to TC by a unit increase in output

Incremental cost is related to change in any number of units of output or even change in its quality

Opportunity Costs

Costs measured in terms of the next best alternative forgone

A manager chooses one course of action sacrificing the other alternative course

All trade off concepts are based on opportunity cost reasoning

Examples

A machine can produce either ‘A’ or ‘B’ products. The opportunity cost of producing a given quantity of ‘A’ is the quantity of ‘B’ which it would have produced; if that machine can produce 20 units of ‘A’ or 10 units of ‘B’ , then opportunity cost of ‘20A’ is ‘10B’

The opportunity cost of holding Rs 1lakh as cash in hand for one year is 10% interest, which could have been earned had it been kept in the form of fixed deposit in the bank

What opportunity cost am I experiencing now?

The most money that you could be making if you were somewhere else instead of studying these slides

Scarcity

Choice

OpportunityCost

Distinction between Main Cost Concepts

Actual Costs (outlay costs) & Opportunity Costs: Actual costs are costs which the firm incurs while

producing or acquiring a good or service e.g. cost on raw materials, labor, rent, interest etc.

Books of account record this Also called outlay cost, acquisition cost or absolute cost Opportunity costs are the return from the second best

use of firm’s resources which the firm forgoes to avail the return from the best use of resources

Explicit costs: factors not owned by the firm

Involve direct payment of money to outsiders Expenditures for production that result from

agreements or contracts Payments to non owners of a firm for their

resources Out of pocket costs All explicit costs like rent, wages, salaries,

interest, transport are out of pocket costs

Implicit costs: factors already owned by the firm

When firm already owns them (e.g. machinery) it does not have to pay money for them

The opportunity costs of using resources owned by the firm

Equal to what the factors could earn for the firm in some alternative use, either within the firm or hired out

Not recognized by accounting system but very important for firms

Implicit costs: factors already owned by the firm

Examples: A firm owns buildings: opportunity cost of using

them is the rent forgone A firm draws 1 lakh from the bank to invest in

equipment: opportunity cost of this investment is not just the1 lakh(explicit cost) but also the interest forgone(implicit cost)

Owner of the firm could have earned Rs 20000 per mth by working for someone: implicit cost

Opportunity & Imputed Costs

Opportunity cost is concerned with the cost of sacrificed opportunities

It is comparison between policy that was chosen & policy that was rejected

Imputed costs are a sub division of opportunity costs

Opportunity cost more comprehensive as it relates to all the resources (both borrowed & owned) whereas imputed costs applies only to the self use of the self owned resource

Incremental & Sunk costs

Incremental costs are the additions to costs resulting from a change in the nature & level of business activity e.g.; change in product line or output level, adding or replacing a machine etc.

Sunk costs are those that do not change by varying the nature or level of business activity e.g. all past costs are sunk costs

Irrelevant for decision making

Book costs & Out-of pocket costs

Out of pocket costs are those expenses which are current cash payments to outsiders

E.g. explicit costs – wages, salaries, interest, transport etc

Book costs are those which do not involve any cash payments but for them a provision is made in the books of accounts to include them in profit & loss accounts & take tax advantages

They are imputed costs

Accounting & Economic costs

Accounting costs are the actual or outlay costs Expenditure already incurred on a particular

process or on production Economic costs are both imputed & explicit

costs as well as opportunity costs Costs that matter for business decisions are the

economic costs

Direct (traceable or assignable ) & Indirect (non- traceable , non- assignable or common) costs

Direct costs have a direct relationship with a unit of operation like a product, process or department of a firm

Indirect costs are those whose source cannot be easily traced to a plant, product , process or department

All direct costs are linked to a particular product/process/deptt , vary with changes in them

All direct costs are variable Indirect costs are both variable & fixed

Private & social costs

Private costs are those which are actually incurred by a firm for its business activity

Social cost is the total cost to the society due to production of a good e.g. pollution, congestion etc

To understand profit, what is necessary?

To distinguish between the way economists measure costs and the way accountants measure costs

What is economic profit?

Economic profit :Total revenue minus total explicit + implicit costs

Accounting profit : Total revenue minus explicit costs

Economic profit is important for decision-making purposes because it includes implicit costs and accounting profit does not

Profits A carpenter makes accounting profit of Rs 500 Has own shop, also used his own capital- Rs 12000 If he had not started his own business he would have

earned say Rs 100 per month as hired carpenter, Rs 1200 as interest per annum(Rs 100 per month) on his capital, and rent of Rs 200 per month on his shop

Total earnings Rs 400 per month This is opportunity cost of running his business So his economic profit is Rs 100 only

Costs & inputs

The relationship depends on two elements: The productivity of factors: greater their

productivity the smaller will be the quantity of them needed

Direct link between TP, AP & MP & costs of production

The price of factors: higher their price higher will be the costs of production

Classifications of Production Costs Fixed Costs

costs that remain constant as output varies Must be paid even if output is zero such as rent

Average Fixed Costs (AFC) =

Variable Costs costs that vary as output changes Costs that are zero when output is zero and vary as output

varies such as wages

Average Variable Costs (AVC) =

produced units ofnumber cost fixed total

produced units ofnumber cost variable total

Food for Thought…. The following are some costs incurred by a shoe manufacturer.

Decide whether each one is a fixed cost or a variable cost or has some element of both.

(a) The cost of leather (b) The fee paid to an advertising agency (c) Wear and tear on machinery (d) Rent of the factory (e) Electricity for heating and lighting (f) Electricity for running the machines (g) Basic minimum wages agreed with the union (h) Overtime pay.

Food for Thought The cost of leather The fee paid to an advertising

agency Wear and tear on machinery Rent of the factory Electricity for heating and

lighting Electricity for running the

machines Basic minimum wages agreed

with the union Overtime pay.

Variable Fixed (unless the fee negotiated depends on

the success of the campaign) Variable (the more that is produced, the more

the wear and tear) Fixed Fixed if the factory will be heated and lit to the

same extent irrespective of output, but variable if the amount of heating and lighting depends on the amount of the factory in operation, which in turn depends on output

Variable Variable (although the basic wage is fixed per

worker, the cost will still be variable because the total cost will increase with output if the number of workers is increased)

Variable.

Classifications of Production Costs

Total Cost (TC) the sum of total fixed cost

and total variable cost at a particular level of output

TC= TFC + TVC Marginal Cost (MC)

the change in total cost resulting from production of one more unit of output

TC/Q = TVC/Q

Average Total Cost (ATC) = AFC+AVC = TC/Q

produced units of numbercost total

Relationship of AFC, AVC, ATC, and MC

The average variable cost curve decreases, reaches a minimum and then rises in value because of the principle of diminishing returns

The average fixed cost curve continuously declines as total fixed costs are spread over a larger and larger amount of output

The average total cost curve declines until the increase in average variable costs offsets the decrease in average fixed costs then it begins to rise

The marginal cost curve decreases, reaches a minimum, and then rises

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Short-Run Cost Curves

TCTVC

TFC

TFCCo

st p

er u

nit

Q

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Short-Run Cost Curves

ATC

AVC

MC

AFC

Co

st p

er u

nit

AFC

Q

The Marginal-Average rule When the MC is less than the AC, the AC falls When the MC is greater than the AC, the AC

rises Following this rule, the MC curve intersects

the ATC & AVC curves at their minimum points

When MC decreases it pulls AC down & when MC increases it pushes AC up

When AC is at its minimum it becomes equal to MC

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Short-Run Cost Curves

ATC

AVC

MCC

ost

per

un

it Minimum

Q

Putting on a Duplicate:Marginal costs of an extra coach

What is the relationship between the minimum and maximum points of the MR and MP curves?

The maximum point of the MP curve corresponds to the minimum point of the MC curve

8

2

1 2 4

Marginal Product Curve

6

4

5

10

63

12

To

tal O

utp

ut

Quantity of Labor

Maximum

Relationship Between Product Curves and Cost Curves

Output

Output

Input

Cost

0

0

B

B

AP

AVC

When average product is increasing, fewer resources are needed per unit of output average variable cost is falling

When average product is declining, more resources are needed per unit of output average variable cost will be increasing

Relationship Between Product Curves and Cost Curves

Output

Output

Input

Cost

0

0

A

A

MC

MP

Diminishing marginal productivity marginal product increases and marginal cost declines up to point A, and then marginal product decreases marginal cost increases

Relationship Between Product Curves and Cost Curves

Output

Output

Input

Cost

0

0

A

A

B

B

MC

MPAP

AVC

(a)

(b)

Optimum output & cost curves

In short run optimum output is one which can be produced at a minimum average cost

Where AC & MC curves intersect AC = MC

What is the long-run average cost curve?

When all inputs become variable The curve that traces the lowest cost per unit

at which a firm can produce any level of output when the firm can build any desired plant size

Long-run average cost curve…

When the LAC decreases as output increases, the firm experiences economies of scale

If the LAC curve remains unchanged as output increases, the firm experiences constant returns to scale

If the LAC curve increases, the firm experiences diseconomies of scale

Also called planning curve or envelope curve

Long Run Average Cost Curve

For every plant size, there is a different short-run average cost curve

Infinite number of plant sizes to choose from infinite number of associated ATC curves

Long run average cost curve, envelopes the short-run cost curves and forms a U-shaped long-run cost curve

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Short and Long-run Average Cost Curves

Short-run average total cost curves

Long-run average cost curveQ

Rs40

Rs30

Rs20

Rs10

2 4 6 8

Rs50

Rs60

Rs70

Rs80

10 12 14 16 18

Long-run Average Cost Curve

Constant returns to scale

Diseconomies of scale

Economies of scale

Q

Long run Marginal Cost Curve

Derived from short run MC curves LMC intersects LAC at its minimum point-

one & only one plant size whose minimum SAC coincides with minimum LAC

Where SAC = SMC = LAC = LMC This point is the optimum scale of the firm in

the long run

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10 12 14 16 18Long-run average & marginal cost curves Q

LRMC

LRAC

Modern view: L shaped Long Run Average Cost curve

Long run cost can be divided into Production cost & Managerial cost

Modern theory says long run cost curve likely to be L shaped than U shaped

Production costs fall continuously with increases in output while Managerial costs may rise at very large scales of output

The fall in production costs more than offsets the increase in managerial costs, so that LAC continuously falls with increases in scale

Revenue

Profit Total Profit is the difference between total

revenue and total cost

total revenue – total cost = profit Normal Profit

amount of profit necessary to induce an entrepreneur to stay in business

Economic Profit revenue in excess of all costs, including normal profit

Revenue Average revenue (AR)

revenue per unit of output sold AR = TR/Q AR = P

Total revenue (TR) amount of revenue or income received from the sale of a given quantity

of goods or services TR = P x Q

Marginal revenue (MR) change in TR that results from the sale of one more unit of output MR = change in TR/change in Q

Marginal Revenue Versus Marginal Cost

Marginal revenue (MR) Measures the change in total revenue per additional unit of

output Marginal cost (MC)

Measures the change in total cost per additional unit of output

If MR > MC, profits will increase or losses will decrease as output is expanded

If MR < MC, profits will decrease or losses will increase when output is expanded

Revenue curves when price is not affected by the firm’s output

Average Revenue: If firm is very small relative to the total market it is likely

to be a price taker Accept the price given by market demand & supply Faces a horizontal demand curve or AR curve Marginal Revenue: In case of horizontal demand curve MR = AR curve Selling one more unit at constant price (AR) merely

adds that amount to TR

Revenue curves when price is not affected by the firm’s output

Total Revenue: Effect on TR of different levels of sales with a

constant price

Deriving TR

Quantity(units) Price=AR=MR(Rs) TR(Rs)

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0100020003000400050006000

TR curve for a price taking firm

Output

200

150

100

50

0 10 20 30 40 50 60 70 80 90

Tot

al R

even

ue

TR

Revenue curves when price varies with output

If firm has relatively large share of the market it will face a downward sloping demand curve- to sell more it must lower the price, raise the price – lower sales

AR = P so AR falls as output increases MR will be less than AR & may even be

negative Why?

Relationship between price elasticity of demand & MR

If demand is price elastic, a decrease in price will lead to a proportionately larger increase in quantity demanded & hence an increase in revenue

MR will thus be positive Inelastic demand- decrease in price- proportionately

smaller increase in sales- revenues will fall. MR will be negative

Total Revenue Unlike in case of a price taking firm, the TR

curve is not a straight line It is a curve that rises first then falls As long as MR is positive(demand is price

elastic), a rise in output will raise TR Once MR becomes negative(demand is

inelastic), TR will fall Peak of TR where MR = 0 (price elasticity will

be = to 1)

Revenues for a firm facing a downward sloping demand curve

Q (units) P = AR (Rs) TR (Rs) MR (Rs)

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Demand and Marginal-Revenue Curves for a Monopoly

Q

Price, AR, MR

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Demand(averagerevenue)

Marginalrevenue

1 2 3 4 5 6 7 8

r

Elastic

Inelastic

8

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TR of a firm facing a downward sloping demand curve

6

4

5

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Q

TR TR

Total Revenue, Total Cost,and Profit Maximization

The firm will want to produce the quantity that maximizes the difference between total revenue and total cost

Determining the profit maximizing level of output through TR & TC Profit = Total Revenue - Total Cost Total Revenue (R) = Pq Total Cost (C) = Cq Therefore:

)()()( qCqRq

Profit Maximization in the Short Run

0

Cost,Revenue,

Profit(Rs per year)

Output (units per year)

R(q)Total Revenue

Slope of R(q) = MR

0

Cost,Revenue,

Profit(Rs per year)

Output (units per year)

Profit Maximization in the Short Run

C(q)

Total Cost

Slope of C(q) = MC

Why is cost positive when q is zero?

Comparing R(q) and C(q) Output levels: 0-

q0:

C(q)> R(q) Negative profit

FC + VC > R(q)

MR > MC Indicates higher

profit at higher output

0

Cost,Revenue,

Profit(Rs per year)

Output (units per year)

R(q)

C(q)

A

B

q0 q*

)(q

Total Revenue, Total Cost,and Profit Maximization

Comparing R(q) and C(q) Question: Why is

profit negative when output is zero?

Total Revenue, Total Cost,and Profit Maximization

R(q)

0

Cost,Revenue,

Profit (Rs per year)

Output (units per year)

C(q)

A

B

q0 q*

)(q

C - R

Total Revenue, Total Cost,and Profit Maximization

q

R MR

q

CMC

Profit Maximization

Break-Even Point the output level at which total revenue

equals total cost

=

Short run profit maximization: using total curves

Output

200

150

100

50

0 10 20 30 40 50 60 70 80 90

Cos

t a

nd

Rev

enue

TFC

TC

TR

Distance between TR and TC is the largest

Break-even point output level at which total revenue equals total cost

Short run profit maximization: using average & marginal curves: to be done separately under each market structure