Theory of Costs

Theory of Costs

Maximization of profit is an important business objective for the firm

Profit = Revenue- Cost

Thus to know the profitability of any decision we need to understand the costs

DTA- Managerial Economics

Total cost(TC) =Total Fixed Cost(TFC) +Total variable costs (TVC)

• Total Fixed costs are the costs that do not vary with the level of output.

• For eg., Cost incurred on account of fixed plant and equipment, rent charges, advertisement expenses, salaries of administrative staff

• Total fixed cost is the total cost of all the fixed inputs employed in a production process( it remains unchanged at all levels of output)


Variable costs

• Variable costs represent those costs that change directly with the change in output.

• Examples are cost of raw materials, Direct labour, electricity charges, fuel charges etc.


Total Fixed, Variable and Total Cost Curves

TFC

Total Cost Curve

Total Variable Cost Curve

TFCQuantity

Cost

Total Fixed Cost Curve


TVC- Inverse S- shape

• Total Variable Cost has an inverse S-shape- reflecting the law of variable proportions( Law of diminishing marginal returns)

• As per the law, at the initial stages of production in a particular plant as more of the variable factor (labour)is employed its productivity increases initially( MP increases ) and the average variable cost falls.


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Short run costs

Inputs Output Total Cost Capital Labour TFC TVC TC

10 1 43 100 20 120 10 2 160 100 40 140 10 3 351 100 60 160 10 4 600 100 80 180 10 5 875 100 100 200 10 6 1152 100 120 220 10 7 1372 100 140 240 10 8 1536 100 160 260 10 9 1656 100 180 280 10 10 1750 100 200 300 10 11 1815 100 220 320 10 12 1860 100 240 340

100

Short run average Costs

• Cost per unit or average costs are more important for businessmen and economists.

• Average Fixed Costs(AFC):• AFC is the total fixed cost divided by the number

of units of output produced.• AFC= TFC/Output• It is always falling as output increases, as fixed

costs are being spread over larger units of output.


Average Costs

• Average Total Costs is calculated as total cost divided by the number of units produced.


DTA Managerial Economics 9

Average and marginal costs

Output Average Cost Marginal Cost AFC AVC ATC MC

43 2.326 0.465 2.791 0.465 160 0.625 0.250 0.875 0.171 351 0.285 0.171 0.456 0.105 600 0.167 0.133 0.300 0.080 875 0.114 0.114 0.228 0.073 1152 0.087 0.104 0.191 0.072 1372 0.073 0.102 0.175 0.091 1536 0.065 0.104 0.169 0.122 1656 0.060 0.109 0.169 0.167 1750 0.057 0.114 0.171 0.213 1815 0.055 0.121 0.176 0.308 1860 0.054 0.129 0.183 0.444


Average fixed costs

0

0.2

0.4

0.6

0.8

0 500 1000 1500 2000

OUTPUT

CO

ST

AFC

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Average total Cost (ATC) and Average variable costs(AVC)

0

0.2

0.4

0.6

0.8

0 400 800 1200 1600 2000

OUTPUT

CO

ST

AVC

ATC


Marginal costs

0

0.2

0.4

0.6

0.8

0 500 1000 1500 2000

OUTPUT

CO

ST AVC

ATC

MC


The supply schedule

The firm’s supply schedule shows the quantities that the firm is willing to offer at each market price

Since a firm is presumed to operate for profits, then it will only offer output when the market price is greater than the cost of producing the last unit offered.

Therefore, the firm’s supply schedule is also the firm’s marginal cost curve, above the average variable cost(when MC > AVC)

Shut down of production

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BE (Rs.51)

OUTPUT

ATC

AVC

MC

AFC

AC/AR

A (Rs.150)

B (Rs.45)

C (Rs.34)Shut down point


Shut down – Analysis of graph

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A(Rs.150); B (Rs.45); C(Rs.34) are the price/Average revenue earned by the firm when the market price is A, B or C.

The minimum ATC is (Rs.51) and the minimum AVC is (Rs.34) the firm is able to achieve (at a production level of 180 units).

The firm can cover its variable and fixed costs (that is the total costs) if price is Rs.51; This is when AR/Price is at least equal to the Average Total Cost(ATC curve)

The AR/Price should at least cover the Average Variable Cost(AVC) for the firm to continue supply in the short-run. If Price falls below AVC then the firm will Shut-down. Hence if price is below Rs.34, firm will not produce.


Productivity and costs in the long run

DTA-Managerial Economics16

In the long run both capital and labour are variable

Firms can change the amount of machines or office space that they use

Therefore, the law of diminishing returns does not determine the productivity of a firm in the long run

In the long run productivity and costs are driven by returns to scale

Implications of factor substitution (1)

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SRATC1

SRATC2

COST

OUTPUT

AC1

AC2

Q11

AC3

Q2


• When a firm substitutes labour with machinery, and the investment makes the firm more efficient, then the average cost curve would move down to the right as in the previous slide.

• If investment does not increase productivity and does not change average costs then the cost curve does not change.

Implications of factor substitution (2)

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SRATC1 SRATC2

COST

OUTPUT

AC1

Q11 Q22


Long run average cost curve

• The long run average cost curve is simply a collection of short run average cost curves, illustrating how average costs change as fixed inputs (plant size, type and number of machines etc) change.

The long run average cost curve

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COST PER UNIT

OUTPUT

LRAC

ATC1

ATC2

ATC3

x1 x3x2


LAC/ Envelope Curve

• The LAC is also called the planning curve because it is a guide to the entrepreneur for planning the future expansion of the firm and choosing the optimal scale or plant size for the production.

Long run averagre cost curves

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OUTPUT

LRAC

attainable

unattainable

Q1

c1

c2

COST PER UNIT


Returns to scale


Returns to scale measures the change in output for a given change in inputs

Increasing returns to scale exist when output grows at a faster rate than inputs

Decreasing returns exist when inputs grow at a faster rate than outputs

Constant returns to scale exist when inputs and outputs grow at the same rate

Returns to scale


MES

OUTPUT

COST PER UNIT

LRAC

increasing decreasing

constant

Qm

Importance of minimum efficient scale (MES)


MES is the size of operation with the lowest average cost. If a factory operate at an output size where it is not achieving MES, it would be incurring higher average costs which would finally make it uncompetitive.

MES is the size beyond which no significant economies of scale can be achieved

Cost advantage over rivals

Firms may merge to achieve MES

Firms may diversify to avoid low cost competition

Examples of economies of scale


Production techniques: Maruthi Suzuki and Rolls Royce

Indivisibilities: huge machinery

Specialisation and division of labour

By-products

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Costs in the Long Run

All inputs that are under the firm’s control can be varied there are no fixed costs ( all inputs are flexible)

Long run is best thought of as a planning horizon

Firms plan for the long run, but they produce in the short run


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Long-Run Planning Curve


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Firm’s Long-Run Planning Curve


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Economies of Scale

Notice that the long-run average curve is U-shaped, a result of economies and diseconomies of scale

Economies of scale imply that long-run average costs decline as output expands while diseconomies of scale imply that long-run average costs increase as output increases


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Economies of Scale

A larger size often allows for larger, more efficient machines and allows workers a greater degree of specialization Production techniques such as the assembly line can be utilized only if the rate of output is large enough

Typically, as the scale of the firm increases, capital substitutes for labor and complex machines substitute for simpler machines


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Diseconomies of Scale

As a firm expands, diseconomies of scale, eventually take over: long-run average cost increase as output expands

Additional layers of management are needed to monitor production

The more levels of management in an organization, the more difficult it is for top management to communicate with those that perform most of the production tasks


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A Firm’s Long-Run Average Cost Curve

DTA Managerial Economics

Theory of Costs

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