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Learning outcomes
In the previous chapter we have illustrated the concept of production. And in this lesson I
am going to tell you about the cost and its related factors. You will also come to know
about cost and output relationship. Cost and revenue are the two major factors that a
profit maximising firm needs to monitor continuously. It is the level of cost relative to
revenue that determines the firm’s overall profitability. In order to maximise profits, a
firm tries to increase its revenue and lower its cost. While the market factors determine
the level of revenue to a great extent, the cost can be brought down either by producing
the optimum level of output using the least cost combination of inputs, or increasing
factor productivities, or by improving the organisational efficiency. The firm’s output
level is determined by its cost.
The producer has to pay for factors of production for
their services. The expenses incurred on these factors of production are known as the cost
of production, or in short cost.
Product prices are determined by the interaction of the forces of demand and
supply. The basic factor underlying the ability and willingness of firms to supply a
product in the market is the cost of production. Thus, cost of production provides
the floor to pricing. It is the cost that forms the basis for many managerial
decisions like which price to quote, whether to accept a particular order or not,
whether to abandon or add a product to the existing product line, whether or not
to increase the volume of output, whether to use idle capacity or rent out the
facilities, whether to make or buy a product, etc. However, it is essential to
underline here that all costs are not relevant for every decision under
consideration.
The purpose of this unit is to explore cost and its relevance to decision-making.
We begin by developing the important cost concepts, an understanding of which
can aid managers in making correct decisions. We shall examine the difference
between economic and accounting concepts of costs and profits. We shall then
consider the concepts of short-run and long-run costs and show that they, in
conjunction with the concepts of production studies in the preceding unit, can
give us a more complete understanding of the applications of cost theory to
decision-making.
There are different types of costs that a firm may consider relevant for decision-
making under varying situations. The manner in which costs are classified or
defined is largely dependent on the purpose for which the cost data are being
outlined.
For example, the opportunity cost of a student’s doing a full time MBA could be
the income that he would have earned if he had employed his labour resources
on a job, rather than spending them in studying managerial economics,
accounting, and so on. The time cost in money terms can be referred to as
implicit cost of doing an MBA.
The out-of-pocket costs on tuition and teaching materials are the explicit costs
that a student incurs while attending MBA. Thus, the total cost of doing an MBA
to a student is implicit costs (opportunity cost) plus the explicit (out-of-pocket)
costs.
On the other hand, variable costs are those costs which increase with the level of
output. They include payment for raw materials, charges on fuel and electricity,
wages and salaries of temporary staff, depreciation charges associated with
wear and tear of this distinctions true only for the short-run. It is similar to the
distinction that we made in the previous unit between fixed and variable factors of
production under the short-run production analysis. The costs associated with
fixed factors are called the fixed costs and the ones associated with variable
factors, the variable costs. Thus, if capital is the fixed factor, capital rental is
taken as the fixed cost and if labour is the variable factor, wage bill is treated as
the variable cost.
Activity :-
a) Can you give specific examples of:
Implicit costs:
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Social costs:
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Directcosts:
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IndirectCosts:
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Sunkcosts:
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Traceablecosts:
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Commoncosts:
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The cost is closely related to production theory. A cost function is the relationship
between a firm’s costs and the firm’s output. While the production function
specifies the technological maximum quantity of output that can be produced
from various combinations of inputs, the cost function combines this information
with input price data and gives information on various outputs and their prices.
The cost function can thus be thought of as a combination of the two pieces of
information i.e., production function and input prices
Now consider a short-run production function with only one variable input. The
output grows at an increasing rate in the initial stages implying increasing retunes
to the variable input, and then diminishing returns to the variable input start.
Assuming that the input prices remain constant, the above production function
will yield the variable cost function which has a shape that is characteristic of
many variable cost function; increasing at a decreasing rate and then increasing
at an increasing rate.
Relationship between average product and average costs, and marginal product
and marginal costs. For example.
TVC = Pr. V
Where Pr stands for the price of the variable factor and V stands for amount of
variable factor.
You may note that Pr being given, AVC is inversely related to the average
product of the variable factors.
In the same way, given the wage rage, MC is inversely related to the marginal
product of labour.
During short run some factors are fixed and others are variable.The short-run is
normally defined as a time period over which some factors of production are fixed
and others are variable. Needless to emphasize here that these periods are not
defined by some specified length of time but, rather, are determined by the
variability of factors of production. Thus, what one firm may consider the long-run
may correspond to the short-run for another firm. Long run and short run costs of
every firms varies.
In the short-run, a firm incurs some costs that are associated with variable factors
and others that result from fixed factors. The former are called variable costs and
the latter represent fixed costs. Variable costs (VC) change as the level of output
changes and therefore can be expressed as a function of output (Q), that is VC =
f (Q). Variable costs typically include such things as raw material, labour, and
utilities. In Column 3 of Table 1, we find that the total of variable costs changes
directly with output. But note that the increases in variable costs associated with
each one-unit increase in output are not constant. As production begins, variable
costs will, for a time, increase by a decreasing amount, this is true through the
fourth unit of the output. Beyond the fourth unit, however, variable costs rise by
increasing amount for each successive unit of output. The explanation of this
behaviour of variable costs lies in the law of diminishing returns.
The following table will give you an idea about all
Table I
Total and Average-Cost Schedules for an Individual Firm in the Short-Rum
(Hypothetical Data in Rupees)
Total cost data, per week Average-cost data, per week
(1) (2) (3) (4) (5) (6) (7) (8)
Total Total Total Total Average Average Average Marginal
Product Fixed variable cost fixed variable total cost
Cost cost (TC) cost cost cost (MC)
(TFC) (TVC) TC = (AFC) (AVC) (ATC) MC =
TFC + AFC = AVC = ATC = change
TVC TFC/Q TVC/Q TC/Q in TC
change
in Q
0 100 0 100
1 100 90 190 100.00 90.00 190.00 90
2 100 170 270 50.00 85.00 135.00 80
3 100 240 340 33.33 80.00 113.33 70
4 100 300 400 25.00 75.00 100.00 60
5 100 370 470 20.00 74.00 94.00 70
6 100 450 550 16.67 75.00 91.67 80
7 100 540 640 14.29 77.14 91.43 90
8 100 650 750 12.50 81.25 93.75 110
9 100 780 880 11.11 86.25 97.78 130
10 100 930 1030 10.00 86.67 103.00 150
93.00
Total Cost
Total cost is the sum of fixed and variable cost at each level of output. It is shown
in column 4 of Table-1. At zero unit of output, total cost is equal to the firm’s fixed
cost. Then for each unit of production (through 1 to 10), total cost varies at the
same rate as does variable cost.
Per Unit, or Average Costs
Besides their total costs, producers are equally concerned with their per unit, or
average costs. In particular, average cost data is more relevant for making
comparisons with product price,
AVERAGE COST:
AC =TC/Q
Where TC =total cost ;
AC = average cost
Q = quantity
The marginal cost concept is very crucial from the manager’s point of view. Marginal
cost is a strategic concept because it designates those costs over which the firm has the
most direct control. More specifically, MC indicates those costs which are incurred in the
production of the last unit of output and therefore, also the cost which can be “saved” by
reducing total output by the last unit. Average cost figures do not provide this
information. A firm’s decisions as to what output level to produce is largely influenced
by its marginal cost. When coupled with marginal revenue, which indicates the change in
revenue from one more or one less unit of output, marginal cost allows a firm to
determine whether it is profitable to expand or contract its level of production.
Taking the values for total cost and output from the expansion path of Figure V
(the most efficient points), we can construct the following table for total cost and
output:
50 150
125 200
250 250
300 300
325 350
These points are graphed in Figure VI as the long-run total cost (LTC) curve. The points
A,B,C,D and E correspond to the equilibrium points in Figure V. Note that the LTC
curve at first increases at a decreasing rate, then at a constant rate, and finally at an
increasing rate. The LTC curve starts from the origin implying thereby that in the long-
run all costs are variable and if nothing is produced, no resources will be used (i.e., the
firm will quit the industry altogether). Thus, the LTC curve is analogous to the short-run
VC curve. Only difference is, while the shape of VC is due to the law of variable
proportions in the short-run, the shape of LTC is due to the existence of increasing,
constant, and decreasing returns to scale in the long-run.
LONG-RUN TOTAL COST
LTC
LAC = -------
Q
∆LTC
LMC = -----------
∆Q
d (LTC)
LMC = -----------
dQ
For the long-run total cost given in Figure VI, these unit costs can be presented
in tabular form as follows:
These LAC and LMC values are graphed in Figure VII. We see, both in the table
and in the graph, that LAC and LMC are U-shaped and that they are equal at the
minimum of LAC. The values of LMC are graphed at the midpoints of the output
intervals they represent.
Activity
a) Why are all costs variable in the long-run?
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Suppose the wage rate is Rs. 10 and that 100 laborers are being employed.
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Activity 3
a) Fill in the blanks in the Table below.
b) Take a separate graph paper and draw all the curves.
Sort-run Cost-Schedules