ANALYSIS OF COST

AIMS & OBJECTIVES

After studying this lesson, you will be able to understand: The concept of economic costs Economic costs vs Accounting costs Short run costs Long run costs To relate cost and production function Economic costs and business accounting Economies & diseconomies of scale

WHAT IS ECONOMIC COSTS?

In economic theory, costs are taken as a function of output. C = C (Q) Output is produced by combining the use of fixed factors & variable factors. In short run, some factors are fixed and others are variable. Accordingly, there is a fixed cost and a variable cost in the short run while in the long run all costs are variable cost

DIFFERENCE BETWEEN ECONOMIC AND ACCOUNTING COSTS

Economic Costs take into account Opportunity Cost Opportunity cost is foregone value. Reflects second-best use. Explicit and Implicit Costs Explicit costs are cash expenses. Implicit costs are non cash expenses. Accounting Cost take into account only explicit cost. It does not include implicit/opportunity cost

SHORT RUN TOTAL COSTS

Short run total cost (STC) is the sum total of Total fixed cost (TFC) and Total variable cost (TVC)

STC = TFC + TVC

Shapes of Short run cost curves

TC TVC

TFC

EXPLANATIONS FOR SHAPES OF TOTAL COST

CURVES

TFC curve is horizontal this is because total fixed cost remains fixed at all levels of output including zero level of output TVC curve is upward rising- this is because total variable cost varies directly with the level of output and is zero when output is zero. In particular, it rises at a diminishing rate initially and then at an increasing rate. This is explained by the shape of the Total Product Curve, which in turn in explained by the Law of Diminishing Marginal Returns to a Factor. The Law states that as the input of the variable factor increases with fixed factor remaining constant total product rises initially at a increasing rate but then at a diminishing rate, eventually reaching a maximum and falling thereafter TC curve is upward rising Total cost which is sum of TFC and TVC looks like the TVC curve and hence its shape too is explained by the law of Diminishing Returns to a Factor. But unlike the TVC curve, TC curve starts from the level of TFC curve. This is because at zero output there is no TVC and TC equals TFC. The difference between TC curve and TVC curve is given by the TFC

AVERAGE COST CURVES

It is the cost per unit of output. It is given as

ATC or AC = TC/Q where TC denotes total cost & Q denotes total output = (TFC + TVC)/Q = TFC/Q + TVC/Q = AFC + AVC

Shapes of Short run cost curves:

EXPLANATION FOR SHAPES OF AVERAGE

COST CURVES

Shape of AFC curve:

AFC = TFC /q TFC remains constant throughout, so as output increases TFC/q falls throughout.

Shape of AVC curve:

Let labour be the only variable factor hired in quantity L and paid a given wage of Rs w per unit. Thus, TVC = wL
AVC =TVC/q = wL/q Or, AVC = w/{1/(q/L)} Or AVC 1/(q/L) i.e. AVC is inversely related to q/L which is the Average Product of labour. Thus, as AP of labour curve is domeshaped, AVC curve is U-shaped ie. When AP rises at first, AVC falls, when AP falls thereafter, AVC starts rising

EXPLANATION FOR SHAPES OF AVERAGE

COST CURVES

Shape of AC curve: The AC curve is a vertical summation of AFC and AVC curves. Initially when both AFC and AVC are falling AC also falls, then when AVC starts rising, AC under the influence of the falling AFC falls briefly. But thereafter the rising AVC pushes the AC curve up. Thus, the minimum point of AC curve comes after the minimum point of AVC curve

MARGINAL COST

It is defined as the addition to total cost due to one unit addition in the total output Marginal Cost, MC = d(TC)/dq = TCq+1 - TCq where d denotes change, q denotes output and C denotes cost

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MARGINAL COST IS INDEPENDENT OF FIXED

COST

MC = TCq+1 TCq = (TFCq+1 + TVC q ) (TFCq + TVCq) = TFCq+1 + TVC q TFCq TVCq = TVC q TVCq (since TFCq+1 = TFCq & cancels)

Thus, MC = d(TC)/q or MC = d(TVC)/q

This implies whenever an additional unit of output is produced the entire addition to cost is addition to variable costs.
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SHAPE OF MARGINAL COST CURVE

Let labour be the only variable factor hired in quantity L and paid a given wage of Rs w per unit. Thus, TVC = wL MC = d(TVC)/q = d(wL)d/q = w dL/dq Or, MC = w/{1/(dq/dL)} Or MC 1/(dq/dL) i.e. MC is inversely related to dq/dL which is the Marginal Product of labour. Thus, as MP of labour curve is domeshaped, MC curve is U-shaped ie. When MP rises at first, MC falls, when MP falls thereafter, MC starts rising

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Shapes of short run cost curves

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LONG-RUN COST CURVES

Long-run cost curves show minimum cost in an ideal environment. The shape of the long run cost curve is explained by the concept of economies of scale

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Recall the shape of TP curve

TC curve in the Long run

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LONG-RUN AVERAGE COSTS

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ECONOMIES OR DISECONOMIES IN
PRODUCTION

The term economies refers to the cost advantages Cost advantages in production can follow from: extending scale of production or following scope of production

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ECONOMIES & DISECONOMIES OF SCALE

Internal Economies & Diseconomies When a firm expands in size by increasing the scale of its output, certain cost advantages (due to factors like division of labor, indivisibility of factors etc) accrue to the firm. This is referred to as internal economies When a firm grows larger and larger, there could be several cost disadvantages facing the firm. This is referred as internal diseconomies. Eg: diseconomies due to managerial issues like trade union related to large scale production External Economies & Diseconomies External economies occur when there are physical and cost advantages that result from the general development of the industry External diseconomies arise when the industry expands in size indefinitely and the control of the industry becomes a problem

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INTERNAL ECONOMIES & DISECONOMIES & LAC CURVE

When the scale (size of production)of a firm increases, the average costs of production fall because of a number of internal economies. When these internal economies are fully exploited, the LAC reaches the minimum. If the firm still continues to increase in size indefinitely, soon several problems begin to emerge and they might lead to internal diseconomies of scale. The point at which the long run average costs are at a minimum, is the optimum size of firm.

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COST ELASTICITY AND ECONOMIES OF SCALE

Cost elasticity is proportionate change in cost due to change in output. Given as C = C/C Q/Q C < 1 means falling AC increasing returns to scale/decreasing cost C = 1 means constant AC constant returns to scale/constant cost C > 1 means rising AC decreasing returns to scale/increasing cost

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LONG RUN MARGINAL COST

Long run Marginal cost is the change in long run total cost due to a change in output when all costs are variable

LMC = (LTC)/Q

The LMC curve is U shaped

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LONG RUN & SHORT RUN COST CURVES

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ECONOMIES OF SCOPE

Economies of Scope Concept Scope economies are cost advantages that stem from producing multiple outputs. Big scope economies explain the popularity of multiproduct firms. Without scope economies, firms specialize. Exploiting Scope Economies Scope economics often shape competitive strategy for new products.

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