Cost Cost Curve

PROJECT ON COST CURVES AND ECONOMIC OF SCALE

Submitted by: - JATIN Trika (91012) Submitted To: - Anju Katyal

Cost curve In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of production, where they make the most profits. There are a few different types of cost curves, each relevant to a different area of economics. •

The Short Run average total cost curve (SATC or SAC)

Typical short run average cost curve The average total cost curve is constructed to capture the relation between cost per unit and the level of output, ceteris paribus. A productively efficient firm organizes its factors of production in such a way that the average cost of production is at lowest point and intersects Marginal Cost. In the short run, when at least one factor of production is fixed, this occurs at the optimum capacity where it has enjoyed all the possible benefits of specialization and no further opportunities for decreasing costs exist. This is usually not U shaped, it is a checkmark shaped curve. This is at the minimum point in the diagram on the right.Example: Q=2K.5L.5 STC=Pk(K)+Pw(Q2/4K) SATC or SAC= (Pk(K)/Q)+Pw(Q/4K)

The long-run average cost curve (LRAC)

Typical long run average cost curve Essentially, the long-run average cost curve depicts what the minimum per-unit cost of producing a certain number of units would be if all productive inputs could be varied. Given that LRAC is an average quantity, one must not confuse it with the long-run marginal cost curve, which is the cost of one more unit. The LRAC curve is created as an envelope of an infinite number of short-run average total cost curves. The typical LRAC curve is Ushaped, reflecting economies of scale when negatively-sloped and diseconomies of scale when positively sloped. Contrary to Viner, the envelope is not created by the minimum point of each short-run average cost curve. This mistake is recognized as Viner's Error. In a long-run perfectly competitive environment, the equilibrium level of output corresponds to the minimum efficient scale, marked as Q2 in the diagram. This is due to the zero-profit requirement of a perfectly competitive equilibrium. This result, which implies production is at a level corresponding to the lowest possible average cost, does not imply that other production levels are not efficient. All points along the LRAC are productively efficient, by definition, but are not equilibrium points in a long-run perfectly competitive environment. In some industries, the LRAC is always declining (economies of scale exist indefinitely). This means that the largest firm tends to

have a cost advantage, and the industry tends naturally to become a monopoly, and hence is called a natural monopoly. Natural monopolies tend to exist in industries with high capital costs in relation to variable costs, such as water supply and electricity supply. The average cost is the total cost divided by the number of units produced. The marginal cost curve (MC)

Typical marginal cost curve A marginal cost that graphically represents the relation between marginal cost incurred by a firm in the short-run product of a good or service and the quantity of output produced. This curve is constructed to capture the relation between marginal cost and the level of output, holding other variables, like technology and resource prices, constant. The marginal cost curve is U-shaped. Marginal cost is relatively high at small quantities of output, then as production increases, declines, reaches a minimum value, then rises. The marginal cost is shown in relation to marginal revenue, the incremental amount of sales that an additional product or service will bring to the firm. This shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing marginal returns - Diminishing returns).

Combining cost curves

Cost curves in perfect competition compared to marginal revenue Cost curves can be combined to provide information about firms. In this diagram for example, firms are assumed to be in a perfectly competitive market. The marginal cost curve will cut the average cost curve at its lowest point. In a perfectly competitive market a firm's profit maximising price would be at or above the price at which the average cost curve cuts the marginal cost curve. If the marginal revenue is above the average total cost price the firm is deriving an economic profit.

Economies of scale in the indian cement industry

The paper purports to investigate the existence or otherwise of economies of scale in the Indian cement industry. The investigation is attempted through the estimation of cost-output (sales) relationships both from the time series and cross-section data and both at the industry level and at the firm level. Furthermore, at the industry level the cost-output relationships have been estimated separately for All-India, Bihar, and Madras, the regional classification for which the time-series data are available. The relationships between the cost components (material cost, labour cost and depreciation cost) and the output have also been determined to identify the sources of economies or diseconomies of scale. It is found that the industry is dominated by the L-shaped average cost curve and horizontal marginal cost curve. In other words, the industry is found to be still operating in the first half of the U-shaped average cost curve and thus cement firms have not yet reached their optimum size. Significant economies of scale exist only with respect to labour costs in AllIndia and Bihar and total costs in Associated Cement Companies Ltd, Jaipur Udyog Ltd, Mysore Cement Ltd and Sone Valle Portland Cement Company Ltd; significant diseconomies exist only with respect to total cost and material cost in Madras industries. Inter-regional comparison has indicated that expansion of the industry in places other than Bihar and Madras and contraction of Madras firms will be beneficial from the side of cost. Among the four cement firms considered the Associated Cement Companies is enjoying the maximum economics of scale. Its sales elasticity of total cost at sample means is 0.42.

Economy of scale

Economies of scale, in microeconomics, are the cost advantages that a business obtains due to expansion. They are factors that cause a producer’s average cost per unit to fall as scale is increased. Economies of scale is a long run concept and refers to reductions in unit cost as the size of a facility, or scale, increases.[1] Diseconomies of scale are the opposite. Economies of scale may be utilized by any size firm expanding its scale of operation. The common ones are purchasing (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial instruments), and marketing (spreading the cost of advertising over a greater range of output in media markets). Each of these factors reduces the long run average costs (LRAC) of production by shifting the short-run average total cost (SRATC) curve down and to the right.

Overview Economies of scale is a practical concept that is important for explaining real world phenomena such as patterns of international trade, the number of firms in a market, and how firms get "too big to fail". Economies of scale is related to and can easily be confused with the theoretical economic notion of returns to scale. Where economies of scale refer to a firm's costs, returns to scale describe the relationship between inputs and outputs in a long-run (all inputs variable) production function. A production function has constant returns to scale if increasing all inputs by some proportion results in output increasing by that same proportion. Returns are decreasing if, say, doubling inputs results in less than double the output, and increasing if more than double the output. If a mathematical function is used to represent the production function, returns to scale are represented by the degree of homogeneity of the function. Production functions with constant returns to scale are first degree homogeneous; increasing returns to scale are

represented by degrees of homogeneity greater than one, and decreasing returns to scale by degrees of homogeneity less than one. The confusion between the practical concept of economies of scale and the theoretical notion of returns to scale arises from the fact that large fixed costs, such as occur from investment in a factory or from research and development, are an important source of real world economies of scale. In conventional microeconomic theory there can be no increasing returns to scale when there are fixed costs, since this implies at least one input that cannot be increased. A natural monopoly is often defined as a firm which enjoys economies of scale for all reasonable firm sizes; because it is always more efficient for one firm to expand than for new firms to be established, the natural monopoly has no competition. Because it has no competition, it is likely the monopoly has significant market power. Hence, some industries that have been claimed to be characterized by natural monopoly have been regulated or publicly-owned. In the short run at least one factor of production is fixed. Therefore the SRAC curve will fall and then rise as diminishing returns sets in. In the long run however all factors of production vary and therefore the LRAC curve will fall and then rise according to economies and diseconomies of scale. There are two typical ways to achieve economies of scale: 1. High fixed cost and constant marginal cost 2. Low or no fixed cost and declining marginal cost Economies of scale refers to the decreased per unit cost as output increases. More clearly, the initial investment of capital is diffused (spread) over an increasing number of units of output, and therefore, the marginal cost of producing a good or service is less

than the average total cost per unit (note that this is only in an industry that is experiencing economies of scale). An example will clarify. AFC is average fixed cost. If a company is currently in a situation with economies of scale, for instance, electricity, then as their initial investment of $1000 is spread over 100 customers, their AFC is

.

If that same utility now has 200 customers, their AFC becomes ... their fixed cost is now spread over 200 units of output. In economies of scale this results in a lower average total cost. The advantage is that "buying bulk is cheaper on a per-unit basis." Hence, there is economy (in the sense of "efficiency") to be gained on a larger scale. Economies of scale tend to occur in industries with high capital costs in which those costs can be distributed across a large number of units of production (both in absolute terms and, especially, relative to the size of the market). A common example is a factory. An investment in machinery is made, and one worker, or unit of production, begins to work on the machine and produces a certain number of goods. If another worker is added to the machine he or she is able to produce an additional amount of goods without adding significantly to the factory's cost of operation. The amount of goods produced grows significantly faster than the plant's cost of operation. Hence, the cost of producing an additional good is less than the good before it, and an economy of scale emerges. Economies of scale are also derived partially from learning by doing.

The exploitation of economies of scale helps explain why companies grow large in some industries. It is also a justification for free trade policies, since some economies of scale may require a larger market than is possible within a particular country — for example, it would not be efficient for Liechtenstein to have its own car maker, if they would only sell to their local market. A lone car maker may be profitable, however, if they export cars to global markets in addition to selling to the local market. Economies of scale also play a role in a "natural monopoly." Typically, because there are fixed costs of production, economies of scale are initially increasing, and as volume of production increases, eventually diminishing, which produces the standard Ushaped cost curve of economic theory. In some economic theory (e.g., "perfect competition") there is an assumption of constant returns to scale. Examples Economies of scale — As a firm doubles output, the total cost of inputs less than doubles Diseconomies of scale — As a firm doubles its output, the total cost of inputs more than doubles.