Mca Costs Of Production

The Theory of the Firm

The Costs of Production

Outline • What are costs? • Link between firm’s production process and its total cost • Measures of Cost • Costs in the short-run and costs in the long-run

Basic Concepts • Total Revenue- Amount a firm receives for the sale of its output • Total Cost- Market value of the inputs a firm uses in production • Profit = Total Revenue – Total Cost

Actual Cost & Opportunity Cost • Explicit/Actual Costs -Actual expenditure incurred for producing goods/services -Costs that are generally recorded in the books of account, eg. Salaries paid, cost of materials/inputs purchased - Input costs that require an outlay of money by the firm. Eg. X starts a business, pays Rs 100000 as salaries, Rs 100000 is the actual cost

Actual Cost & Opportunity Cost • Implicit/Opportunity Costs -OC of a good/service is measured in terms of revenue which could have been earned by employing that good/service in another alternative use -Eg. X could earn Rs 50000 a month as a software professional, this foregone income is an opportunity cost • An accountant would consider only explicit costs as visible money flows are observed in business • An economist would also consider implicit costs like foregone income

Cost of Capital as an Opportunity Cost • Opportunity Cost of the financial capital invested in business • Eg. X has invested 1000000 to start a business. Opportunity cost is the income X forgoes had he kept this amount in a bank (at the rate of 57%). This is the implicit opportunity cost of the business

Economic Cost In economics, the notion of a firm’s costs is based on the notion of economic cost. • The key principle underlying the computation of economic cost is opportunity cost. 

PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it.

Accounting versus Economic Cost Accounting versus Economic Cost Accounting Approach Explicit Cost (purchased inputs)

$60,000

Economic Approach $60,000

Implicit: opportunity cost of entrepreneur’s time

30,000

Implicit: opportunity cost of funds

10,000

Total Cost

______

______

$60,000

$100,000

Economic Profit Vs Accounting Profit • Economic Profit = Total Revenue minus Total Cost, including both explicit and implicit costs • Accounting Profit = Total Revenue minus Total explicit costs • Economic Value-Added = NOPAT – Cost of Capital (Cost of Debt + Cost of Equity)

Fixed Costs & Variable Costs • In buying factor inputs, the firm will incur costs • Costs are Classified as: – Fixed costs – costs that are not related directly to production – rent, insurance costs, admin costs. They can change but not in relation to output/production. – Fixed Costs are incurred even when output is nil – Variable Costs – costs directly related to variations in output. Raw materials, labour, primarily. – Increase in volume means a proportionate increase in total variable cost and vice versa

Variable Cost Total Fixed Cost

Fixed Cost

Output

Total Variable Cost

Output

Short-run & Long-run Costs • Time Horizon key factor in dividing costs into short-run and long-run costs • Short run – In the short-run increase in production results from adding successive quantities of variable factors to a fixed factor - Short-run costs are costs that vary with output when fixed plant and capital equipment remain the same - Relevant when a firm decides whether or not to produce more in the immediate future • Long run – Increases in capacity results in increasing production. All costs become variable in the long-run - Long-run costs are those which vary with output when all input factors including plant and equipment vary - Relevant when a firm decides whether to set up a new plant.

Analysis of Production Function: Short Run In times of rising sales (demand) firms can increase labour and capital but only up to a certain level – they will be limited by the amount of space. In this example, land is the fixed factor which cannot be altered in the short run.

Analysis of Production Function: Short Run If demand slows down, the firm can reduce its variable factors – in this example it reduces its labour and capital but again, land is the factor which stays fixed.

Analysis of Production Function: Short Run If demand slows down, the firm can reduce its variable factors – in this example, it reduces its labour and capital but again, land is the factor which stays fixed.

Analysing the Production Function: Long Run • The long run is defined as the period of time taken to vary all factors of production. – By doing this, the firm is able to increase its total capacity – not just short term capacity – Associated with a change in the scale of production – The period of time varies according to the firm and the industry. – In electricity supply, the time taken to build new capacity could be many years; for a market stall holder, the ‘long run’ could be as little as a few weeks or months!

Analysis of Production Function: Long Run

In the long run, the firm can change all its factors of production thus increasing its total capacity. In this example it has doubled its capacity.

Past Costs & Future Costs • Past costs are actual costs incurred in the past and generally contained in the financial accounts -Record keeping activity however passive function for management -These costs can be observed and evaluated in retrospect • Future costs are expected to be incurred in some future period -Their incurrence is a forecast and they are subject to management control, hence matter to managerial decisions -Managerial uses of future costs are cost control, projection of future profit and loss statements, expansion programmes and pricing, introduction of new products

Incremental/Differential Costs & Sunk Costs • Incremental cost is the additional cost due to a change in the level or nature of business activity -Change may take several forms: addition of a new product-line, changing channel of distribution, adding of new machines, expansion into additional markets • Sunk Costs is one which is not affected/altered by a change in the level or nature of business activity -Remains the same whatever the level of activity Eg operating costs and space and occupancy costs remain the same whether equipment is purchased or hired

Other Cost Categories • Out-of-pocket and Book Costs -Out-of-pocket costs involve current cash payments to outsiders -Book costs do not require current cash payments, eg depreciation • Direct and Indirect Costs -Direct/traceable costs can be identified very easily with a unit of operation eg salary of a divisional manager -Indirect costs are those that are not easily traceable to a unit of operation eg salary of a general manager

…Other Cost Categories • Replacement and historical costs -Historical cost is the original price paid for equipment, replacement cost means price that would have to be paid currently for acquiring the same equipment • Controllable and Uncontrollable costs

Production & Costs

Production Function

Production Function • States the relationship between inputs and outputs. • Inputs – the factors of production classified as: – Land – all natural resources of the earth – not just ‘terra firma’! • Price paid to acquire land = Rent

– Labour – all physical and mental human effort involved in production. • Price paid to labour = Wages

– Capital – buildings, machinery and equipment not used for its own sake but for the contribution it makes to production. • Price paid for capital = Interest

Production Function Inputs Land Labour Capital

Process Product or service generated – value added

Output

… Production Function • Marginal Product: Increase in output that arises from an additional unit of input • Diminishing Marginal Product: Marginal Product of an input declines as the quantity of the input increases (Why?) -Initially increasing returns due to efficient utilisation of fixed factor as more units of variable factor are applied to it (MP increasing) -Subsequently diminishing returns as the fixed factor becomes more and more scarce in relation to the variable factor (MP diminishing)

Analysis of Production Function: Short Run • In the short run at least one factor fixed in supply but all other factors capable of being changed. • Reflects ways in which firms respond to changes in output (demand). • Can increase or decrease output using more or less of some factors but some likely to be easier to change than others. • Increase in total capacity only possible in the long run

Production Function • Mathematical representation of the relationship: • Q = f (K, L, La) • Output (Q) is dependent upon the amount of capital (K), Land (L) and Labour (La) used.

Diminishing Returns and Marginal Cost • The key principle behind the firm’s shortrun cost curves is the principle of diminishing returns. PRINCIPLE of Diminishing Returns Suppose that output is produced with two or more inputs and we increase one input while holding the other inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate.

Labor Input and Output 

The shape of the production function is explained by diminishing returns.



Beyond 15 workers the marginal product of labor decreases and the production function becomes flatter.

Costs • Total Cost - the sum of all costs incurred in production • TC = FC + VC • Average Cost – the cost per unit of output • AC = TC/Output • Marginal Cost – the increase in total cost that arises from producing an additional unit of output • MC = TCn – TCn-1 units

Labor Input and Output 

The shape of the production function is explained by diminishing returns.



Beyond 15 workers the marginal product of labor decreases and the production function becomes flatter.

Short-run Average and Marginal Costs: An Example Short-run Marginal Cost

Average Fixed Cost

Short-run Average Variable Cost

Short-run Average Total Cost

Q 0 1 2 3 4 5 6 7 8 9 10

SMC 8 4 3 5 7 9 12 17 25 40

AFC 36.00 18.00 12.00 9.00 7.20 6.00 5.14 4.50 4.00 3.60

SAVC 8.00 6.00 5.00 5.00 5.40 6.00 6.86 8.13 10.00 13.00

SATC 44.00 24.00 17.00 14.00 12.60 12.00 12.00 12.63 14.00 16.60

Per-unit costs 40 35 30

Cost in $

Output: Rakes per Minute

25 20 15 10 5 0 0

1

2

3

4

5

6

7

8

9

10 11

Output: Rakes per minute

MC

ATC

AFC

AVC

Short-run Average Total Cost (SATC) •

The SATC curve is Ushaped because of the behavior of its two components as output produced increases. – AFC decreases as output increases. – SAVC increases as output increases.

Diminishing Returns and Increasing Marginal Cost Diminishing Returns and Increasing Marginal Cost Quantity of Chips

Additional Additional Additional Marginal Labor Hours Labor Cost Material Cost Cost

Small: 100

2

$16

$10

$26

Medium: 300

6

48

10

58

Large: 400

10

80

10

90

Initially, it takes 4 additional labor hours to increase the quantity of chips by 200, from 100 to 300. Then, it takes another 4 hours of labor to increase output by only 100 more chips, from 300 to 400. Marginal cost increases because output increases at a decreasing rate with additional labor hours.

Relationship between Short-run Marginal and Average Cost Curves • As long as SATC is declining, marginal cost lies below it.  When SATC rises, SMC is greater than SATC.  At point m, SATC=SMC.

Relationship between Short-run Marginal and Average Cost Curves Quantity Produced

Marginal Cost ($)

Average Total Cost ($)

100

26

90

300 400

58 90

58 68



The marginal cost curve (SMC) intersects the average cost curve (SATC) when average cost is minimum.

Production and Cost in the Long Run

• The key difference between the short run and the long run is that there are no diminishing returns in the long run. 

Diminishing returns occur because workers share a fixed facility. In the long run the firm can expand its production facility as its workforce grows.

Long-run Average Cost • Long-run average cost (LAC) is total cost divided by the quantity of output when the firm can choose a production facility of any size. • The LAC curve describes the behavior of average cost as the plant size expands. Initially, the curve is negatively sloped, then beyond some point, it becomes horizontal.

Long-run Average Cost When long-run total cost is proportionate to the quantity produced, long-run average cost does not change as output increases.

12

0

Average cost: $ per rake

•

0

Long-run Average Cost Curve

7 14 21 28 Output: Rakes per minute

Output: Rakes per Minute

3.5 7 14 28



Long-run Total Cost

Long-run Average Cost

$70 $84 $168 $336

LAC $20.00 $12.00 $12.00 $12.00

The long-run average cost curve is horizontal for 7 or more rakes per hour.

Labor Specialization • In a large operation, each worker specializes in fewer tasks thus is more productive than his or her counterpart in a small operation. • Higher productivity (more output per worker) means lower labor costs per unit of output, thus lower production costs (ever-decreasing average cost).

Economies of Scale •

Economies of scale: a situation in which an increase in the quantity produced decreases the long-run average cost of production.

•

Economies of scale refer to cost savings associated with spreading the cost of indivisible inputs and input specialization. When economies of scale are present, the LAC curve will be negatively sloped.

•

Minimum Efficient Scale • The minimum efficient scale describes the output at which economies of scale are exhausted and the long-run average cost curve becomes horizontal. • Once the minimum efficient scale has been reached, an increase in output no longer decreases the long-run average cost.

Diseconomies of Scale • A firm experiences diseconomies of scale when an increase in output leads to an increase in longrun average cost—the LAC curve becomes positively sloped. • Diseconomies of scale may arise for two reasons: – Coordination problems – Increasing input costs