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)

DTA- Managerial Economics

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.

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Total Fixed, Variable and Total Cost Curves Cost Total Cost Curve Total Variable Cost Curve

TFC

Total Fixed Cost Curve TFC

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Quantity

TVC- Inverse S- shape • Total Variable Cost has an inverse S-shapereflecting 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.

DTA- Managerial Economics

Short run costs Inputs Output Capital Labour 10 1 43 10 2 160 10 3 351 10 4 600 10 5 875 10 6 1152 10 7 1372 10 8 1536 10 9 1656 10 10 1750 10 11 1815 10 12 1860

TFC 100 100 100 100 100 100 100 100 100 100 100 100

Total Cost TVC 20 40 60 80 100 120 140 160 180 200 220 240

TC 120 140 160 180 200 220 240 260 280 300 320 340

100

DTA- Managerial Economics

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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. DTA- Managerial Economics

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

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Average and marginal costs Output 43 160 351 600 875 1152 1372 1536 1656 1750 1815 1860

Average Cost AFC AVC ATC 2.326 0.465 2.791 0.625 0.250 0.875 0.285 0.171 0.456 0.167 0.133 0.300 0.114 0.114 0.228 0.087 0.104 0.191 0.073 0.102 0.175 0.065 0.104 0.169 0.060 0.109 0.169 0.057 0.114 0.171 0.055 0.121 0.176 0.054 0.129 0.183

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Marginal Cost MC 0.465 0.171 0.105 0.080 0.073 0.072 0.091 0.122 0.167 0.213 0.308 0.444

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Average fixed costs 0.8

COST

0.6 AFC

0.4 0.2 0 0

500

1000

OUTPUT DTA Managerial Economics

10

1500

2000

Average total Cost (ATC) and Average variable costs(AVC) 0.8

COST

0.6 AVC ATC

0.4 0.2 0 0

400

800

1200

OUTPUT DTA-Managerial Economics

11

1600

2000

Marginal costs 0.8

COST

0.6 AVC ATC MC

0.4 0.2 0 0

500

1000

OUTPUT DTA Managerial Economics

12

1500

2000

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) DTA Managerial Economics

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Shut down of production AC/AR MC

ATC

A (Rs.150)

AVC

BE (Rs.51) B (Rs.45) C (Rs.34)

Shut down point

AFC

OUTPUT

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Shut down – Analysis of graph

 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. DTA- Managerial Economics

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Productivity and costs in the long run  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

DTA-Managerial Economics

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Implications of factor substitution (1) COST SRATC1 SRATC2

AC1 AC2 AC3 Q1

Q2

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OUTPUT

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• 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) COST SRATC1

SRATC2

AC1

Q1

Q2

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OUTPUT

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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 COST PER UNIT ATC3 ATC2

ATC1

LRAC

x1

x2

x3

DTA- Managerial Economics

OUTPUT 21

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 COST PER UNIT LRAC

attainable

c1 c2

unattainable

Q1

OUTPUT DTA- Managerial Economics

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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 DTA- Managerial Economics

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Returns to scale COST PER UNIT

g

sin rea

de cre asi

inc

ng

LRAC

constant MES

Qm DTA- Managerial Economics

OUTPUT

25

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 Managerial Economics  Firms may diversifyDTAto avoid low cost competition

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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 DTA- Managerial Economics

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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 31 DTA- Managerial Economics

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 DTA- Managerial Economics

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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 DTA- Managerial Economics

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A Firm’s Long-Run Average Cost Curve

DTA Managerial Economics

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