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Subject ECONOMICS

Paper No and Title PAPER 3, FUNDAMENTALS OF MICROECONOMIC

THEORY
Module No and Title Module 17 MODERN THEORY OF COST: short run and
long run
Module Tag ECO_P3_M17

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Short Run theory of costs
3.1 Average Fixed Cost
3.2 Average Variable Cost

3.3 Marginal Cost

3.4 Relationship between different cost concepts

4. Long-run theory of costs
ECONOMICS PAPER 3, FUNDAMENTALS OF MICROECONOMIC THEORY
Module 17 MODERN THEORY OF COST: short run and long run
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4.1 Economies and Diseconomies of scale

4.2 Long- run costs and its components

4.3 Measures of Economies of scale

5. Summary

ECONOMICS PAPER 3, FUNDAMENTALS OF MICROECONOMIC THEORY

Module 17 MODERN THEORY OF COST: short run and long run
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1. Learning Outcomes
After studying this module, you shall be able to

· Know …Modern theory of costs

· Learn… the difference between the traditional and modern theory of costs
· Identify … reserve capacity
· Evaluate. – Economies and diseconomies of scope
· Analyse – different types of shapes of Long run costs

2. Introduction: MODERN THEORY OF COSTS

MODERN THEORY OF COSTS:

The Modern theory suggests the existence of ‘built- in- reserve capacity ‘which imparts flexibility
and enables the plant to produce larger output without adding to the costs. Built –in- reserve
capacity are planned by firms.
Modern theory of costs does not agree with the U-shape of the cost curves. The short-run cost
curve has a saucer- type shape whereas the long-run Average cost curve is either L-Shaped or
inverse J-shaped.

According to the Modern theory of costs,the firm can produce a range of output and not a single
level of output as under the traditional theory of cost. Firms build industrial plants with some
flexibility in their productive capacity so that instead of a single output level, there is a whole
range of output that can be produced optimally at low cost. The ‘Built-in Reserve capacity’
provides ‘maximum flexibility’ in the production process. The Planned reserve capacity explains
the ‘Saucer – shaped’ short run average variable costs.

The Modern theory of cost stresses on the role of economies of scale, which significantly enables
the firm to continue production at the lowest point of average cost for a considerable period of
time. The firm checks diseconomies of scale by planning in advance and enjoys the gains of
production in comparison to the traditional theory where the average cost rises after the firm
reaches the optimal level of output. Developments in managerial economies explain the L –
Shaped and inverse J –Shaped LAC Curves.

ECONOMICS PAPER 3, FUNDAMENTALS OF MICROECONOMIC THEORY

Module 17 MODERN THEORY OF COST: short run and long run
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3. SHORT-RUN COSTS CURVES UNDER MODERN THEORY:

The short-run Average costs consist of the Average fixed costs and Average variable costs.
Because of the U- shaped AVC curve under the traditional theory, the Plant is designed to
optimally produce a single level of output (at the minimum point of AVC CURVE) . In case there
is any departure from the optimizing output, there arises an excess capacity or unplanned
capacity.

If the firm produces a lower level of output OX1 then costs would be high compared to OXm
level of output. The short- run Average variable costs (SAVC) has a Saucer-type shape where
there is a flat- stretch corresponding to the ‘RESERVE CAPACITY ‘ or the ‘PLANNED
CAPACITY ‘ – which the Plant builds to provide flexibility in the firm’s production process.

THE SHAPES OF SHORT-RUN AVERAGE VARIABLE COST CURVES UNDER

TRADITIONAL AND MODERN THEORY OF COSTS:

Figure 1

ECONOMICS PAPER 3, FUNDAMENTALS OF MICROECONOMIC THEORY

Module 17 MODERN THEORY OF COST: short run and long run
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Figure 2

3.1 AVERAGEFIXED COST CURVE:

The Average Fixed cost curve under conditions of Reserve capacity is downward
sloping- falling continuously as output expands.

AVERAGE COST CURVE is the sum of AFC and AVC. Initially both AFC and AVC are falling
upto OX1 level of output causing the Average Cost to fall. Between X1 and X2 level of output,
AFC continues to fall but AVC remains constant, causing AC to decline. At X2 level of output,
the Reserve capacity is fully utilized and so beyond this point AC starts rising.

3.2 AVERAGE VARIABLE COST:

The Average Variable cost is equal to the total variable cost divided by the total output.
AVC = TVC÷Q = (P × V)÷ Q , where P is the price per unit of input and Vis the quantity of
variable input
The Average Variable cost curve is not ‘U’ Shaped as under the traditional theory but ‘trough
shaped/ saucer-shaped’ under the Modern theory of cost due to the ‘RESERVE CAPACITY’
maintained by the firm.

3.3 MARGINAL COST CURVE:

The MC curve intersects the SAVC curve at its minimum point. Since the SAVC curve reaches
its minimum point not at a single point but over the whole flat stretch e1e2 , therefore the short-run

ECONOMICS PAPER 3, FUNDAMENTALS OF MICROECONOMIC THEORY

Module 17 MODERN THEORY OF COST: short run and long run
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marginal cost curve (SMC) coincides with the SAVC over the
entire range of output corresponding to the flat stretch of the
SAVC Curve. For any output less than OX1 , the SMC curve will lie below the Saucer-shaped
SAVC curve and for any output higher than OX2 , the SMC curve will be above the SAVC curve.
Thus, over the flat stretch pertaining to the Reserve Capacity the short-run marginal cost curve
coincides with the SAVC Curve.

Figure no - 3

RELATIONSHIP BETWEEN SHORT-RUN AVERAGE VARIABLE COST AND

MARGINAL COST CURVES

ECONOMICS PAPER 3, FUNDAMENTALS OF MICROECONOMIC THEORY

Module 17 MODERN THEORY OF COST: short run and long run
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The falling portions of the SAVC Curve show the

reduction in costs due to better utilization of the fixed
factors and the consequent rise in productivity of the variable factors. The rising portion
of the SAVC Curve depicts the rise in costs on account of diminishing returns from the
variable factor and also overutilization of the fixed factors. The SAVC Curve has a flat
stretch over a range of output wherein the SAVC is equal to the short run marginal cost,
both being constant per unit of output.
The short-run Average cost curve continues to fall even over the range of output X1
andX2 corresponding to the flat stretch of the SAVC Curve where in SAVC is assumed to
be constant. As Average cost consists of Average fixed cost and Average variable cost
and Average fixed cost continues to fall as the level of output increases. Even after the
Planned Reserve capacity is exhausted, the Short-run Average cost curve continues to
decline despite rise in SAVC because AFC continues to fall throughout. Eventually, the
rise in short run Average cost becomes greater than the fall in Average fixed cost and the
short-run Average cost starts to rise.
The SAC Curve is intersected at its lowest point by the short-run marginal cost curve as
in case of the traditional theory of costs. Beyond OX3 level of output , the SAVC Curve
asymptotically approaches the short-run Average cost SAC since the gap between the two
curves gradually diminishes on account of falling AFC but the two can never coincide
because AFC cannot be zero.

4.1 ECONOMIES AND DIS-ECONOMIES OF SCALE:

The economies and dis-economies of scale explain why under the traditional theory of
costs, the LAC curve is U-shaped and under modern theory, theLAC is L –shaped.
Alfred Marshall classified Economies of scale into internal economies and external
economies.
Internal economies are internal to a firm and are not shared by its competitors in the
industry while external economies are those benefits of large –scale production which
accrue from outside due to the growth of the whole industry.

4.2 LONG-RUN COSTS UNDER MODERN THEORY;

The shape of the long-run cost curve is dependent on the returns to scale. The traditional theory
assumes a ‘U’ shaped Long-run cost curve under the presumption that after the optimal level of
output, the diseconomies of scale overtake the economies of scale. The modern theory contends
that the long run average costs essentially comprised production and managerial costs of which
the average production costs continue to fall even at large scales while the managerial costs per
unit of output may rise only gradually and at large scales of output. The long-run Average cost
curve is ‘L-Shaped’ or inverse J – Shaped under the modern theory of cost.

The long run Average cost curve LAC can be derived from the short-run Average cost curves.
Under the modern theory of costs, the falling portions of SAC curves are considered to obtain/
derive the LAC Curve. A firm is assumed to operate till its load factor and not full capacity is
achieved. Load factor generally lies between two-thirds and three-fourths of the total capacity and
corresponds to the falling portion of the short-run Average cost curve. Thus, the long-run
ECONOMICS PAPER 3, FUNDAMENTALS OF MICROECONOMIC THEORY
Module 17 MODERN THEORY OF COST: short run and long run
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Average cost curve does not envelop the SACs but intersects
them at the level of output defined by the load-factor of each
plant. The existence of economies of scale checks the increase in cost and decreasing returns
under the modern theory of costs.

In fig 4, we find that as the average costs of production falls continuously with the
increase in the level of output , the LAC curve assumes an inverse J-shaped which
signifies that there are no diseconomies of scale even at very large scales of output. If, the
average costs of production continues to fall only till a certain optimal level ox1 and
beyond that it becomes constant, then the LAC curve is roughly L-shaped and this
signifies that the economies and diseconomies of production balance out each other
beyond the optimal level of output ox1 .In case of an inverse J- shaped LAC curve, the
LRMC will lie below the LAC curve at all output levels since the average costs of
production can fall continuously if and only if the LRMC pulls them downwards by
remaining below it. If there is a minimum optimal scale of plant., OX1 at which all
possible scale economies are reaped, beyond that level of output the LAC remains
constant. In this case , the LRMC lies below the LAC curve until the minimum optimal
scale is reached and coincides with the LAC beyond that level of output. According to the
modern theory of costs, the long run average costs essentially comprised of production
and managerial costs , where the fall in production costs more than offsets the rise in
managerial costs , thus the LAC curve either falls continuously or remains constant at
very large scales of output.

ECONOMICS PAPER 3, FUNDAMENTALS OF MICROECONOMIC THEORY

Module 17 MODERN THEORY OF COST: short run and long run
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DIFFERENT SHAPES OF LONG-RUN AVERAGE COST CURVES UNDER

MODERN THEORY OF COSTS:

L – SHAPED LONG-RUN AVERAGE COST CURVE

Figure no – 4

INVERSE-J SHAPED LAC CURVE

Figure no: 5

ECONOMICS PAPER 3, FUNDAMENTALS OF MICROECONOMIC THEORY

Module 17 MODERN THEORY OF COST: short run and long run
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4.3 MEASUREMENT OF ECONOMIES OF SCALE:

Economies of scale are usually measured in terms of cost-output elasticity (Ec ) , where Ec is
defined as the percentage change in the cost of production resulting from a 1- percent increase in
∆ /
output , Ec =∆ / , EC relates to the traditional measures of cost and does not show this
∆ /∆
relationship, therefore we can rewrite this equation as EC = /
= .
This equation can be used to measure Ecin different cases and alsoto know whether there is
economies or diseconomies of scale . If Ec = 1 , then the firm ‘s economies of scale is equal to the
dis-economies of scale . If Ec is less than one , then the firm enjoys economies of scale . Finally,
if Ec is greater than one, the dis-economies of scale exceed the economies of scale.

SUMMARY

Ø Modern theory of costs does not agree with the U-shape of the cost curves.
Ø The short-run cost curve has a saucer- type shape whereas the long-run Average
cost curve is either L-Shaped or inverse J-shaped.

Ø The Modern theory suggests the existence of ‘built- in- reserve capacity ‘which
imparts flexibility and enables the plant to produce larger output without adding to
the costs.
Ø Built –in- reserve capacity are planned by firms.

Ø Because of the U- shaped AVC curve under the traditional theory, the Plant is designed to
optimally produce a single level of output (at the minimum point of AVC CURVE) .

Ø In case there is any departure from the optimizing output, there arises an excess capacity or
unplanned capacity

Ø The short- run Average variable costs (SAVC) has a Saucer-type shape where there is a
flat- stretch corresponding to the ‘RESERVE CAPACITY ‘ or the ‘PLANNED CAPACITY
‘ – which the Plant builds to provide flexibility in the firm’s production process.

Ø Average Fixed Cost under conditions of RESERVE CAPACITY is downward

sloping-falling continuously as output expands

ECONOMICS PAPER 3, FUNDAMENTALS OF MICROECONOMIC THEORY

Module 17 MODERN THEORY OF COST: short run and long run
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Ø AVERAGE COST CURVE is the sum of AFC and AVC.

Initially both AFC and AVC are falling,causing the
Average Cost to fall.

Ø AFC continues to fall but AVC remains constant, causing AC to decline. After the Reserve
capacity is fully utilized, AC starts rising.

Ø The MC curve intersects the SAVC curve at its minimum point.

Ø Since the SAVC curve reaches its minimum point not at a single point but over the whole
flat stretch , therefore the short-run marginal cost curve (SMC) coincides with the SAVC
over the entire range of output corresponding to the flat stretch of the SAVC Curve.

Ø Over the flat stretch pertaining to the Reserve Capacity the short-run marginal cost curve
coincides with the SAVC Curve.

Ø The economies and dis-economies of scale explain why under the traditional theory
of costs, the LAC curve is U-shaped and under modern theory, theLAC is L –
shaped .

Ø Internal economies are internal to a firm and are not shared by its competitors in the
industry while external economies are those benefits of large –scale production
which accrue from outside due to the growth of the whole industry.

Ø Economies of scale are usually measured in terms of cost-output elasticity (Ec ) , where Ec
is defined as the percentage change in the cost of production resulting from a percent
∆ /
increase in output , Ec = .
∆ /

∆ /∆
Ø We can rewrite this equation as EC = = .
/
Ø This equation can be used to measure Ec in different cases and also to know whether there
are economies or diseconomies of scale.

Ø If Ec = 1 , then the firm ‘s economies of scale is equal to the dis-economies of scale .

Ø If Ec is less than one , then the firm enjoys economies of scale .

Ø Finally, if Ec is greater than one, the dis-economies of scale exceed the economies of scale.

ECONOMICS PAPER 3, FUNDAMENTALS OF MICROECONOMIC THEORY

Module 17 MODERN THEORY OF COST: short run and long run