COST THEORY AND ANALYSIS

NATURE OF COSTS

Actual cost: cost incurred in production Opportunity cost: return from the second best use of firms resources which the firm foregoes in order to avail the return Explicit / Accounting Costs : Actual money spent in purchasing or hiring services of factor

Implicit / Imputed cost: Cost of self-owned and selfemployed resources

NATURE OF COSTS

Fixed costs: Costs which do not change with change in O/P Variable or Prime costs: Costs which change with change in level of O/P Accounting costs: Cost as stated in books of accounts (explicit cost only) Economic Costs: includes both explicit & implicit cost

NATURE OF COSTS

Marginal cost: Change in total cost associated with a one-unit change in output Incremental Costs: Total additional cost of implementing a managerial decision

NATURE OF COSTS

Private cost: Actually incurred or provided for by an individual for its business activity Social cost: Cost to society on account of production of good Original cost: cost incurred originally

Replacement cost: cost incurred in replacing

EXERCISE
A Carpenter makes 100 chairs per month & sells them at Rs 150 per piece. His expenses on rent of shop, cost of wood & other materials are worth Rs 5000. He employs 2 workers whose monthly wage bill stand at Rs 2400 & pays electricity bill of Rs 500 per month. He has invested Rs 50,000 in the form of machines, tools & inventories of which Rs 25,000 is from his own fund & remaining 25,000 is a loan from bank at interest rate of 18% p.a. Assuming imputed cost of his own time, own shop & own savings of Rs 25000 as Rs 3000, Rs 1000 & Rs 250 respectively, find: Explicit cost Implicit cost Accounting profit Economic profit

ANSWERS

Explicit cost : Rs 8275 Implicit cost: Rs 4250 Accounting profit: Rs 6725 Economic profit: Rs 2475

COST FUNCTION
C = f (S, O, P, T) Where: C: Cost of O/P S: Size of plant O: level of O/P P: price of I/Ps used in production T: nature of technology

SHORT-RUN COST FUNCTIONS

Total Cost = TC = f(Q)

TC = TFC + TVC
Total Fixed Cost = TFC Total Variable Cost = TVC

SHORT-RUN COST FUNCTIONS

Average Fixed Cost = AFC = TFC/Q

Average Variable Cost = AVC =TVC/Q

Average Total Cost = ATC = TC/Q

Average Total Cost = AFC + AVC

Marginal Cost = TC/Q =TVC/Q

SHORT-RUN COST FUNCTIONS

Q
0

TFC
60

TVC
0

TC
60

AFC
-

AVC
-

ATC
-

MC
-

1
2 3 4 5

60
60 60 60 60

20
30 45 80 135

80
90 105 140 195

60
30 20 15 12

20
15 15 20 27

80
45 35 35 39

20
10 15 35 55

Cost

250

Total Cost Function TC TVC

200

150

100

50

TFC

0 0 1 2 3 4 5 6

Output

Cost

90

80
70 60 50 40 30 20 10 0 0 1 2 3 4

Per Unit Cost Function MC AC AVC

AFC
5 6

Output

SHORT RUN COST FUNCTION: IMPORTANT OBSERVATIONS

AFC declines steadily over the range of production In general, AVC, AC, and MC are U shaped When MC<AVC, AVC is falling When MC>AVC, AVC is rising When MC=AVC, AVC is at its minimum The distance between AC and AVC represents AFC

SR RELATIONSHIP BETWEEN PRODUCTION AND COST

A firms cost structure is intimately related to its production process
Costs are determined by technology and input prices the production

SR RELATIONSHIP BETWEEN PRODUCTION AND COST

In order to illustrate the relationship, consider the production process described in table
Total Input (L) 0 1 2 3 4 5 6 7 8 9

Q (TP) 0 1,000 3,000 6,000 8,000 9,000 9,500 9,850 10,000 9,850

MP 1,000 2,000 3,000 2,000 1,000 500 350 150 -150

SR RELATIONSHIP BETWEEN PRODUCTION & COST

Total variable cost (TVC) is the cost associated with the variable input, in this case labor Assume that labor can be hired at a price (w) of Rs 500 per unit

TOTAL I/P (L) 0

Q (TP) 0

MP

TVC (wL) 0

MC (TVC/ Q)

1
2 3 4 5 6 7 8 9

1000
3000 6000 8000 9000 9500 9850 10000 9850

1000
2000 3000 2000 1000 500 350 150 -150

500
1000 1500 2000 2500 3000 3500 4000 4500

0.5
0.25 0.16 0.25 0.5 1 1.4 3.33

SR RELATIONSHIP BETWEEN PRODUCTION & COST

TP and TVC are mirror images of each other When TP increase at an increasing rate, TVC increase at a decreasing rate

RELATION B/W MP & MC

When MP is increasing, MC is decreasing When MP is decreasing, MC is increasing Also when MP= AP at max AP, MC = AVC at min AVC

Total Input (L) 0 1 2 3 4 5 6 7 8 9

Q 0 1,000 3,000 6,000 8,000 9,000 9,500 9,850 10,000 9,850

MP 1,000 2,000 3,000 2,000 1,000 500 350 150 -150

TVC (wL) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500

MC 0.50 0.25 0.17 0.25 0.50 1.00 1.43 3.33

SHORT-RUN COST FUNCTIONS

Average Variable Cost AVC = TVC = w L Q Q = w = w

Q/L

APL

Marginal Cost TC/Q = TVC/Q = (w L)/Q = w = w Q/L MPL

EXERCISE
Given Total Cost function: TC = 1000 + 10 Q 0.9 Q 2 + 0.04 Q 3 Find the rate of O/P that result in minimum Average Variable cost

LR RELATIONSHIP B/W PRODUCTION & COST

All I/Ps variable No fixed costs LR cost structure of firm is related to firms long run production process which is described by RTS Economists hypothesize that a firms long-run production function may exhibit at first IRS then CRS & finally DRS

LR RELATIONSHIP B/W PRODUCTION & COST

IRS: A proportional increase in all I/Ps increases O/P by a greater percentage than costs Costs increase at a decreasing rate CRS: A proportional increase in all I/Ps increases O/P by same percentage as costs Costs increase at a constant rate DRS: A proportional increase in all I/Ps increases O/P by a smaller percentage than costs Costs increase at an increasing rate

LR RELATIONSHIP B/W PRODUCTION & COST

LONG-RUN COST CURVES

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q

Long-Run Marginal Cost = LMC = LTC/Q

DERIVATION OF LONG-RUN COST CURVES

LAC
It shows the lowest average cost of producing each level of O/P when the firm can build the most appropriate plant to produce each level of O/P

RELATIONSHIP B/W LONG-RUN & SHORT-RUN AVERAGE COST CURVES

RELATIONSHIP B/W LONG-RUN & SHORT-RUN AVERAGE COST CURVES

LONG-RUN COST FUNCTION

When LAC declines: firm experiences economies of scale (per-unit costs are falling) When LAC increases: firm experiences diseconomies of scale (per-unit costs are rising)

LONG-RUN COST FUNCTION: GENERAL SHAPE

ECONOMIES OF SCALE
Internal Real economies Specialization Indivisibility Advertising Team work External Pecuniary economies Quantity discounts Lower cost of capital transportation Sales promotion

DISECONOMIES OF SCALE
Congestion Scarcity of resources Difficulty in Coordination & control

MANAGERIAL USES OF COST FUNCTIONS: DETERMINING OPTIMUM OUTPUT LEVEL

O/P level at which AC is minimum Necessary condition: (AC) / Q = 0 Sufficient condition: 2(AC) / Q2 > 0

MANAGERIAL USES OF COST FUNCTIONS: DETERMINING OPTIMUM SCALE

Value of plant size (K) at which total cost (C) is minimum Necessary condition: C / K = 0 Sufficient condition: 2C / K2 > 0

SPECIAL TOPICS IN COST THEORY

(1) PROFIT CONTRIBUTION ANALYSIS

Total Revenue = TR = (P)(Q) Total Cost = TC = TFC + (AVC)(Q) Profit = TR -TC

Profit = = PQ - [TFC + (AVC)(Q)]

Q = TFC + P - (AVC) Profit contribution = P - AVC

EXAMPLE Fixed cost = Rs 10,000 Price = Rs 20 AVC = Rs 15 How much O/P should the firm produce to have a profit of Rs 20,000? Answer: 6000 units

(2) BREAKEVEN VOLUME (TR = TC) (zero economic profit) = TR - TC = 0

TR = TC

(P)(Q) = TFC + (AVC)(Q)

QBE = TFC

(P - AVC)

EXAMPLE
Fixed cost = Rs 10,000 Price = Rs 20 AVC = Rs 15 How much O/P should the firm produce in order to break even?

Answer: 2000 units

Also : TR = 20Q TC = 10,000 + 15Q TR = TC

LINEAR BREAKEVEN ANALYSIS

P = 10 TFC = 200 AVC = 5

LINEAR BREAKEVEN ANALYSIS: SHORTCOMINGS

Assumes constant prices Assumes constant average variable costs

EXCERCISE

Petersen & Lewis Page # 239: Breaking even on Microcomputer software

NONLINEAR BREAKEVEN ANALYSIS

TR/TC
350 300 250 200 150 100 50 0 0 1 2 3 4 5 6

TC

TR

Profit

40 30 20 10 0 0 1 2 3 4 5 6

-10 -20 -30 -40 -50

(3) OPERATING LEVERAGE

Operating Leverage = TFC/TVC
Degree of Operating Leverage (or profit elasticity) = DOL

DOL = % = / = * Q = E %Q Q/Q Q
= PQ - TFC + (AVC)(Q) = Q(P - AVC) - TFC = Q(P - AVC)

DOL = Q(P - AVC)Q = Q(P - AVC) Q[Q(P - AVC) - TFC] Q(P - AVC) - TFC

(4) LEARNING CURVE

Workers improve with practice so per unit cost of additional O/P declines Measures % decrease in additional labor cost each time O/P doubles An 80 percent learning curve implies that each time O/P doubles, L costs associated with incremental output decrease to 80% of previous level

UTILITY OF LEARNING CURVES

To forecast needs of

personnel
machinery raw materials

Scheduling production Determining Selling price of product

(5) ECONOMIES OF SCOPE

The reduction of a firms unit cost by producing two or more goods or services jointly rather than separately Degree of economies of scope = TC(Q1) + TC(Q2) TC(Q1 + Q2)
TC(Q1 + Q2)

EXAMPLE
Firm A produces 100 units of X & 500 units of Y per month at the TC of Rs 1,00,000. If X & Y are produced separately by firms B & C then the TC to firm B of producing 100 X is Rs 25000 & firm C of producing 500 Y is Rs 90,000. Check whether firm A is experiencing economies or diseconomies of scope

Answer: 0.15 so economies of scope NOTE: Positive: economies of scope Negative: diseconomies of scope