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COST THEORY Cost is a sacrifice or foregoing that has occurred or has potential to occur in future, measured in monetary terms. Cost results in current or future decrease in cash or other assets, or a current or future increase in liability. Cost is determined by various factors and each of this has significant implications for cost decisions. An increase in any of these will affect cost pattern. The most important determinant is price(/s) of factor(/s) of production, which are uncontrollable, as they are largely determined by the external environment of any business. The marginal efficiency and productivity of these factors is strongly related to their cost, higher the productivity or efficiency, lower will be the cost of the production, other things remaining the same.

COST ANALYSIS

Technology is the third important determinant and has the same relationship with the cost as the efficiency of inputs. Other things remaining the same, better the technology enhances productivity and reduces the cost of production. Production and cost analysis constitute the supply side of the market. The production analysis deals with the supply side in terms of physical units of inputs and output, the cost analysis is concerned with the supply side in terms of physical units of output and the cost of production as expressed in nominal terms.

COST ANALYSIS

COST FUNCTIONS Cost functions are derived functions. They are derived from the production function, which describes the availability of efficient methods of production at any one time. Economic theory distinguishes between short-run costs and long-run costs. Short-run costs are the costs over a period during which some factors of production (usually capital equipment and management) are fixed. The long-run costs are the costs over a period long enough to permit the change of all factors of production. In the long run all factors become variable. Both in the short run and in the long run, total cost is a multivariable function, that is, a total cost is determined by many factors. Symbolically we may write the long run cost function as C= f (X, T, Pf) And the short run cost function as C = f (X, T, Pf, K) Where, C = total costs, X = output, T = technology, Pf = prices of factors, and K = fixed factor(/s)

COST ANALYSIS

Graphically, costs are shown on two-dimensional diagrams. Such curves imply that cost is a function of output, C = f (X), ceteris paribus. The clause ceteris paribus implies that all other factors which determine costs are constant. If these factors do change, their effect on costs is shown graphically by a shift of the cost curve. This is the reason why determinants of costs, other than output, are called shift factors. Mathematically there is no difference between the various determinants of costs. The distinction between movements along the cost curve (when output changes) and shifts of the curve (when the other determinants change) is convenient only pedagogically, because it allows the use of two-dimensional diagrams. But it can be misleading when studying the determinants of costs. It is important to remember that if the cost curve shifts, this does not imply that the cost function is indeterminate.

COST ANALYSIS

VARIOUS TYPES OF COSTS In economic analysis, the following types of costs are considered in studying costs data of a firm: Total Cost (TC) Total Fixed Cost (TFC) Total Variable Cost (TVC) Average Fixed Cost (AFC) Average Variable Cost (AVC) Average Total Cost (ATC) and Marginal Cost (MC)

COST ANALYSIS

TOTAL COST (TC) Total cost is the aggregate of expenditures incurred by the firm in producing a given level of output. Total cost is measured in relation to the production function by multiplying factors of prices with their quantities. If the production functions is: Q = f (a, b, c.n), then total cost is TC = f (Q), which means total cost varies with output. For measuring the total cost of a given level of output, thus, we have to aggregate the product of factors quantities multiplied by their respective prices. Conceptually, total cost includes all kinds of money costs, explicit as well as implicit. Thus, normal profit is included in total cost. Normal profit is an implicit cost. It is a normal reward made to the entrepreneur for his organizational services. It is just a minimum payment essential to retain the entrepreneur in a given line of production.

COST ANALYSIS

If this normal return is not realized by the entrepreneur in the long run, he will stop his present business and will shift his resources to some other industry. Now, an entrepreneur himself being the paymaster, he cannot pay himself, so he treats normal profit as implicit costs and adds to the total cost. In the short run, total costs may be bifurcated into total fixed cost and total variable cost. Thus, total cost may be viewed as the sum of total fixed cost and total variable cost at each level of output. Symbolically, in the short-run, TC = TFC + TVC.

COST ANALYSIS

TOTAL FIXED COST (TFC) Total fixed cost corresponds to fixed inputs in the short run production function.

It is obtained by summing up the product of quantities of the fixed factors multiplied by their respective unit prices.

TFC remains the same at all levels of output in the short run.

Suppose a small furniture shop proprietor starts his business by hiring a shop at a monthly rent of Rs. 1,000 borrowing Rs. 50,000 from a bank at an interest rate of 12% and buys capital equipment worth Rs. 2,000.

Then his monthly total cost is estimated to be: Rs. 1,000 (Rent) + Rs. 2,000 + Rs.500 = Rs. 3,500 (Equipment cost) (Monthly interest on th loan)

COST ANALYSIS

TOTAL FIXED COST CURVE

Cost (C)

C = Rs. 1,00,000

TFC Curve

Output (Q) O

COST ANALYSIS

TOTAL VARIABLE COST (TVC)

Corresponding to variable inputs in the short-run production is the total variable cost.

Again, TVC = F (Q), which means, total variable cost is an increasing function of output. Suppose, if a shop proprietor starts with the production of chairs and he employs a carpenter on a wage of Rs. 200 per chair. He buys wood worth Rs. 2,000 rexine sheets worth Rs. 1,500, spends Rs. 400 for other requirements to produce 3 chairs. Then this total variable cost for producing 3 chairs is measured as Rs. 2,000 (wood price) + Rs. 1500 (rexine cost) + Rs. 400 (allied cost) + Rs. 600 (labour charges) = Rs. 4,500.

COST ANALYSIS

Output (Q) O

COST ANALYSIS

Cost (C)

COST ANALYSIS

AVERAGE FIXED COST (AFC) AND AFC CURVE Average fixed cost is total fixed cost divided by total units of output. AFC = TFC / Q, Where, Q = number of units of the product. Thus, average fixed costs are the fixed cost per unit of output. In the above example, when TFC = Rs. 3,500 and Q = 3, then AFC = Rs. 3,500 /3 = Rs. 1,166.67

Cost (C)

COST ANALYSIS

SHORT-RUN AVERAGE VARIABLE COST (SAVC) AND SAVC CURVE

Average variable cost is total variable cost divided by total units of output. AVC = TVC / Q, where, AVC means average variable cost. Thus, average variable cost is variable cost per unit of output. If TVC = Rs. 4,500 for Q = 3, then AVC = 4,500 / 3 = Rs. 1,500

Cost (C)

SAVC Curve

Output (Q) O

COST ANALYSIS

SHORT-RUN AVERAGE TOTAL COST (SATC)

Average Total Cost or average cost is total cost divided by total units of output.

Thus: ATC or AC = TC / Q

In the short run, since TC = TFC + TVC So, ATC = TC / Q = [TFC + TVC] / Q = (TFC / Q) + (TVC / Q)

Therefore, ATC = AFC + AVC. Hence, average total cost can be computed simply by adding average fixed cost and average variable cost at each level of output. To take the above example, ATC = Rs. 1,166.67 + Rs. 1,500 = Rs. 2,666.67 pr chair.

COST ANALYSIS

SHORT-RUN AVERAGE TOTAL COST (SATC) CURVE

Cost (C)

COST ANALYSIS

SHORT-RUN MARGINAL COST (SMC) The marginal cost is also per unit cost of production in additional sense. It is the addition made to the total cost by producing one more unit of output. Symbolically, MCn = TCn TCn1, that is, the marginal cost of the nth unit of output is the total cost of producing n units minus the total cost of producing n1 (i.e. one less in the total) units of output. Suppose the total cost of producing 4 chairs (i.e. n = 4) is Rs. 10,000 while that for 3 chairs (i.e. n1 is Rs. 8,000. Marginal cost of producing the 4th chair, therefore, works out as under: MC4 = TC4 TC3 = Rs. 10,000 Rs. 8,000 = Rs. 2,000. Marginal cost is the cost of producing an extra unit of output. In other words, marginal cost may be defined as the change in total cost associated with a one unit change in output. It is also an extraunit cost or incremental cost, as it measures the amount by which total cost increases when output is expanded by one unit. It can also be calculated by dividing the change in total cost by the one unit change in output.

COST ANALYSIS

SHORT-RUN MARGINAL COST (SMC) CURVE Symbolically, thus, MC = TC / 1Q where, denote change in output assumed to change by 1 unit only. Therefore, output change is denoted by 1. It must be remembered that marginal cost is the cost of producing an additional unit of output and not of average product. It indicates the change in total cost of producing an additional unit.

Cost (C) SMC Curve SATC or SAC Curve

Output (Q) O

COST ANALYSIS

RELATIONSHIP BETWEEN AC AND MC Economists have observed a unique relationship between the two as follows: When AC is minimum, the MC is equal to AC. Thus, MC curve must intersect at the minimum point of ATC curve. When AC is falling, MC is also falling initially, after a point MC may start rising but AC continues to fall. However AC is greater that MC (AC > MC). Hence ultimately at a point both costs will be equal. Thus, when MC and AC are failing, MC curve lies below the AC curve. One MC as equal to AC, then the output increases AC will start rising and MC continues to rise further but now MC will be greater than AC. Therefore, when both the costs are rising, MC curve will always lie above the Ac curve. The above stated relationship is easy to see through geometry of AC and MC curves, as shown in following figure.

COST ANALYSIS

It can be seen that; Initially, both MC and AC curve are sloping downward. When MC curve lies below AC. When AC curve is rising, after the point of intersection, MC curve is above it. It follow thus when MC is less than AC, it exerts a downward pull on the AC curve. When MC us more than AC it exerts an upward pull on the AC curve. Consequently, MC must equal AC, while AC is at the minimum. Hence, MC curve intersects at the lowest point of AC curve. It may be recalled that MC curve also intersects the lowest point of AVC curve. Thus, it is a significant mathematical property of MC curve that it always cuts both the AVC and ATC curve at their minimum points. In the following figure, the MC curve crosses the AC curve at point P. At this point, for OQ level of output the average cost of PQ which is minimum.

COST ANALYSIS

Cost MC AC

B N C

COST ANALYSIS It should be noted that no such relationship cab ever be traced between the MC curve and the AFC curve simply because by definition, the MC curve is independent. Further, the area underlying the MC curve is equal to the total variable cost of the given output. In fact, the point on each average cost curve measures the average cost but the area underlying them denote total costs as under: Total, area underlying the AFC curve measures the total fixed cost. The area underlying the AVC curve measures the total variable cost. The area underlying the MC curve measures the total variable cost.

COST ANALYSIS

The area underlying the ATC curve measures the total cost. Finally, the MC curve is important because it is the cost concept relevant to rational decision making. It has greater significance in determining the equilibrium of the firm. On fact, the increasing MC due to diminishing returns sets a limit to the expansion of a firm during the period. Further, it is the MC curve which acts on the supply curve of the firm. From the above discussion of cost behavior we may conclude that short run average cost curves (AVS, ATC and MC curves) are U shaped, except then AFC curve, which is an asymptotic and downward sloping curve.

COST ANALYSIS

SHORT RUN AND LONG RUN CONCEPTS The short run is a period during which one of the factors of production is considered to be constant (assuming that there are only two factors of production labor and capital) and the other is variable. Usually it is assumed that capital is the fixed factor in the short run. All costs are variable in the long run since factors of production, size of plant, machinery and technology are all variable. This in turn implies radical changes in the cost structure of the firm. The long run cost function is often referred to as the planning cost function and the long run average cost (LAC) curve is known as the planning curve. As all cost are variable, only the average cost curve is relevant to the firms decision-making process in the long run. The long run consists of many short runs, e.g., a week consists of seven days and a month consists of four weeks and so on. So, the long run cost curve is the composite of many short run cost curves.

COST ANALYSIS

LONG RUN COST CURVES In the long run, all inputs (factors of production) are variable and firms can enter or exit any industry or market. Consequently, a firm's output and costs are unconstrained in the sense that the firm can produce any output level it chooses by employing the needed quantities of inputs (such as labor and capital) and incurring the total costs of producing that output level. The Long Run Average Cost (LRAC) curve of a firm shows the minimum or lowest average total cost at which a firm can produce any given level of output in the long run (when all inputs are variable). The LRAC curve is the envelope of the short run average total cost (SRATC) curves, where each SRATC curve is defined by a specific quantity of capital (or other fixed input).

COST ANALYSIS

LAC, SACs

SAC3

LAC SAC1 SAC2

COST ANALYSIS

Economies / Dis-economies of Scale The LAC curve is the mirror image of the returns to the scale in the long run. It is apparent that since returns to the scale are based on the internal economies and the diseconomies of scale, the long run average cost curve traces these economies of scale. As a matter of fact that increasing returns to scale can be largely traced to the economies which become available to a firm when it expands its scale of operations. As a result of these economies, the firm enjoys a number of cost advantages and return in terms of total output. Thus, economies of scale explain the falling segment of the LAC curve. This shows that the decline average cost of output in the long run is due to economies of large scale enjoyed by the firm. Increasing LAC is attributed to the diseconomies of scale after a certain point of further expansion.

COST ANALYSIS

In short, economies and diseconomies of large scale play a significant role in determining the shape of the LAC curve. Again the structure of an industry is also affected by the cost consideration which is conditioned by the economies and diseconomies of scale. Of the many determinants of the number and size of firms in an industry, the cost consideration and relevant economies and diseconomies are a significant determining factor. Increasing average costs in the long run, attributed to the growing diseconomies of scale, set a limit to the further expansion of the firm. Economies and diseconomies of scale reflect upon the behavior of LAC curve. Analytically speaking the downward slope of the LAC curve may be attributed to the internal economies of scale. Similarly, the upward slope of the LAC curve is caused by the internal diseconomies of scale. And the horizontal slope of the LAC curve may be explained in terms of the balance between internal economies and diseconomies.

COST ANALYSIS

Cost

A Net Diseconomi es

D LAC

Economie s

Q

COST ANALYSIS

In short, the internal economies and diseconomies have their significance in determining the shape of the LAC curve of a firm. However, the shift in the LAC curve may be attributed to the external economies and diseconomies. External economies reflect in reducing the overall cost function of the firm. Thus, a downward shift in the LAC may be caused by external economies as shown in following Figure. In following figure, ABCD is the LAC curve. Its AB portion is the downward slope, which is subject to the internal economies. Its BC portion the horizontal slope is due to the balance between economies and diseconomies. Its CD portion the upward slope is subject to internal diseconomies. In following figure, the original LAC1 curve shifts downward as LAC2 on account of external economies.

COST ANALYSIS

External Economies

Output O

The effect of External Economies on the LAC curve

COST ANALYSIS

Similarly, an upward shift in the LAC curve may be attributed to the external diseconomies, as shown in following figure.

External Diseconomies

Output O

In above figure, the original LAC1 curve shifts up as LAC2 owning to the external diseconomies

BREAK-EVEN AND SHUT-DOWN POINT Breakeven point is the point where total cost just equals to the total revenue; it is the no profit no loss point. It is an important application of cost analysis. It examines the relation between total revenue, total cost and total profits of a firm at different levels of output. This analysis is about determining profit at various projected levels of sales, identifying the breakeven point, and making a managerial decision regarding the relationship between likely sales and the breakeven point. Break-even analysis is used synonymously with Cost Volume Profit Analysis, though many are of opinion that finding the breakeven point is just the first step in any planning decision. There are several approaches of breakeven analysis, but here we would explain graphical method only. Total revenue and total cost measured in the vertical axis and output is measured in the horizontal axis.

COST ANALYSIS

COST ANALYSIS

Here, total cost (TC) is total fixed cost (TFC) plus total variable cost (TVC); i.e., TC = TFC +TVC. Total revenue (TR) is 45o line, which starts from origin, where output (Q) is zero and TR is also zero. In the following figure, at point E, the total revenue is equal to total cost, i.e., TR=TC, that means no loss no profit case. In this case, the total output is OQe units. So, the breakeven point is E and Breakeven amount of output is OQe units. The fixed cost is that cost which is occurs irrespective of output, which means the firm has to bear this TFC even when the production is stopped. To get normal profit or zero profit, the firm has to cover TC (TFC + TVC). But if the firm is not able to cover this TC then also the firm will continue to produce up to the level where the loss amount is equal to TFC. Because, the firm is identical in both the cases, i.e., if stopped production then the maximum amount of loss is TFC or if they produce then also they can bear the same amount of loss (equal to TFC). So, in the following figure, the shut-down point is S and shut-down output is OQs.

COST ANALYSIS

TR

TVC

TC=TFC+TVC

TFC

Qs

Output (Q)

Qe

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