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Costs of Production

Definition

• Cost – An amount that has to be paid or given up in order to get

something. – Cost refers to the amount of expenditure incurred in acquiring

something

• Thus the cost incurred in connection with raw material, labour, other heads constitute the overall cost of production

• A managerial economist must have a clear understanding of the different cost concepts for clear business thinking and proper application

• Output is an important factor which influences the cost

Role of costs analyses in managerial economics

• Cost and revenue are the two major factors that a profit maximizing firm needs to monitor continuously.

• It is the level of cost relative to revenue that determines the firm’s overall profitability.

• Revenue= QxP

• Profit = Revenue-Costs

Role of costs analyses in managerial economics

• In order to maximize profits, a firm tries to increase its revenue and lower its cost.

• While the market factors determine the level of revenue to a great extent, the cost can be brought down either by – producing the optimum level of output using the

least cost combination of inputs,

– increasing factor productivities,

– by improving the organizational efficiency.

Cost Determinants

• Level of output: The cost of production varies according to the quantum of output. If the size of production is large then the cost of production will also be more.

• Price of input factors: A rise in the cost of input factors will increase the total cost of production.

• Productivities of factors of production: When the productivity of the input factors is high then the cost of production will fall.

• Size of plant: The cost of production will be low in large plants due to mass production with mechanization.

• Output stability: The overall cost of production is low when the output is stable over a period of time.

Cost Determinants

• Lot size: Larger the size of production per batch then the cost of production will come down because the organizations enjoy economies of scale.

• Laws of returns: The cost of production will increase if the law of diminishing returns applies in the firm.

• Levels of capacity utilization: Higher the capacity utilization, lower the cost of production

• Time period: In the long run cost of production will be stable.

• Technology: When the organization follows advanced technology in their process then the cost of production will be low.

Cost Determinants

• Experience: over a period of time the experience in production process will help the firm to reduce cost of production.

• Process of range of products: Higher the range of products produced, lower the cost of production.

• Supply chain and logistics: Better the logistics and supply chain, lower the cost of production.

• Government incentives: If the government provides incentives on input factors then the cost of production will be low.

Types of costs

• Fixed Costs (FC). The costs which don’t vary with changing output. Fixed costs might include the cost of building a factory, insurance and legal bills. Even if your output changes or you don’t produce anything, your fixed costs stays the same.

• Variable Costs (VC). Costs which depend on the output produced. For example, if you produce more cars, you have to use more raw materials such as metal. This is a variable cost. – Semi-Variable Cost. Labour might be a semi-variable cost. If you

produce more cars, you need to employ more workers; this is a variable cost. However, even if you didn’t produce any cars, you may still need some workers to look after empty factory.

• Total Costs (TC) – Fixed + Variable Costs • Marginal Costs – Marginal cost is the cost of producing an extra

unit.

Example

Types of costs

• The opportunity cost of doing or getting something is: – what you could have done or gotten instead – The revenue which could have been earned by

employing that good or service in some other alternative uses.

In other words, it is the return from the second best use of the firms resources which the firms forgoes in order to avail of the return from the best use of the resources. Opportunity cost is also called as "Alternative Cost"

Types of costs

• Explicit and Implicit Costs

– Explicit costs are input costs that require a direct outlay of money by the firm.

– Implicit costs are input costs that do not require an outlay of money by the firm.

• Implicit costs are a part of opportunity cost. They are the theoretical costs, they are not recognised by the accounting system and are not recorded in the books of accounts but are very important in certain decisions

Types of costs

• Accounting Costs – Accounting costs are the actual or outlay costs that

point out the amount of expenditure that has already been incurred on a particular process or on production as such accounting costs facilitate for managing the taxation need and profitability of the firm.

• Economic Costs – Economic costs are related to future. They play a vital

role in business decisions as the costs considered in decision - making are usually future costs. They have the nature similar to that of incremental, imputed explicit and opportunity costs.

Economic versus Accountants

Copyright © 2004 South-Western

Revenue

Total opportunity costs

How an Economist Views a Firm

How an Accountant Views a Firm

Revenue

Economic profit

Implicit costs

Explicit costs

Explicit costs

Accounting profit

Types of costs • Direct Cost • Direct costs are those which have direct relationship with a unit of operation like

manufacturing a product, organizing a process or an activity etc. In other words, direct costs are those which are directly and definitely identifiable. The nature of the direct costs are related with a particular product/process, they vary with variations in them. Therefore all direct costs are variable in nature. It is also called as "Traceable Costs" – Examples: In operating railway services, the costs of wagons, coaches and engines are direct

costs.

• Indirect Costs • Indirect costs are those which cannot be easily and definitely identifiable in

relation to a plant, a product, a process or a department. Like the direct costs indirect costs, do not vary ie., they may or may not be variable in nature. However, the nature of indirect costs depend upon the costing under consideration. Indirect costs are both the fixed and the variable type as they may or may not vary as a result of the proposed changes in the production process etc. Indirect costs are also called as Non-traceable costs. – Example: The cost of factory building, the track of a railway system etc., are fixed indirect costs

and the costs of machinery, labour etc.

Types of costs

• Sunk Costs. These are costs that have been incurred and cannot be recouped. If you left the industry you cannot reclaim sunk costs. For example, if you spend money on advertising to enter an industry, you can never claim these costs back. If you buy a machine, you might be able to sell if you leave the industry.

• Avoidable Costs. Costs that can be avoided. If you stop producing cars, you don’t have to pay for extra raw materials and electricity. Sometimes known as an escapable cost.

Short-Run Cost Functions

• During short run some factors are fixed and others are variable.

• Total Costs

– Total Fixed Costs (TFC)

– Total Variable Costs (TVC)

– Total Costs (TC)

– TC = TFC + TVC

Short-Run Cost Functions

• Average Costs

• Average Fixed Costs (AFC)

• Average Variable Costs (AVC)

• Average Total Costs (ATC)

• ATC = AFC + AVC

Short-Run Cost Function and Their Shapes

• The average total-cost curve is U-shaped.

• At very low levels of output average total cost is high because fixed cost is spread over only a few units.

• Average total cost declines as output increases.

• Average total cost starts rising because average variable cost rises substantially.

Cost Curves and Their Shapes

• The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost.

• This quantity is sometimes called the efficient scale of the firm.

Average-Cost Curve

Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output

(glasses of lemonade per hour)

0 1 4 3 2 7 6 5 9 8 10

ATC

Short-Run Cost Functions

• Marginal Cost

– Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production.

– Marginal cost helps answer the following question:

• How much does it cost to produce an additional unit of output?

Marginal Cost

• Marginal cost rises with the amount of output produced.

– This reflects the property of diminishing marginal product

Marginal-Cost Curve

Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output

(glasses of lemonade per hour)

0 1 4 3 2 7 6 5 9 8 10

MC

The Various Measures of Cost

Total-Cost Curves

Total Cost

$15.00

14.00

13.00

12.00

11.00

10.00

9.00

8.00

7.00

6.00

5.00

4.00

3.00

2.00

1.00

Quantity of Output

(glasses of lemonade per hour)

0 1 4 3 2 7 6 5 9 8 10

Total-cost curve

Average-Cost and Marginal-Cost Curves

Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output

(glasses of lemonade per hour)

0 1 4 3 2 7 6 5 9 8 10

MC

ATC

AVC

AFC

Relationship between Marginal Cost and Average Total Cost

• Whenever marginal cost is less than average total cost, average total cost is falling.

• Whenever marginal cost is greater than average total cost, average total cost is rising.

• The marginal-cost curve crosses the average-total-cost curve at the efficient scale.

• Efficient scale is the quantity that minimizes average total cost.

Average-Cost and Marginal-Cost Curves

Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output

(glasses of lemonade per hour)

0 1 4 3 2 7 6 5 9 8 10

ATC

MC

Long-Run Cost Functions

• In the long-run, costs are not divided into fixed and variable components; all costs are variable

• In the long run costs fall as output increases due to economies of scale, consequently the average cost AC of production falls.

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

Long Run Total Cost Curve

Learning curve effect

• The learning curve effect measures the relation between an increase in per-worker productivity (a decrease in per-unit labor cost at fixed labor prices) associated with an improvement in labor skills from on the-job experience.

Learning curve

• Average Cost of Unit Q = C = aQβ

• Q - is the level of output

• a - is the per-unit cost of producing the first unit of output

• β-, β = (ln m)/(lnl), m is the learning factor, and l is a factor of output proportionality.

Learning Curves

Estimation Form: log C = log a + b Log Q

Learning Curve

• β is a measure of the learning curve effect.

• It determines the rate at which per-unit labor requirements fall given the rate at which workers “learn” (m) following a scalar (proportional) increase in production (l)

• 0<m<1

• If m is close to 0 the learning curve effect on lowering per unit labor costs becomes more powerful

ECONOMIES OF SCALE

• If per-unit costs of production decline as the scale of a firm’s operations increase, the firm is said to experience economies of scale.

• If we assume constant factor prices, while the firm’s total cost of production rises proportionately with an increase in total factor usage, per-unit cost of production falls because output has increased more than proportionately.

• In other words, an increase in the firm’s scale of operations results in a decline in long-run average total cost (LRATC)

Types of Economies of Scale Internal Economies of Scale

• It refers to the advantages that arise as a result of the growth of the firm.

• When a company reduces costs and increases production, internal economies of scale are achieved.

• Internal economies of scale relate to lower unit costs.

External Economies of Scale

• It refers to the advantages firms can gain as a result of the growth of the industry.

• External economies of scale occur outside of a firm and within an industry.

• Thus, when an industry's scope of operations expands due to the creation of a better transportation network, resulting in a decrease in cost for a company working within that industry, external economies of scale are said to have been achieved

ECONOMIES OF SCALE

Constant return to scale

Diseconomies of scale

REASONS FOR ECONOMIES AND DISECONOMIES OF SCALE

Economies of scale

• specialization in production, sales, marketing, research and development, and other areas.

Diseconomies of scale

• Size and disproportion

Economies of Scope

• A production process exhibits economies of scope when the cost of producing multiple goods is less than the aggregate cost of producing each item separately

• Sources for economies of scope: – a single production process yields multiple

outputs

– The consumption of many clusters of goods and services is complementary.

Isocost

• An isocost line (equal-cost line) is a Total Cost of production line that recognizes all combinations of two resources that a firm can use, given the Total Cost.

• Moving up or down the line shows the rate at which one input could be substituted for another in the input market

TC = (WL) + (RK)

• TC= Total Cost, W= Wage, L= Labor, R= Cost of

Capital, K= Capital

Isoquants and Isocosts

• The isocost line is combined with the isoquant map to determine the optimal production point at any given level of output.