INTRODUCTION

• When a producer makes his decision of “how to produce” it is necessary for him to determine the factors necessary to produce different levels of output,the prices to be paid for acquiring those factors and physical conditions of production.costs of production is thus very important for determining the output that will be produced.

CONCEPT OF COST

ACCOUNTING COST

• It includes all costs incurred by the firm in acquiring various inputs from the outside suppliers.

• Eg.purchase of raw material,payment of wages,rent on hired land.

• Also called explicit/nominal cost.

ECONOMIC COST• Sum of explicit and implicit costs.• Implicit costs arise when certain inputs are owned by

the employer himself and employed in the production process.

• Eg.Interest on capital.here capital contributed by the enterpreneurs himself.

• They are implicit because if the money capital contributed by enterpreneurs in his own firm,had been invested else where say bank,it would have earned a certain amount of interest.

• Economic cost=accounting cost(explicit cost)+implicit cost

OPPORTUNITY COST

• Benham said “the opportunity cost of anything is the next best alternative that could be produced instead,by the same factors or by an equivalent group of factors,costing the same amount of money.”

• When a factor unit is employed for one use,the next best use for which this factor could have been put is forgone.

• OR simply it is the cost of displaced alternatives.

• Suppose a piece of land can be employed for growing the wheat crop or rice crop.let the farmer using plot of land can produce either 80 quintals of rice or 60 quintals of wheat.if he produces only rice he can’t produce wheat.

• Also he can produce any combination of the two crops on the production possibilty curve AB.

ILLUSTRATION

• Assuming that he is producing 35 quintals of rice and 40 quintals of wheat by operating at point C.

• Now he decides to operate at point D.In this,he has to increase the production of rice by 15 quintals to make it to 50 quintals and to reduce the production of wheat from 40 quintals to 30 quintals.

• Therefore the opportunity cost of 15 quintals of rice is 10 quintals of wheat forgone.

TOTAL COST

• It is the actual cost that must be incurred to produce a given quantity of output in the short run, using both fixed & variable inputs.

OR • It is the sum of total variable & total cost. TC = TVC + TFC

TOTAL FIXED COSTS

• It refers to the total obligations incurred by the firm per unit of time for all fixed inputs.

OR• It is the sum of short run fixed costs that must be paid regardless of

the level of output produced.• TFC are those costs which in total do not vary with the changes in

output.• These are fixed in nature as they need to be incurred irrespective of

the size of the output.• Even if the level of output is zero, they will still have to be incurred.• They are also called OVERHEAD COST, as they are common to all

units produced & not specific to anyone of them.• Some economists call them Supplementary Costs, while some

others have called it as Unavoidable Costs.

EXAMPLES OF TOTAL FIXED COSTS

• Salaries of administrative staff.• Depreciation of machinery.• Property taxes.• Insurance fee.• Payment of factory rent.• Payment of interest on bonds etc.

GRAPHICAL REPRESENTATION OF TFC

Y

TFC

COST IN RUPEES

X OUTPUT IN UNITS

TOTAL VARIABLE COSTS(TVC)

TVC is the sum of the amounts spent for each of the variable inputs used.

OR They are the costs that are incurred on the employment of variable

factors, whose amount can be altered in the short run.• Variable costs vary directly with the change in output level.• In the short run ,when the firm wants to increase its output, it will

have to employ additional variable factors, therefore, variable costs will increase when output rises & vice –versa.

• TVC is zero, when output is zero it increases with an increase in output though the rate of increase is not constant.

• Some economists call it as PRIME COSTS,DIRECT COSTS OR AVOIDABLE COSTS.

EXAMPLES OF TVC

• COST OF RAW MATERIAL.• COST OF LABOUR.• COST OF FUEL ,ELECTRICITY.• COST OF TRANSPORTATION etc.

Average and Marginal Cost curves

• Average Fixed cost (AFC)Total fixed cost divided by output.

AFC=TFC/Q• Average Variable cost (AVC)

Total Variable Cost divided by outputAVC=TVC/Q

• Average total cost (ATC)short total cost divided by output

ATC= TC/Q• Short run Marginal cost (SMC)

change in either total variable cost or total cost per unit change in output

SMC = ΔTVC/ΔQ = ΔTC/ΔQ Since TC = TFC + TVC ,

SMC = ΔTC/ΔQ =ΔTFC/ΔQ + ΔTVC/ΔQ = 0 + ΔTVC/ΔQ = ΔTVC/ΔQ

Short-Run Cost schedules for XYZ ltd.

Output (Q)

TFC TVC TC AFC AVC ATC SMC

0 $6000 $0 $6000

100 6000 4000 10000 $60 $40 $100 $40

200 6000 6000 12000 30 30 60 20

300 6000 9000 15000 20 30 50 30

400 6000 14000 20000 15 35 50 50

500 6000 22000 28000 12 44 56 80

600 6000 34000 40000 10 56.7 66.7 120

Average and Marginal Cost curves

OBSERVATIONS1. AVC, ATC and SMC all the three curves first decrease, reach their

minimum and then rise.2. SMC crosses AVC and ATC at their respective minimum values.3. SMC lies below both AVC and ATC till these curves decline; SMC lies

above them when they are rising.

Total Cost Curves

Average and Marginal Cost

Average Fixed Cost (AFC) :- Total Fixed Cost divided by output

AFC = TFC/QAverage Variable Cost (AVC):-Total Variable Cost divide by output

AVC = TVC/QAverage Total Cost (ATC) :- Total cost divided by output

ATC = TC/Q

TC = TVC + TFC = AVC + AFC Q Q

ATC =

Marginal Cost :-The change in either Total Variable Cost or Total Cost per unit change in output ∆TC ∆TVC ∆TFC ∆TVC ∆TVC ∆Q ∆Q ∆Q ∆Q ∆Q

SMC = = + = 0 + =

Relation Between ATC,AVC,AFC And SMC1. AFC declines continuously, approaching both axes

asymptotically(as shown by the decreasing distance between ATC and AVC) .

2. AVC first declines, reaches a minimum at Q2,and rises thereafter. When AVC is at its minimum, SMC equals AVC.

3. AVC first declines, reaches a minimum at Q3, and rises thereafter. When ATC is at its minimum, SMC equals ATC.

4. SMC first declines, reaches a its minimum at Q1, and rises thereafter. SMC equals both AVC and ATC when these curves are at their minimum values.

5. SMC lies below both AVC and ATC over the range for which these curves decline; SMC lies above them when they are rising.

figOutput (Q)

Cost

s ($

)

AFC

AVC

MC

Q1

AC

Q3

Q2

General Short-Run Average and Marginal Cost CurvesGeneral Short-Run Average and Marginal Cost CurvesGeneral Short-Run Average and Marginal Cost CurvesGeneral Short-Run Average and Marginal Cost Curves

AVERAGE AND MARGINAL COST CURVES

OUTPUT TFC TVC TOTAL COST (TC)

AFC= TFC/Q

AVC= TVC/Q

ATC= TC/Q

SMC= ∆TC/∆Q

0 $6000 $0 $6000 - - -

100 6000 4000 10000 $60 $40 $100 $40

200 6000 6000 12000 30 30 60 20

300 6000 9000 15000 20 30 50 30

400 6000 14000 20000 15 35 50 50

500 6000 22000 28000 12 44 56 80

600 6000 34000 40000 10 56.7 66.7 120

AVERAGE AND MARGINAL COST CURVES

COST

($)

UNITS OF OUTPUT(Q)

Q3

Q2Q1

LONG RUN AVERAGE COST

• Long-run average cost (LAC) is total cost divided by the quantity of output when the firm can choose a production facility of any size.

LAC=LTC/Q• The LAC curve describes the behavior of average cost as the

plant size expands. Initially, the curve is negatively sloped, then beyond some point, it becomes horizontal.

OutputO

Cost

s

LRACEconomiesof scale Constant

costs

Diseconomiesof scale

long-run average cost curve

long-run average cost curves

OutputO

Cost

s

LRAC

Economies of scale: a situation in which an increase in the quantity

produced decreases the long-run average cost of production.

When economies of scale are present, the LAC curve will be negatively sloped.

OutputO

Cost

s LRAC

A firm experiences diseconomies of scale when an increase in output leads to an increase in

long-run average cost—the LAC curve becomes positively sloped.Diseconomies of scale may arise for two reasons:

Coordination problemsIncreasing input costs

long-run average cost curves

OutputO

Cost

s

LRAC

CONSTANT COST:The minimum efficient scale describes the output at which economies of scale are exhausted and

the long-run average cost curve becomes horizontal.

long-run average cost curves

LONG RUN MARGINAL COST

LMC curve shows the minimum amount by which cost is increased each time, when output is increased.

LMC=change in LTC/change in output

LMC curve can be defined as the locus of those points on the SMC curves which corresponds to the optimum plant size for each output

OutputO

Cost

s

LRMC

LRAC

The relationship between AC and MC curves: When MC < AC, AC is falling. When MC > AC, AC is rising. When MC = AC, AC is at its minimum (neitherrising nor falling)

RELATIONSHIP BETWEEN LAC AND LMC

Case studyTopic: general theory on cost behavior

“Huxley maquiladora” is a large firm in defense industry. Its planning to shift production from its California plant to mexico.There are 3 options:1)Negotiate subcontract : Mexican firm will manufacture steering column components as per Huxley specifications & Huxley will pay Mexican firm.2)Shelter operation : Mexican firm should allow Huxley to maintain control over production so Mexican firm provide import/export services.3)Setting wholly-owned subsidiary : Huxley select a plant site, staff its own employees, implement its own procedures, obtain permits.

COST BEHAVIORManager want to determine relevant cost so as to make profit maximizing decisions.Fixed costs does not vary with production Variable cost increases as output increasesIn case of Huxley :Case 1:if company select option 1,no fixed costsCase 2:if company select option 2,fixed costs include construction, site lease, startup expenditure, plant manager salary, corporate taxes & other expenses.Case 3:if company select option 3,mostly fixed cost are construction, site lease, startup expenditure, plant manager salary, corporate tax, consulting fee,mexican legal fee.

PRODUCTION & COST THEORY*production theory: relation between inputs & outputs*cost theory: relation between production & costsin Huxley case, most employees at California plant were women & plant experienced high employee turnover as working with metals was dirty so it was suggested that Mexican women workers might be more productive so lower unit costs will be introduced.

Table 1:correlation between production theory and cost theory during these stages of production

LABOUR TOTAL O/P MARGINAL PRODUCT

TFC($) TVC($) TOTAL COST($)

0 0 10 $0 $10

1 1 1 10 10 20

2 4 3 10 20 30

*Let FC=$10/hr ,if worker is paid $10/hr then TC of producing 1 unit=$20If 2 workers,4 units are produced so TC=$30 so TVC rises from $10 to $20.* Due to increase in production firm comes on law of diminishing return ,as marginal product of each additional input diminishes more input needed for producing same output ,FC do not change as production increases but TVC rises.

Table 2 : relationship between production and costs during once diminishing returns set in

labor Total o/p Marginal product

TFC($) TVC($) TOTAL COSTS($)

0 0 10 0 10

1 1 1 10 10 20

2 4 3 10 20 30

3 6 2 10 30 40

4 7 1 10 40 50

As FC is not changing,VC rises as production rises, TV for producing 4 units is 20$,for 6 units is 30$,for 7 units is 40$.When o/p increases by 75% TVC increases by 100%

total fixed and total variable costs

TFC TVC 40 total fixed cost 10$ 30

20 10 1 4 6 7 1 4 6 7

quantity quantity

Total cost

50 TC

40 TVC

30 TFC

10

1 4 6 7

As inputs are initially added, total cost rises as a relatively slow rate. Once diminishing returns in production sets in, total costs begin to accelerate

average fixed cost, average variable cost, and average total cost

TOTAL O/P

TFC($) AFC($) TVC($) AVC($) TOTAL COST($)

AVERAGE TOTAL COST($)

0 10 0 10

1 10 10 10 10 20 20

4 10 2.5 20 5 30 7.5

6 10 1.6 30 5 40 6.6

7 10 1.4 40 5.7 50 7.1

as output increases, AFC decline because the TFC are spread out over more units of output. If labor to be the only variable cost, when experiencing increasing marginal product, AVC(i.e. variable cost per unit) decreases from $10 to $5. During the diminishing returns stage of production, AVC rises. The same can be said for average total cost (the sum of both total variable and total fixed costs divided by the number of units of output). Average total cost decreases as marginal product increases, but eventually rises at some point after the law of diminishing returns sets in.

AVERAGE COST CURVES

$ ATC

AVC

AFC

QUANTITY

MARGINAL COST

. Marginal cost refers to the change in costs resulting from a given change in outputtotal cost associated with six units is $40 and the total cost of producing seven units is $50. If thefirm decides to produce the seventh unit, its expenses will rise by $10.The problem with average total cost is that it represents an average; unless marginal cost is constant, average total cost does not represent the cost of production for the output under consideration. Because fixed costs do not vary with output, marginal costs are, by definition, variable costs. $ MC

QUANTITY

• when output increased from 0 to 1 unit, TVC increased by $10 (the cost of the worker’s labor). The cost increase reflects the need to hire the first worker. Because fixed costs are incurred even if the first unit is not produced, the marginal cost of the first unit is the added cost of a worker, or $10. Increasing marginal product was encountered when the second worker was hired. Here, an additional worker resulted in three additional units of output (i.e. production increased from one unit to four units). The added variable cost was $10. The cost of the additional production, therefore, was $3.33/unit ($10 divided by three additional units of output). Note that marginal cost decreased during this stage of production.

• Diminishing returns began when the third worker was hired. Output increased by two units (from four units to six units) whereas TVC increased by $10. Consequently, the marginal cost of increasing production from four units to six units is $5/unit ($10 divided by two units). When the fourth worker was hired, production increased by only one unit. Hence, the marginal cost of the seventh unit is $10. Note that once diminishing returns sets in, marginal cost increases. In sum, rising marginal product results in falling marginal costs whereas decreasing marginal product leads to rising marginal costs

LABOR TOTAL O/P TVC($) MC($)

0 0 0

1 1 10 10

2 4 20 3.3

3 6 30 5

4 7 40 10

CONCLUSIONS• 1. A firm’s costs consist of fixed and variable costs. Fixed costs do not vary with production.

Variable costs increase as production increases.• 2. Total fixed costs remain constant as output increases. Total variable costs and total costs

rise at varying rates. As marginal product increases, total variable costs and total costs rise at a slower rate relative to increases in output. During diminishing returns to scale, total variable cost and total cost rise at a faster rate than output.

• 3. Average costs convey more useful information to the decision-maker. Average fixed costs decrease as production rises because the firm’s fixed costs become spread out over more units of output. Average variable costs and average total costs decrease as marginal product increases, but eventually increase at some point after the law of diminishing returns sets in.

• 4. The most important cost for decision-makers is marginal cost, which refers to the cost of producing additional output. Marginal cost falls during increasing returns to scale and rises during decreasing returns to scale.

• 5. The output at which average total cost is minimized is called minimum efficient scale. A firm does not necessarily maximize profits by producing at this level. However, it represents the lowest price the firm can charge and remain in business.

• 6. With respect to selecting a country to locate one’s manufacturing facilities, low wage rates in a country often reflect an abundance of unskilled workers, inadequate infrastructure, and/or political instability. Hence, the firm should base its decisions on unit costs rather than hourly costs.

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