THEORYOFCOSTS

Cost
sofpr
oduct
ion

 Thet er m cost sisasacr if

iceincur edbyt hebusi nessast heyproducegoodsand
serviceswhi chcanbef inancialornonf i
nanci al
.
 Whenout puti sproducedcost sar eincurred.
 Thet heor yofcost sisconcernedwi thallexpensest hataf ir
mi ncursdur i
ngthe
product ionpr ocessandhowt heseexpensesar er el
ated.
Ty
pesofCost s
(i
)Oppor tunitycost
 Ref erst ot henextbestal t
er nativ
ef orgone, whenaf ir
m choosest ouse
resour cesi naparti
cularway .
 I not herwor dsifafirm user esour cesi naayt henitforgoest hebenefitof
usi ngt her esourcesinsomeot herway .
 E. g.af ir
m usesi tsownpr emi sesinpr oducingcement ,
itforgoest hebenef
it
ofal lrent alsi
twoul dhav erecei vedifot herfi
rmswoul dhav er endedatthe
pr emi ses.

(
ii
)FixedCost s
 Acostofpr oduct iont hatdoesnotchangeov eragi v enrangeofquant i
ty.
 AFCi sincur redasar esultofbuy
ingfixedf actorsofpr oducti
on
 Fixedcost sar eindi r
ectlyrel
atedtoquant i
tyofabusi ness.
 Theyarer eferredt oassetupcost s,t
heyar eincurredev enifoutputiszero
andinot herwor dsf ixedcostswon’tbezer oanddonotchangeasout put
changes.
 Fixedcost sar etot al
lyindependentofout put,thatis,theydonotv arywith
output.
 Fixedcost shav et obepai doutevenifthef actorystopspr oducti
on;hence
theyaret hef irm’ sov erheads.
 Fixedcost si ncluder entpaidfort
heuseofpr emi sest hatisproducti
onorno
producti
onr enthast obepai dandint
er estpaidonl oan,contr
actualpayment
forequipment .

cost
s

FC

out
put
102030

(
ii
i)
AverageFi xedCost(AFC)
 Anav eragef i
xedcostistot
alfixedcostdivi
dedbyoutput.AFC=TFC
Q
 AFCi stheamountofmoneyt hateachunitofQproducedshouldcontr
ibute
towardst hepay mentoffi
xedcost s.
 Theav eragefixedcostdecli
nesorf al
lsconti
nuosl
ywithi
ncreasesinoutput.
 Mathemat i
call
y,theaver
agefixedcostcurveisarect
angularhyper
bol
a, t
hat
 i
s,iti
sasy mptot
ictotheoutputaxi
s( i
t
 approachestheoutputaxi
swithoutevercut
ti
ngt
heaxis)
.
 Thisisduetototal
fixedcostwhichishel
dconst
antwhenout
puti
s
i
ncreasing.

(
iv)
Variabl
eCost s(
TC)
 Variabl
ecost sareincurredbyt hef irm ont hevari
abl
efactorinputssuchas
rawmat erialsandlabour.
 Theyar edirectcostsofpr oduct i
on.
 Largervolumesofout put,requireslargerv ari
abl
efact
orinput.
 Thusv ari
ablecostsv aryindi r
ectpr opor ti
ontooutput
.
 Theyar ezerowhenout puti szeroandr isedir
ectl
ywit
hout pute.g.poweror
energychar gestooper atethef actory,fuel,wagespai
dtoshopf l
oorworker
s
andt hecostofbuy ingrawmat er i
als.

Av
erageVar i
ableCost( AVC)
 Av eragev ari
ablecosti stot alvariablecostdi vi
dedbyout put.AVC=TVC
Q
 Theyar eequal tototal v
ariablecostdi vi
dedbynumberofuni t
sproduced.
 E. g.supposet otalvariablecost sar e1000andout putis20unit
st henAVC
1000di v i
dedby20equal st o$10peruni t
.
 Atf i
rst,i
ncreasesi nout putr esultindecr easesinav eragevari
ablecost,
bey ondapoi nt,theyr esultinhigherav er
agev ariablecost.
 Thusav eragev ari
ablecost sdecl inesi ni
tial
ly,
reachesami ni
mum, andt
hen
i
ncr easesagai n,givi
ngt hem agr aphi calU-shape.

Tot
alCosts(
TC)
 Istheoverall
costofproduci
ng.
 Duringtheproduct
ionprocess,
thef
irm combinesfi
xedandvariabl
ef act
orsto
pr
oduceitsoutput
.
 Bydef i
nit
ionfi
xedfact
orinputr
emainsconstantasoutputi
sincreasedwhile
 vari
ablefact
orinputchangesindir
ectproport
iontooutput.
 Theamountspentonpr oduci
ngagi v
enamountofapr oducti
scal
ledtot
al
cost(TC).
 Totalcostsar
ef oundbyaddingtogethert
otalvar
iabl
ecosts(TVC)andtot
al
fi
xedcost s(
TFC)
 Isthesum of TC=TVC+TFC

Av
erageTotalCost(
ATC)
 Theav eraget
otalcosti
stotalcostdi
vi
dedbyoutput.
 Theav eraget
otalcostequal
st hesum ofav
eragef
ixedcostandav
erage
v
ari
ablecost.
 Thiswecanst ateas:-ATC=AFC+AVC

Mar ginalCosts( MC)

Themar ginalcosti
st headdi
ti
ontot ot
al costresul
ti
ngfrom t
hepr oduct
ionofan
additionalunitofoutput.
I
not herwor ds, margi
nalcosti
stheadditionalcostofproduci
ngonemor euni
tof
output .
I
tr eferstothechangei ntot
alcostthatresultsfrom achangeinoutputbyoneunit
.
Algebr ai
call
y:MC=TCn-TCn-1, thati
s,changei ntotal
costdivi
dedbychangein
output .
MC= Changei nTVC
Changei noutput

MPi sthemar ginal pr

oductofthevariableinput .SinceMPgener al
l
yincreases,
attainsamaxi mum anddecl i
neswithi ncreasei nout put,
itfoll
owst henthatmarginal
costnor mallydecr eases,
att
ainsami ni mum, andt henincreases.Thisexplainst
he
factt hat
themar gi
nal costscur veisami r
rorreflecti
onoft hemar ginalproductcurve.
Themar ginal cost( MC)andav er
agev ar i
ablescost( AVC)cur v
esar emirrorimages
oft hemar ginal product(MP)andav eragepr oduct( AP)cur v
esr espect
ively
)

7.
4ShortRunAverageCosts(SRAC)andLongRunAv er
ageCosts(LRAC)
 Av er
agecostscanbedividedintoshor tr
unandlongrunaver
agecosts.Both
SRACandLRACar eU-shaped.
 Howev ert
heSRACar enar r
owt hant heLRACwhichareopenU-shaped.The
SRACi sU-shapedduetotheinfluenceoft hel
awofdimini
shi
ngmar ginal
retur
ns.WhiletheLRACisopenU- shapedduetoeconomicanddiseconomies
ofscale.
  TheLRACcur v
eisdownwar dslopi
ngasar esul
tofeconomiesofscaleand
upwardsl
opingduetodiseconomiesofscalewhil
eincr
easingretur
nsto
scal
econt
ributet
othefall
ingporti
onoftheSRACanddi minishi
ngretur
nst
o
scal
econt
ributet
otheupwar dslopi
ngporti
on.

Der
ivat
ionoft heLongRunAv erageCur ve
 TheLRACi smadeupwi t
haser i
esofshor trunav eragecostcur ves.The
LRACi sapl anni ngcur vewhi chenv elopesv ar i
ousSRATCcur ves.Itisderi
ved
from t heSRATCi nthef oll
owi ngway :-
 Assumet hr eepl antsi zest owhi chaf irm canadj ustint helongr untomeeti ts
product ionr equi rement s,thatis, smal lmedi um andl argepl antas
represent edbyt heirshor t-runav eraget otalcost sdemot edbySRATC1,
SRATC2andSRATC3r espect ively.
 Thepr oduceout putQ1, thef i
r m shoul duseasmal lplantsoast oincur
mi ni
mum cost .Thepl antsi zeisr epresent edbySRATC1.
 Topr oduceout putQ2, theopt i
mum pl antsizei sgivenonSRATC2.Howev erit
canusesmal lplantt opr oducet hesameout putbutwi llmeanhi ghercostsof
product ion( C2)t hani fitusest hemedi um pl ant(SRATC2)wher ei ti
ncurs
costsC1.
 Theopt imum pl antsi zef orQ3i sSRATC3.Joi ni
ngal ltheseopt i
mal point
swi l
l
givet heLRACcur v
e.
 I tisimpor tantt onot et hatl ongr uni sapl anni nghorizon.Whi leoperati
ngin
theshor t-
run, thef ir
m mustcont inuallybepl anningaheadanddeci dingit
s
strategyi nt hel ongr un.
 I tsdeci sionsconcer ningt hel ongr undet ermi nethesor tofshortrunpositi
on
thefirm wi ll occupyi nt hef uture.
 Onceadeci sionont hepl antsi zei smade, thef i
rmi sconf rontedwi t
hashor t
runsi tuation, sincet het ypeandsi zeofequi pmenti s,toaconsi derableextent
,
frozen.

7.
4.2Techni calpr ogress
 Whi lewef ocusont heshapeoft heSRACandt heLRACcur v
es,itisalso
i
mpor tantt oconsi derthefactorst hatmaycauset heshift
ingofthecost
cur v
es.
 Themaj orcausei schangesi npr oductivi
ty.
 Thepr oduct i
vi
t yofwor kersdependsupont hei
rinnateabil
iti
es,cult
ural
backgr ound, andl ev el
sofeducat ionandt raini
ngamongot herfactor
s.
 Technol ogyi nt hef orm ofnewmachi nesandnewpr oduct
iontechniques
playsapi v otalrolei nuti
li
zi
ngexi stingskil
l
s.
 Te chnologyenabl esaf irmtoproducet hesameout putwithfewerinputsora
l
ar gerout putwi ththesamei nputs–whi chisanot herwayofsay ingthatit
l
ower
spr
oduct
ioncost
s.