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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.
ILLUSTRATION
• 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.
• 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

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 output
AVC=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 TFC TVC TC AFC AVC ATC SMC
(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
OBSERVATIONS
1. 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/Q
Average Variable Cost (AVC):-Total
Variable Cost divide by output
AVC = TVC/Q
Average Total Cost (ATC) :- Total
cost divided by output
ATC = TC/Q

ATC =TC = TVC + TFC = AVC +


AFC
Q Q
Marginal Cost :-The change in
either Total Variable Cost or Total
Cost per unit change in output
∆TC ∆TVC ∆TFC
MC = = +
∆TVC ∆TVC=0 + =
∆Q ∆Q ∆Q
∆Q ∆Q
Relation Between ATC,AVC,AFC
And SMC
1. 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.
General Short-Run Average and Marginal Cost
Curves
MC
AC
AVC
Costs ($)

Q3

Q2

Q1
AFC

Outputfig(Q)
AVERAGE AND MARGINAL COST CURVES

OUTPU TFC TVC TOTAL AFC= AVC= ATC= SMC=


T COST TFC/Q TVC/Q TC/Q ∆TC/∆Q
(TC)
0 $6000 $0 $6000 - - -
100 6000 4000 10000 $60 $40 $100 $40
200 6000 6000 12000 30 30 60 20
300 6000 9000 15000 20 30 50 30
400 6000 14000 20000 15 35 50 50
500 6000 22000 28000 12 44 56 80
600 6000 34000 40000 10 56.7 66.7 120
COST($)
AVERAG
E AND
MARGIN
AL COST Q3

CURVES
Q1 Q2

UNITS OF OUTPUT(Q)
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.
Costs long-run average cost curve

Economies Diseconomies LRAC


of scale Constant
of scale
costs

O Output
long-run average cost curves
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.
Costs

LRAC

O Output
long-run average cost curves
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 problems
Increasing input costs

LRAC
Costs

O Output
long-run average cost curves
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.
Costs

LRAC

O Output
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 cur
which corresponds to the optimum plant size for each output
RELATIONSHIP BETWEEN LAC
AND LMC
The relationship between AC and MC curves:
When MC < AC, AC is falling.
When MC > AC, AC is rising. LRMC
When MC = AC, AC is at its minimum (neither
rising nor falling)

LRAC
Costs

O Output
Case study
Topic: 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 BEHAVIOR
Manager want to determine relevant cost so as to
make profit maximizing decisions.
Fixed costs does not vary with production
Variable cost increases as output increases
In case of Huxley :
Case 1:if company select option 1,no fixed costs
Case 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 &
costs
in 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/PMARGINALTFC($) TVC($) TOTAL


PRODUCT 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=$20
If 2 workers,4 units are produced so TC=$30 so TVC rises from $10 to $20.
* Due to increase in production firm comes on law of diminishing return ,as
marginal product of each additional input diminishes more input needed for
producing same output ,FC do not change as production increases but TVC
rises.
Table 2 : relationship between production and costs
during once diminishing returns set in
labor Total o/p Marginal TFC($) TVC($) TOTAL
product COSTS($)

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
As inputs are initially added,
40 TVC total cost rises as a relatively
slow rate. Once diminishing
30 TFC returns in production sets in,
total costs begin to accelerate
10

1 4 6 7
average fixed cost, average variable cost, and average
total cost
TOTAL TFC($) AFC($) TVC($) AVC($) TOTAL AVERAG
O/P COST($) E TOTAL
COST($)

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
7as output increases,
10 1.4decline because
AFC 40 the5.7 50 out over
TFC are spread 7.1more
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 output
total cost associated with six units is $40 and the total cost of producing seven units is $50. If the
firm 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
LABOR TOTAL O/P TVC($) MC($)

0 0 0
1 1 10 10
2 4 20 3.3
3 6 30 5
• when output4 increased from
7 0 to 1 unit,40 TVC increased 10by $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
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.
THANK YOU!!!

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