Professional Documents
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NATURE OF COSTS
C = f (S, O, P, T……)
Where:
C: Cost of O/P
S: Size of plant
O: level of O/P
P: price of I/Ps used in production
T: nature of technology
SHORT-RUN COST FUNCTIONS
0 60 0 60 - - - -
1 60 20 80 60 20 80 20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
Cost 250
Total Cost Function
200 TC
150
TVC
100
TFC
50
0 Output
0 1 2 3 4 5 6
Cost
90
80 Per Unit Cost Function
70
60 MC
50
40
AC
30 AVC
20
10 AFC
0 Output
0 1 2 3 4 5 6
SHORT RUN COST FUNCTION: IMPORTANT
OBSERVATIONS
Total
In order to illustrate
Input
the relationship,
(L) Q (TP) MP
consider the
0 0
production process
1 1,000 1,000
described in table
2 3,000 2,000
3 6,000 3,000
4 8,000 2,000
5 9,000 1,000
6 9,500 500
7 9,850 350
8 10,000 150
9 9,850 -150
SR RELATIONSHIP BETWEEN PRODUCTION & COST
MC
TOTAL TVC (∆TVC/
Total variable
I/P (L) Q (TP) MP (wL) ∆Q)
cost (TVC) is
the cost 0 0 0
associated with 1 1000 1000 500 0.5
the variable
2 3000 2000 1000 0.25
input, in this
case labor 3 6000 3000 1500 0.16
Assume that 4 8000 2000 2000 0.25
labor can be 5 9000 1000 2500 0.5
hired at a price
6 9500 500 3000 1
(w) of Rs 500
per unit 7 9850 350 3500 1.4
8 10000 150 4000 3.33
9 9850 -150 4500
SR RELATIONSHIP BETWEEN PRODUCTION & COST
TP and TVC are mirror images of each other
When TP increase at an increasing rate, TVC increase at a
decreasing rate
RELATION B/W MP & MC
Total
When MP is
Input TVC
increasing, MC is
decreasing (L) Q MP (wL) MC
When MP is 0 0 0
decreasing, MC is 1 1,000 1,000 500 0.50
increasing 2 3,000 2,000 1,000 0.25
Also when MP= 3 6,000 3,000 1,500 0.17
AP at max AP, 4 8,000 2,000 2,000 0.25
MC = AVC at min 5 9,000 1,000 2,500 0.50
AVC 6 9,500 500 3,000 1.00
7 9,850 350 3,500 1.43
8 10,000 150 4,000 3.33
9 9,850 -150 4,500
SHORT-RUN COST FUNCTIONS
Marginal Cost
TC/Q = TVC/Q = (w L)/Q
= w = w
Q/L MPL
EXERCISE
Internal External
Quantity discounts
Specialization
Indivisibility Lower cost of capital
Advertising
transportation
Team work
Sales promotion
DISECONOMIES OF SCALE
CRS:
A proportional increase in all I/Ps increases O/P by same
percentage as costs
Costs increase at a constant rate
DRS:
A proportional increase in all I/Ps increases O/P by a
smaller percentage than costs
Costs increase at an increasing rate
EXAMPLE: IDENTIFYING RTS
UNITS OF UNITS OF TP
L K
1 100 100
2 200 220
3 300 350
4 400 500
5 500 625
6 600 750
7 700 860
8 800 940
9 900 1000
EXAMPLE: IDENTIFYING RTS
UNITS UNITS %INCRS TP %INCRS RTS
OF L OF K IN L & K IN TP
1 100 - 100 - IRS
Q = TFC +
P - (AVC)
= TR - TC = 0
TR = TC
QBE = TFC
(P - AVC)
EXAMPLE
Fixed cost = Rs 10,000
Price = Rs 20
AVC = Rs 15
How much O/P should the firm produce in order
to break even?
Also : TR = 20Q
TC = 10,000 + 15Q
TR = TC
LINEAR BREAKEVEN ANALYSIS
P = 10
TFC = 200
AVC = 5
LINEAR BREAKEVEN ANALYSIS: SHORTCOMINGS
Assumes constant prices
Assumes constant average variable costs
EXCERCISE
Petersen & Lewis Page # 239: Breaking even on
Microcomputer software
(3) OPERATING LEVERAGE
A firm is said to be highly leveraged if FC are
large relative to variable cost.
NOTE:
Positive: economies of scope
Negative: diseconomies of scope