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Companies
Types of Cost
Fixed Cost:
•The cost of employing fixed factors.
•Fixed Cost does not vary with the level of output in the short run.
•Fixed cost remains the same no matter how much output the firm
produces.
•Fixed cost must be paid even if there is no output.
•cost incurred in hiring fixed factors whose amount can not be
altered in the short run.
•Fixed cost include contractual rent, insurance fee, Property
taxes, Machinery expenditure, Expenditure on a plant,
expenditure on Chairs, tables, fans and AC, payment on borrowed
capital, salary of the top management(that are fixed by contract
and must be paid over the life of the contract) whether the firm
produce or not.
•The only way the firm can eliminate fixed cost by going out of
business or shutting down the factory.
Fixed Cost:
• These costs are those that remain unchanged as the output
level of the firm changes. It does not matter what level of
output the firm produces (even zero output makes no
difference), any cost which is a fixed cost will remain the
same.
• Examples of fixed costs: Rent, Interest on loans, Insurance,
Depreciation
• Fixed costs can be represented graphically and this would
appear as follows:
Variable cost
Social Costs: The Cost that the Society bears because of Companies
activities. Air pollution, Noise, Garbage etc are the costs for Societies.
Sunk Costs: Expenditure that has been already made and can’t be
recovered.
•refers to the cost that a firm cannot recover from the expenditure it
has made
•e.g. the machine purchased is designed only for specific work, with
no alternative use.
•Accounting costs are those costs that have a specific monetary value you
need to pay in order to receive the associated benefit.
•Therefore, the accounting costs involve cash payments that the firm
makes.
•Appear on the financial statements of a firm
•Accounting costs are also called explicit costs
Economic Costs:
Economic Costs:
Economic cost is the combination of explicit cost and implicit cost.
The economic cost of a college is the accounting cost plus opportunity
cost.
Semi variable cost: Electricity cost. If you are not using electricity, you
are paying the minimum charge. If you are using more you have to pay
more.
Actual costs
•Actual costs are those costs, which a firm incurs while
producing or acquiring a good or service like raw materials,
labour, rent, etc.
•It is also called acquisition costs or outlay cost
Cost function describes the relationship
between cost and output.
Output
=?
Measure of costs
Output changes Cost changes
Change in cost can be expressed in three ways:
Total cost (TC)
Average cost (AC)
Marginal cost (MC)
Total cost (Total Fixed Cost)
is the whole amount of payments to all factors used
in producing a given amount of output (Q). Total cost is
the combination of total fixed cost and total variable
cost. That is TC=TFC+TVC.
Total fixed cost (TFC): is the whole amount of
payments to fixed factors.
TFC
average fixed cost: AFC
Q
Marginal Cost
• Long Run: Quite Enough a time to vary all the Factors with the
Change in the output level. Hence, in the long run, all cost is
variable.
• In long run, Cost means the cost incurred in hiring the variable
factors because all factors are variable in long run
Relationship between short run production function and short
run cost
Total
Relationship between short run production function and short
run cost
Cost
Important Points
ATC
C C
B
Average Total Cost
TC TVC TFC
AC AVC AFC
q q
Some Points:
In the beginning, AVC and AFC AC
Fall, so AC Falls A
V
AVC rises but AFC steeply C
falling outweighs the rise in AVC
which leads to fall in AC
AVC rises steeply offsetting the
fall in AFC which leads to rise in AFC
AC
Output
Marginal Cost
• Marginal Cost is addition to total cost because of the
production of one additional unit of output
TC
MC
q
Long run marginal cost curve: curve showing the changes in long run
total cost as output increased by 1 unit
Long run Average Cost Vs. Short run Average
cost
LTC/
Reason behind the shape of the LTC
LTC curve increases at a diminishing rate up to point A that is
because of increasing return to scale. Increasing return to scale
means when you are increasing the inputs, the output
increases more than proportionately. More clearly, the output
is more than double while doubling the inputs. Keeping the
input prices constant, as output is increasing more in
comparison to inputs, the per unit cost diminishes. Up to point
A, the company enjoys economies of scale. After point A,
LTC increases at an increasing rate. That is because of
decreasing return to scale. Decreasing return to scale means
output increases less than proportionately in comparison to
inputs. Keeping the input prices remaining same/constant, as
output grows less than proportionately compared to inputs, the
per unit cost increases.
Long Run Average Cost (LAC)
• LAC is the long run total cost divided by the level of output.
• In long run, a company has different plant size having
corresponding short run average cost curves
• LAC depicts the least possible average cost for producing all
possible levels of output.
• LAC is thus the locus of the tangency points with short run
average cost curves
Why LAC is U-shaped in General?
• Each segment of the long run average cost curve reflects a
particular returns to scale.
- Falling part of LAC implies increasing returns to scale
(Economies of scale)
Figure A
A
Point A to B corresponds to
increasing return to scale.
Increasing return to scale means
B decreasing cost.
Figure B
Figure C
Constant return to scale means cost per units are the same for any level of output.
Decreasing return to scale means increasing cost.
By joining the Figure A, B and C , we will get LAC. Three possible shapes of LAC (U
shape, L shape and constantly declining)
L-Shaped Average Cost: Frequently Confronted
Cost will be
reduced as both
Per unit cost
management and
labor become
more familiar
with the
production
process
Cumulative output
Learning curve continues
• Learning curve describes the relationship between a firm’s cumulative output
and the amount of inputs needed to produce each unit of output.
As management and labour gain experiences with production, the firms marginal
and average costs of producing a given level of output fall for following reasons.
Worker often taken longer to accomplish a given task the first few times they do
it. As they become more adept, their speed increases
Managers learn to schedule the production process more effectively, from the
flow of materials to the organization of the manufacturing itself
Engineers who are initially cautious in their production design may gain
enough experience to be able to allow for tolerances in design that save costs
without increasing defects.
when LAC is falling , LMC lies below the LAC and when LAC is rising, LMC
lies above LAC. when LAC is falling LMC is lower than LAC. Conversely,
When LAC is increasing, LMC is greater than LAC.
Two curves intersect each other at point A, where the long run average cost curve
achieves its minimum. In the special case in which LAC is constant, LAC and
LMC are equal.
Optimum Plant, Optimum Output,
Optimum Company
• What is optimum plant?
The plant, the minimum point of whose short-run average cost curve coincides
with the minimum point of the long run average cost curve. It is the least-cost
Plant.
• What is optimum output?
The plant being efficiently utilized produces the output called as optimum
output
LAC is Envelope of Short Run Average Cost
Curve
• LAC is not tangent to the minimum points of the short-run average
cost curves
• When the LAC is falling, LAC will be tangent to the falling
portions of the SACs
• When the LAC is rising , LAC will be tangent to the rising portions
of the SACs
• The LAC curve never lies above any of the short run average cost
curves.
• Larger output can be produced at the lowest cost with larger plants
and smaller output can be produced at the lowest cost with smaller
plants.
• LAC is envelope of short run average cost curve.
• With the presence of economics and diseconomies of scale, the
minimum point of the short run average cost curves do not line on
the long run average cost curves.
LAC is Envelope of Short Run Average
Cost Curve
Return to factor Vs. Return to scale
Now you studied 2 hours but you scored 40. It is like miracle. How it is
possible? This might be your parents are encouraging you to study,
they might have told you the reality of life, they might have given you
one new laptop with your favourite brand, new headphone, one single
room with new AC, all the food you like is given to you. Some of your
best friends are encouraging you on regularly basis. Because of all the
factor the miracle occurs. This is nothing but economies of scope.
Economies of scope means many other factors (Internal and external)
factors other than inputs. Internal factors are new AC, New Laptop,
headphone etc and external factors are here your friends
return to scale and economies of scale
• Large dairy firms, however have the option of using milking machine.
If a large firm continues milking cows by hand, regardless of the size
of the firm, constant return would continue to apply. However, when
the firm moves from 50 to 100 cows , it switches its technology
towards the use of machine, and , in the process, it able to reduce its
average cost of milk production from Rs. 10 per litre to Rs 7 per litre.
In this case, there are economies of scale.
Economies of Scale Vs. Economies
of Scope
What is Economies of Scale
In the long run, the industry/Firm may experience certain advantages in
terms of cost reduction and output expansion. These advantages while
producing a single product is known as economies of scale. Per-unit declines
in the cost of production as quantity of production increases. Economies of
Scale is a situation in which output can be doubled for less than a doubling of
cost. In other words, a doubling of output requires less than a doubling of cost.
These benefits can be internal and external. Economies of scale occurs in the
long run and hence all inputs are variable. Economics of scale refers to the
benefits a firm gets due to large scale operation
Eg. Economies of scale is a rail road track, which carries 100 trains per day . The
total cost will be higher when it carries one train .
Internal and External Economies of
Scale
(a) Internal Economies of Scale
Internal factors are controlled by a firm/ industry. The benefits/advantages
the firm is getting while producing a single product in the long run is called
internal economies of scale. The benefits on which the industry has control
are called internal economies. Advantages accrue to the company due
to the changes within the company. Cost per unit declines.
Production economics of scale- if the firm operates on a large scale, workers can
specialize in the activities at which they are more productive.
Research and Development expenditure: more efficient use of research &
development expenditure
Improvement in technology: better and specialized machines ( Gujrat
Ambuja case study example replacement of V belt to flat belt)
Tanning: to enhance knowledge and skills of the employee
Labor economies: Specialized Labors
Replacement of coal for crushed sugar cane ang ground not husk
Transportation economics of scale-Efficient transportation. More than 200
KM distance they preferred by train, water ways
Inventory economics of scale-Ware housing(inventory management)
Quality control-every half an hour. 48 times per day
Managerial economics of scale: By varying the combination of inputs utilized
to produce the firms output, manager can organize the production process
more effectively.
Internal Economies of Scale continued…..
Financial economies: Large firms receives loans easily
compared to smaller firms and receives bank loan at lower
interest rates than the smaller firms.
Marketing economies: spread high cost of advertising
more bargaining power: The firm may able to acquire some
production inputs at lower cost because it is buying them in
large quantities and can therefore negotiate better prices.
Advertisement cost- Due to frequent advertisement, cost per
unit decreases
PC Production
Local labor force becomes scarce. Higher wages are needed to attract
workers.