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Chapter 04 - Cost Theory and Analysis
Chapter 04 - Cost Theory and Analysis
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Significance
À Cost of Production is the basis of Product
Pricing Decisions.
À Resource Allocation decisions are based on
the basis of analysis of cost.
À Decisions to add a new product is based on
the basis of comparing additional revenues
to the additional costs.
À Decisions on capital investment are made by
comparing the rate of return on investment
with the opportunity cost of the funds.
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À Cost function can be derived from production
function by adding information about factor
prices.
C = f (Q, P1, I1, P2, I2, ……..Pn, In)
C = Cost of Production
Q = Level of Output
P1, P2 …= Prices of various factors
I1, I2… = Quantities of factor inputs 1, 2, etc.
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À Total Cost (TC) is an increasing function of
output.
À An increase in input price, would lead to an
increase in the cost of production.
À The relationship between TC and Q though
is unique in direction, is varying in terms of
magnitude.
Types of Cost
À Economic Cost: Payments made by a firm to
all the factors (hired + self owned) used in
the production.
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À Direct Cost: Costs which can be directly
attributed to production of a given product.
À raw material, labor and machine time
involved in the production of each unit.
À Indirect Cost: Costs that can not easily and
accurately be separated and attributed to
individual units of production, except on
arbitrary basis.
À Stationery and other administrative
expenses, depreciation of plant and
buildings.
À Direct (Separable) and Indirect (Common
Costs).
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À Marginal Cost: Change in TC associated with
a one-unit change in Q.
À Incremental Cost: Total additional costs of
implementing a managerial decision which
vary with the decision.
À Referred to as relevant costs, incurred as a
result of the decision under consideration.
À Cost associated with adding a new product
line, acquiring a major competitor etc.
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À For managerial decisions HC may not be
appropriate.
À Private Costs: Costs incurred by an
individual firm engaged in relevant activity.
À Includes both explicit and implicit costs that
a firm incurs in production.
À Social Costs: Costs incurred by the society
as a whole.
À External costs passed on to persons (society
at large) not involved in the activity in any
direct way.
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À LR Costs: Refer to costs across all possible
production capacities.
À Costs when all factors of production are
subject to change. In LR all costs are
variable costs.
À SR Costs: Stand for costs within a given
production capacity.
À Costs when at least one of the factors of
production is fixed.
À Total Costs: Sum total of explicit and implicit
costs. In the SR, STC = TFC + TVC.
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Class Assignment 1.
A furniture shop makes 100 chairs per month and
sells them at $ 15 per piece. The expenses on rent
of the shop, cost of material are worth $ 500, the
wage bills stand at $ 240 and electricity bill is $ 50
per month. The shop has invested $ 5000 of which
$2500 is the own fund and the remaining $2500 is
a loan from a bank at the interest rate of 18% per
annum. Assuming imputed costs of owners’ time,
own shop and own savings of $ 2500 for the
month are $300, $100 and $ 25 respectively.
Q. Calculate the explicit and implicit costs and find
out the Business profit and Economic profit.
SR Cost-Output Relationship
À Assuming two inputs L and K, Total Cost,
TC = (L X PL) + (K X PK)
À If L is the variable input & K is the fixed
input, then TVC = L X PL and TFC = K X PK
À AVC = TVC / Q
À ATC = TC / Q, TFC / Q + TVC / Q,
AFC + AVC
À MC = ∆ TC / ∆Q
À If factor prices PK = 50$, PL = 30$ and K =
2, the various calculations of TFC, TVC, TC,
AFC, AVC, AC and MC are as follows:
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SR Production Function & Cost Output Relationship
L Q AP MP TFC TVC TC AFC AVC AC MC
0 0 - - 100 0 100 - - - -
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À Trend of MC is derived from MP. Influenced
by the Law of Variable Returns.
À TFC curve is horizontal.
À TVC curve starts from origin.
À TC curve starts from a point above the
origin and then follows the shape of the TVC
curve.
À TC and TVC curves are parallel.
À MC curve passes through the minimum
points of both the AVC and ATC curves.
Cost
Total cost
Fixed cost
TFC
Output
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Cost
Variable cost
Output
STFC
STFC
Q
0
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STVC STVC
STC
STFC, STVC, STC
STVC
STFC
Q
0
13
AFC
P E
F
R
AFC
0
Output
Q S
S
S
S
AVC
AVC
Q
O
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Relationships between Product Curves and Cost Curves
AP
AP
&
MP MP
Labor
Maximum MP
And Minimum MC
MC
Maximum AP
Cost And Minimum AVC
AVC
output
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SR Average and Marginal Cost Curves
Cost
AC
MC
A
Point of Diminishing Returns
Output
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Cost –output Relationships
LR Cost-Output Relationship
À In LR being factors are not fixed, all LR costs
are variable.
À In LR, the firm is concerned with optimum
firm size whereas SR is concerned with
optimum Q within a given plant size.
À In LR firms change the scale of their
operations by varying all inputs.
À Given factor prices and specific production
function, the least-costs associated with
various levels of Q, yields LR TC schedule.
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LR Cost-Output Relationship
0 - - -
LTC
B
A
LTC
LMC
Q LAC
Economies of scale
LAC
LMC
Diseconomies of scale
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À The LTC curve is first concave & then
convex as looked from the output axis.
À At the point of inflexion on LTC curve (A),
LMC takes the minimum value.
À At point of kink on LTC curve (B), LAC
assumes the minimum value.
À LAC is the least when LMC = LAC.
À LAC curve is falling when LMC < LAC.
À LAC curve is rising when LMC > LAC.
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LAC Curve: The Envelope Curve
À LAC curve envelopes all SAC curves, for the
LR cost can not exceed the SR cost.
À LAC curve is known as Planning curve as it is
a guide to the producer to plan for the
future expansion of Q.
À LAC is the locus of the tangency points of
the SAC curves.
À LAC curve is U-shaped as SAC curves are
but it is more flatter than the SAC curves.
LAC
SAC 1 SAC 2 SAC 3
LAC
A B
0 Q
N1 N2 N N3
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À The points of tangency between SAC curves
and LAC represent the least cost way of
producing particular Q.
À As SAC1 is tangent to LAC curve at point A, it
indicates the least cost output point.
À Point B depicts the lowest AC along SAC1.
À Decision to produce output level at N2 is
possible by choosing at point B on the first
plant to minimize AC.
À The firm could reduce AC further with a
larger plant associated with another SAC.
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Economies of scale are two types:
1. Real Economies (Internal Economies)
2. Pecuniary Economies (Ext. Economies)
À Internal economies accrue to a firm by
expanding the scale of production to the
optimum point.
À Helps in better use of underutilized inputs.
À Associated with a reduction in inputs used-
raw materials, labor, capital etc.
À Internal economies are broadly divided into:
1. Production Economies
2. Selling and Marketing Economies
3. Managerial Economies
4. Transport and Storage Economies
À Production Economies:
a. Labor economies:
À Labor economies are achieved as the scale
of output increases.
Division of Labor & Specialization.
Time saving and Automation
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b. Technical economies:
À Are associated with the ‘fixed capital’.
À Arise from the use of better plant, machinery,
equipment & techniques of production.
Specialization and indivisibilities of capital.
Economies of superior techniques.
Economies of the use of by-products.
c. Inventory economies:
À To meet the random changes in the input & output
sides of the operation of the firm.
Inventories in raw materials
Inventories in ready products
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Specialization of Management
Decentralization of Decision Making
Mechanization of managerial function
À Transport and Storage Economies:
À Concerned partly with production side and
partly on the selling side of the firm.
Causes of Internal economies:
À Indivisibilities: Larger scale of production
makes better use of certain factors of
production which can not be used in parts.
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À Transport rates are often lower if the
amounts of goods transported are large.
Causes of External economies:
À Localization of Industries: Concentration of
firms at a particular place results in
endowing in certain advantages to the
firms.
À Specialization: Growth of an area induces
the emergence of firms supplying
specialized services at a lower cost.
Diseconomies of scale: Beyond a certain
point, firm compels to produce more output
at an increasing cost per unit.
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In l e
re crea sca
tu to
rn sin u rns
st g re t
o ing
sc as
al e LAC
e
Constant returns D ecr
to scale
AC
Q1 Q2
o Q
Economies of Constant Diseconomies of scale
scale cost
Economies of Scope
À Refers to reduction in production costs by
producing a set of different goods together
rather than separately.
À Efficiencies arise when a firm produces more
than one product.
À Exist when the TC of producing given
quantities of two goods in the same firm is
less than producing those quantities in two
single-product firms.
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À Measured in terms of saving in cost (SC) of
production.
À Saving in cost is measured as
C(Q1) + C(Q2) – C(Q1,Q2)
SC = ------------------------------------
C(Q1,Q2)
À C(Q1), C(Q2) represents the cost of producing
output Q1,Q2 respectively and C(Q1,Q2) the
joint cost of producing both outputs.
À With economies of scope, the joint cost is
less than the sum of individual costs, SC > 0
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