, an understanding of ere + jihcanetets gorse Pm iran understanding of tN ‘Sraduate class in economic theory would be a success ifthe ‘meaning of cost in all its many aspect 11 Cost of Production cision-making and LEARNING OBJECTIVES : ‘After having read this chapter, you should be able to sou for managerial J @ draw a distinction between thos¢ those elements which are not useful for this PurPose vrence between the various cost concepts fe cost elements that are relev © understand the basic differ © analyse the behaviour of cost of economies of scale : Jation in specific cases. @ comprehend the different sources €@ specify the appropriate method of measuring cost-outPut FEATON 11.1. COST AND MANAGERIAL DECISION-MAKING Study of costs is essential for making a choice from among the comPeINg production plans. Production decisions se not possible without their respective cost considerations. Since the productive resources are scuce with any firm and also since these have alternative uses, the use of these reste involves sacrifice and, therefore, cost. The firm will have to analyse these sacrifices or costs whenever it decides to use the fit-maximising firms need to deal carefully. resources. Cost and revenue are the two major factors with which the pro Itis the difference between revenue and cost that determines the firms overall profitability. From the decision than revenue because the firm can influence cost more mal-ing point of view, cost is even more important ¢ been found that in the present-day competitive business environment, the major easily than revenue. It ha mphasis is on controlling costs. According to Business Week (February 2, 1981), it is being increasing recognised that “the best conceived strategic plans or marketing analyses are useless if products are too costly to produce or too shoddy to sell And they (companies) ae puting in corporatewise programs aimed at sporting every quick and luratve fix available to increase manufacturing productivity atthe lowest possible cost” Lower costs help a firm earn higher profits while selling at the same price as its rivals. However, the solution of various economic problems needs cost fi ‘ in the balance sheets, income statements, ec. ofthe firm. The eae oe eee ea co eee aaa nal ofthe Tiny but are not dretly helpful for managcrial decisions. For the managers ar née costs in terms of their source, period, rate of change with respect to output, the degre je management necds etc. This needs re-doing the cost figures. the degree of their controllability, Itmust also be mentioned that in managerial decision pes The current or historical costs are relevant only if pen the estimate of future costs thal mistens policies in future too, and ifthe environment in which the firm operates ronats anevr ay eo present rose costs which are affected by the decision of the management need boven eee Further, only igement need be analysed; while expenses that remain unchanged should be ignored in the decision-making proces s.JP PAGE NO. Cost of Production 11:2. TYPES OF Costs There are several types of go, 2iL n sts that a f%, : ented ture cont acount Sy consider rel, saribl cons private cost, socigy ee com Porn cost pe = Under venous Circumstances, Such tow the fundamental diterense soe nthe 8S ete Forte decision-making. it costs, fixed, I » ete. For the: Pad costs, variable costs, semi. n Q en the main cost concents apes Of decision-making, itis essential 1. Actual (or, Acquisi ‘alongwith the condition ir use i 5 5 of thei ie costs which the frm inorse e OWay) Coty and ere the read imeeae fe rs While produ ity (OF Alternative) Costs. Actual costs labour, rent, i * etc. The books of ace fervice like the cost on raw mo, ial, called the outlay costs or acquisih her oTmation. The actual cost ae a costs are the return from the Second-best hand, opportunity costs or alterna, the return, from the best use of the resour lich the firm, ‘Jorgoes in order to avail of pape pressing machine with his trees rn can buy either a lathe machine or, respectively from the two alternatives, 4 ration: annually Rs, which gives him a higher return, But nly buy a paper-pressing machine carn Rs. $0,000 annually from the lat Ns has forgone the opportunity to Thedierence between actual cost and oppor HS opportunity cost or alternative cows ezoomic profit fom paperspre Ce oo or Mera For example, ‘ ,000-Rs. $0,000 = Rs. 20,00 ipl sscrooni ae shoe St resources in paper pressing mache oA 2.Sunl ind Outlay Cost tly costs mean the actual expenditure incurred forproducing or acquiring a good or expenditures are recon ofthe business unit, e,g., wage bill. Th depreciation. Sunk costs are ap; thatare essentially incremental and not sunk in nature. Explicit (or, Paid-out) Costs and Implicit (or, Imputed) Costs. id-out costs). These costs appear in the accounting records ofthe fe obts are theoretical costs in the sense that they go unrecognised by the fhe ang system. These costs may be defined as the earnings of those ‘employed resources which belong to the over himself. For example, the interest payment on borrowed fugine an explicit cost and enters the ‘SSounting record, but the amount of interest which the employer coul. ld have earned (and which he forgoes ‘hen he uses his own capital in his firm) is his implicit cost. Similarly, the amount of rent, wages, utility c i i cit le wages, rent, etc. which are due to the “xpenses, ete. which are paid out are the explicit costs of the firm, whil 1 ‘ . ir implicit sts are important ¢ntrepreneur for employing his own resources inthe firm are alin. The rit cossaeingoan for: calculation of profit and loss account, but for economic decision-mah ing ‘heexplicit as well as the implicit costs. 3 of forgone 4. Opportunity Costs and Imputed Costs. Spportnty es enced he cnt of fr rene iti the pol : port tis the comparison between ey tat ae Ite The nce ores tis Cost focuses attention on he net revente iit oe be generated ae next bes use ofa scarce input. Since this ne revenue muse ee ees i the input , In ! at it is called opportunity costo ortunity cost of using this no Sue and (eth rent) inte ims Account. Butte fim a 9 pp eland (ie, ee cereal alee ides the return forgone on the use 0 Jnputed costs, onthe other, are a3 intpesof ders Bese te tu sont so “vords but are definitely important for certa Fat sven pad orresved) ease cl incluc i imputed cost concept can wr pawned resources, the imputed costs alo include rent (never paid For ocmaple aut Surees ill in use, interest on equity capital, etc. For example ses i onde x dort cteecated Lape erie se nt luate the relative profitability ofits two warchou * usefully employed by a firm that wii iy and cannot be recovered, eg, ess decisions require cost estimates Explicit costs are those expenses =Managerial Economic, oncept of opportunity cost is m, oe wever, the c However Swned) whereas the concept of impuieg ue or lease them. to decide whether to continue, ener s (both borrowed and ownes ; the re comprehensive as it relates to all ares ON. cost nly tote seleuse ofthe selPowned RATT Costs and Sunk (oF, Non-avoidable Shai (or, Avoidable or, Escapable 0” Pd to costs resulting from a change in the nature 5. Incremental (0m, ; the additions eras f vremental costs are a at level, adding or replacing a machine. DD ad duct line oF ov ringing about any change in th, 4 ro i b ni ass activity, ¢-g- change in P wwoided by not and level of busines Since these costs can be eo Ocapable cost. Moreover, since increment changing distribution channels, ete, aes activity, the incremental costs are also called avo ec ting from a contemplate d change, they are alg, ce in to costs may also be regarded as the differen: called differential costs. shange by vary) # a On the other hand, sunk costs are those that oe : ee vecouse any change inthe activity and the activity, For example, all the past costs are consi f gay cep amen ilcea ts! resulting incremental ests will have to take ins rg ot nr deer malig costs is the amortization of past expenses, 8.» dep . a reid the inereaiettal?eS they do not vary with the changes contemplated for future by the managemen ge which are important for decision-making. . : iAtough varale costs are general ineremental, ut all incremental cots are not harable casts Incremental costs may include fixed costs also, e.g., anew proposal may invol pi ixe¢ nature also, besides a variable one. Further, whether a particular cost belongs to the category of sunk or sherementel cost depends upon the condition ofeach business activity. particular cost may be sunk costin ‘one case and incremental cost in the other case. 6. Book Costs and Out-of-pocket Costs. Out-of-pocket costs are those expenses which are current cash payments to outsiders, All the explicit costs like payment of rent, wages, salaries, interest, transport charges, ctc., fall in the category of out-of-pocket costs. On the other hand, book costs are those business costs which do not involve any cash payments but for them: a provision is made in the books of account to include them in profit and loss accounts and take tax advantages, like the provisions for depreciation and for unpaid amount of the interest on the owner's capital employed in the firm. In a way book costs are the imputed costs or the ing the nature or the level of business payments by a firm to itself. 7. Accounting Costs and Economic Costs. Accounting costs are the actual or outlay costs. These costs point out how much expenditure has already been incurred on a particular process or on production as such. ince these costs relate to the past, these are generally sunk costs. The accounting costs are useful for managing taxation needs as well as to calculate profit or loss of the firm. On the other hand, economic costs relate to Suture. They are in the nature of the incremental costs—both the imputed and the explicit costs as well as the opportunity costs. Since the only costs that matter for business decisions are the future costs, itis the economic costs that are used for decision-making. 8, Private Costs and Social Costs, Economic costs can be calculated at two levels : micro-level and macro-level. The micro-level economic costs relate to functioning of a firm as a production unit, while the macro-level economic costs are the ones that are generated by the decisions of the firm but are paid by the society and not the firm. For example, if the decision of a firm to expand its output leads to ii aie its costs, this cost will be of the former type, known as private costs, Whereas, if it also leads io erated te the soci (may fe inte hature of greater pollution, greater congestion, et.) th ee occa eae zl a! costs from iety’s o " ve incurred or provided fr by an individuah fe ers tunes CQSt are those which are actualy the total costs 10 the society on account of production ofa good. Thus, the seo ener Han private and ~ an Breve. the net social cost isthe total social rost mina they rh i eae 9. Direct (or, Traceable or, Assignabi : fe private cost. or, Common) Costs. The diet o aceble oreo et (or Non-traceable or, Non-assignable wvith a unit of operation lke a product a prose we senate one that have direct relationship ie firm. In other words, the costs TES TE ACost of Production i finitely identifiabl H hich are directly and definitely identifiable are the di ple or common 0: non-assignabe costs ae the et cons, On the other hand, the indirect or non- toap! tobe equipment, staff, ec. cannot be ass tests, Whereas, the cost of wagons, coaches or engines cn upon the costing under consideration. In the above exam the costs are classified as labour cost, repairs and mainte of cost to a process or a type of output is, therefore, th ‘Common costs may or may not change as a result of a factory building, the track of a railway system, etc, services, etc. (which are common) can be put under the category of variabl ant, a product, a process or a department, For Since all the direct costs are linked to a particular. em. In other words, all direct costs are variable. On th process or marketing process. So, indirect costs are bo example, igned to cither pass, Whether a specific cost is direct or indirect depends ple, since costing units are zones and divisions and ance cost, fuel cost, etc, any specific identification not easy. Product/process/department they vary with changes in other hand, indirect costs may or may not be variable. the proposed changes in production level, production th the variable and fixed types. For example, the cost of are fixed indirect costs, while those of machines, labour le indirect costs. It is the variable indirect costs that are relevant for decision-making and the attempt should be made to allocate these costs to products, processes, etc., as the need be. complex ways. But any rational producer will like to get the idea of the amount of change in costs wh ‘be brought about by changing the amount or the mix of the output. Given this information he can The distinction between the direct costs and indirect costs is important. The modern firms are often multiple product ones. Any decision to expand output or to change the output-mix affects the total costs in will cost, maximize output or maximize profits. Similarly, when different processes involved in production have common cost elements (e.g., electricity for operating machines), the producer will like to identify the changes incosts with changes in output or changes in the processes. Thus, the traceability of costs is quite important in decisions involving additions or subtractions from the product line, product pricing, product marketing, changes in processes, changes in the strength and nature of work of different departments, etc. Traceability of costs _ becomes further important where the multiple products that incurred common costs differ considerably in production or marketing processes. 10, Controllable Costs vs, Non-controllable Costs. Controllable costs are those which are capable of being controlled or regulated by executive vigilance and, therefore, can be used for assessing executive efficiency. Non-controllable costs are those which cannot be subjected to administrative control and supervision. Most of the costs are controllable, except, of course, those due to obsolescence and depreciation. The level at which such control can be exercised, however, differs. For example, some costs (like, capital costs) are not controllable at factory's shop level, but inventory costs can be controlled at the shop level. and replacement costs is the way in which the assets are carrie 11. Replacement Costs and Original (or, Historical) Costs. The basis of distinction between historical .d on in the balance sheet and the manner in Which the amount of cost is determined. Historical cost of an asset states the cost of plant, equipment and mat have to incur ire the same as re ur ifit ce or acquire the same ass i : A, al eine i Suppose a machine was acquired for Rs. 10,000 in 14,000 in 1996. Here, Rs. 10,000 is the historical or jlacement cost. The difference of Rs. 4,000 between the repl 198 “nginal cost of the machine and Rs. 14,000 is its rep! two Financial accounts the value of assets is shown at their try tem Herials at the price paid originally for them, lacement costs result from price changes over time. 8 and the same machine can be acquired for Rs. Costs has resulted because of the price change of the ‘0 adjust historical costs to reflect price level changes. 12. Shutdown Costs and Abandonment Costs. Shu Porarily stops it operations. These costs could be saved i while the replacement cost states the cost that the firm would ‘ets now, The difference between the historical and machine during this period. In the conventional historical costs. But for decision-making, firms should tdown costs are those which the firm incurs if it the operations are allowed to continue. Shutdown.Managerial Economics ? i lay-off expenses, employmeny plant and equipment, lay- heltering plant an Sat market. Costs include, besdesthe ine cons, the cost oF shel MMT Joss oie Sa ae ! is rest se ae and training of workers when the plant ise tera fixed asst omg peacetime. Abandormen ina(Sandonment costs a xs improvised that it may not be Fea luring wartime may be so improvis Z , costs, thus, involve the problem of the disposal of assets: that must be incurred so that the ant costs are those 13, Urgent Costs and Postponable Costs. Urgent! cov 1 fuel, etc. Those costs whose postponement ‘operations of the firm continue, like the costs on material, labour tponable costs, firm, are known as post, € costs, does not affect (at least for some time) the operational St becomes quite obvious during the i ‘his dist g., the maintenance of building, machinery, etc. TI itenance of thei ind postpone the maint 4 Period of war or inflation when firms want to produce the maximum 2 plants, buildings, ets. 's profit and loss accounts and for the firm's profit 14. Busineas Costs and Full Costs. Business costs are relevant ual obligations made by the firm trac for legal and tax purposes. These costs include all the payments ee the other hand, the fill costs are the together with the book cost of depreciation on plant and equipment. 1m the next best use o sum of opportunity cost and normal profit. Opportunity costs the pee ee order that the ete the firm’s resources like capital, land, buildings and entrepreneur's e He continues to produce, it must earn a necessary minimum return, called the normal profit. 15. Marginal Costs, Average Costs and Total Cost. Total cost represents the money value bP total resources required for production of goods and services by the firm. Average cost is the cost per unit of output, assuming that production of each unit of output incurs the same cost. That is, AC = TC + Number of units Marginal costs are the incremental or additional costs incurred when there is addition to the existing ‘output of goods and services. For example, if the total cost increases from Rs. 2,000 to Rs. 2,100 when Production increases from 10 units to 11 units, the marginal cost of I Ith unit is : Rs. 2,100 — Rs. 2,000 = Rs. 100. Thus, marginal cost of ath unit (MC,)is the difference between the total costs of nth unit (7C,) and total cost of (m— 1)th unit (7C,_,), ie, MC, = (TC,-TC,_1) The relationship between MC, AC and TCiis shown in Table 11.1 Table 11.1 : Relationship Between TC, AC and MC Unit of good Total Cost ‘Average Ci ° produced (0) 70) ate (ac a Cost a (col. 2/col. 1) =(1C,-TC,_1) @ n~ TC, 4 10 Rs. 200.0 7 i on 195.5 2 187.5 ie te 1770 a LE 1714 n 0 7 173.3 1813 200 ‘As can be seen that : 300 (1) Total cost increases throughout though at di : ferent rates; (2) Average and marginal costs first decline and then at is ‘MC rising earlier than AC. rrProduction cost of 215 costs. Fixed (oF, constant) costs are that ps and ae re Sade canes eer a mf thea Cost of the firm which does not vary with ou paion is ong enough 10 alo the necessary adjustments ee Pe RES, ee If he period under cover remain fixed. These can then be varied, To an economist thes cif te firm, the fixed costs no et these are indirect costs. When the output goes up the ee are overhead costs and to an theta fined costs then divided between larger numberof units of outpeg nua comes down as Variable costs, onthe other hand, are directly dependent on th forexample, expenditure on labour, aw material, ete) inereare tr ineease in output. The degree of proportionality between th uilsation of fixed facilities and resources during the process 0 itisusually assumed by theorists thatthe variable costs continuously vary with output. Butt where costs remains fixed for each of range of output but the movement of cost frontend a sof out te anteris discontinuous, .¢, the cost curve would show a jump as we move from one range anothe, The ieephone bill, wages paid toa supervisor, etc. are some examples of such costs, Those caste cover ot tied portion and a variable Portion and is, therefore, known as semi-variable costs. For simplicity we assume that there ae only two categories of costs: fixed and variable. , Letus understand the nature of relationship between the various ‘cost components with the help of Table 112. Thetable reveals that : (The fixed cost remains the same for al levels of outputs upto capacity limit of the equipment. The average fixed cost, therefore, declines proportionately with additions to output. (i) Variable cost increases as output increases but this increase need not be equally proportionate. Its proportion first declines, becomes constant and then starts rising. Average variable cost also behaves in a sila way. (ii) Total cost is the sum of fixed and variable costs. The average total cost is, therefore, the sum of averge fixed and average variable cost. Average variable cost and average total cost curves are U-shaped. | 17,Short-run Costs and Long-run Costs. The short-run is defined as a period in which the supply of at east one of the inputs cannot be changed by the firm. To illustrate, certain inputs like machinery, buildings, tc., cannot be changed by the firm whenever it so desires. It takes time to replace, add or dismantle them. Long-run, on the other hand, is defined as a period in which all inputs can be varied as desired. In other words, itisthat time-span in which all adjustments and changes are possible to realise. Thus, in the short-run, some inputs are fixed (like installed capacity) while others are variable (like the level of capacity utilization). While inthe long-run all inputs, including the size of the plant, are variable. Inthe short-run, by definition, some inputs are fixed while the others are variable. The latter kind of ‘tputs give those costs that vary with the degree of utilisation of variable input. The short-run costs are, therefore, of two types : fixed costs and variable costs. The fixed costs remain unchanged, while variable costs situate With output. Long-run costs, in contrast, are costs that can vary with the size of plant and with other facilities, normally regarded as fixed in the short-run. In fact, in the long-run there are no fixed inputs and, er 7 7 tefore, no fixed costs, ie., all costs are variable. Sine lRetemental Cost and Marginal Cost. ae “rity and difference between these two must be wel t ‘re efficient, while in others the incremental cost is more suitable. (O Marginal cost deals with unit-by-unit changes in output, whereas incremental cost isnot restricted to retthange, Marginal costs the amount added to total cost by a unit increase in output. Incremental cost is “sito change in any number of units of output or even change in its au. 2 i) Marg f jor to incremental cost when dealing with decisio ike (o Marginal cost as a concept is particularly superior fo increm: ig with decisions volume of output or service. Variable costs but not necessarily in the same proportion as 'e variable cost and output depends upon the f production. Incremental cost and marginal cost are closely related. 11 understood. In some applications the marginal cost ba—e 13. THEORY OF COST : COST-OUTPUT FUNCTION 11.3.1. Determinants of a cost function. When we study cost of production of any good or service, we bseve that there are several factors that inluerice the cost. Cost function expresses the relationship between sostand is determinants, like the size of plant, level of output, input prices, technology, etc. In a mathematical form itcan be expressed as, C=f(S OF T....) C= refers to cost (unit cost or total cost) = refers to size of plant = means level of output P= denotes the price of inputs used in production T= refers to the nature of technology. Letus discuss the main determinants of cost in detail : (9 Size ofplant Plant size is an important variable influencing cost. The relation between scale of operations orsize of plant to the unit cost is negative inthe sense that a the former increases per unit cost decreases and vice versa, Such a relationship gives step-type downward sloping cost function, steps depending upon the different sizes of plants taken into account. Such a cost gives primarily engineering estimates of cost. ut and total cost are obviously related—total cost increasing with increase ‘al costs first decline and then increase with the increase in output. The nction are derived by relating the relevant costs with the level of capacity U-shaped curve, a quadratic or cubic where (ii) Output level, Level of outp' in output. But average and margin average total cost or marginal cost fu utilisation of given sized plant, Since such a cost function forms a function is more appropriate to use. (ii) Price of inputs. Obviously, ofthe inputs and relative changes in their prices. becomes relatively costly it raises the cost significantly. (iv) Technology. Technology is often quantified as capital-output ratio, Modern and efficient technology iscerainly cost saving and is, therefore, generally found to have higher capital-output ratio. () Managerial efficiency. Though cos is influenced a°great deal by managerial efficiency, it is difficult may explain how organisational or managerial ‘quantify it, However, a change in cost at two points of time may explain how oF changes iin he tans have Erought labour cost efficiency, provided it is possible to exclude te effect of changes in input prices influence costs, depending on the selective usage ‘When a factor, which is a major component in production, et factors, i tis believed that out of all the cost determinants, the most important component is the rate of output. It ‘therefore, assumed that the determinants other than the rate of output are held constant while analysing cost Constructing cost curves. ; : oo : a that the shape of cost curve is determined by the nature of underlying production function, while Tofeost curve is affected by the input prices. : Veq!32-Relationship Between Production and Cost. ‘Analysis of production and cost are closely related. =n ven say that the coat fonction is simply the production function expressed in money units. The show ~~218, Managerial Economics Tun cost function operates under the same limitations as do the short-run production function (except the assumption regarding input prices). Table 11.4 illustrates the relationship between production and cost in the short run, The cost of using variable input is determined by multiplying the units of variable input (labour, here) by its price. The Table reveals that the total product (Q) first increases at an increasing rate and later on ata decreasing rate, Correspondingly, the total variable cost (TVC) first increases at a decreasing rate and then at an increasing rate. By plotting the data of the first three columns of Table 11.4, we get Figure 11.1, which reveals that the total variable cost and total product are mirror image of each other : points 4), By, C), ete, match with points 4, By, Cp, etc. ‘Table 11.4, Production and Cost in the Short Run Units of Variable Total Product ‘Total Variable Cost Marginal Marginal Input, Labour (L) @ (L * wage rate Cost Product of Rs. 100)* (ATVC/AQ) (AQ/AL) 0 0 0 = = 1 10 100 10.00 10 2 22 200 8.33 12 3 40 300 5.55 18 4 35 400 6.67 15 5 62 500 14,33 1 6 65 600 33.33 3 7 60. 700 (20.00 or We may restate the relationship between cost and production (shown in Fig. 11.1) in terms of marginal products! and marginal cost2, Comparison of columns 4 and $ reveals that when MP is increasing the MC is decreasing and, while MP is deceasing MC is increasing. MC increases in the ranges where production experiences diminishing returns. This relationship can also be proved algebraically. Assuming that labour is Total Product (Q) (tonnes) 65 —<~ wé a ea area TP 40) 22 10} Cost. (Rs.)* 700 600 500 400 300 200 100 1234 5 6 7 Gale Fig, 11.1. Cost and Production, 1. Marginal product is the change in total product due to change in output. 2. Marginal cost can be taken either as the change in total variable cost or in total cost with respect to the change in ‘output. This is because itis only the variable cost component of total cost which changes with output.219 Costof Production the variable input and the wage rate is given, we can state that thew! ATVC = ALXW MC =ATVC14Q since avait (aL) y2(L yet es Me=~ 50 wee MP, (since MP, ‘Thus, assuming that wage rate is given, MC and MP move in opposite directions. 114, SHORTRUN COST FUNCTION ‘Short-run total cost. Once money resources of the firm have been invested into buildings, machinery a ir amounts cannot be readily changed. Ifthe firm wants to expand its ourpus © woe iat thr rn nly by a change inthe rate of ulation of these asses. This results in two kinds of, Fert: Fixed and variable inputs, Since the fixed inputs donot change with the rate of output, the costo the inet these fixed resources i also fixed. On the other hand, cost of those inputs whose quantity can be {hanged to match the production needs is known as variable cost. Thus ¢ TC=TFC+TVC where TC= total cst, TFC = total fixed cost and 77C = total variable cost. The total fixed cost includes o rpetee of the administrative staff, (i) depreciation of machinery and buildings, and (if) expenses on repairs safd maintenance of buildings and machinery. On the other hand, total variable cost includes (i) expenses on aie material i) cost of direct labour, and (i) the running expenses of fixed capital such as fuel, ordinary repairs and routine maintenance. Based on the information in Table 11.2, we nfay draw different short-run cost curves (Fig. 11.2). The shape ofthe total variable cost (TVC) curve is principally determined by the productivity ofthe variable input. TE increases at a decreasing rate upto Q, output, beyond which TVC increases at an increasing rate. This is. because below Q, output, the variable input is insufficient for the given fixed inputs. So, an increase inthe of variable input results in better utilisation ofthe fixed inputs, leading to more than proportionate increase in Cpu, For output levels greater than Q,, the fixed inputs fall short of the variable input. As a result the increase in variable input can add proportionately less to output. Since fixed costs do not change with output, the ZFC curve is a horizontal straight line. TC curve is the lateral summation of the FC and TVC curves as shown in Fig. 11.2. TC Zz 1c z i FC oO} ————— ashe @ ge MC ATC 3% AVC 89 i 2. “AFC 9 9 Unity {Bt Output Fig. 11.2. Short run Cost Curves,~~~ ar and AIC at their respective minimum points, 118. LONG-RUN COST FUNCTION tn the long-run, by definition, all factors are variable so that the sniepentr hs bfoe hin sonar alternative plant sizes and levels of output which he can adopt. The long-run cost curve is therefore anc et Planning curve, in the sense that itis a guide to the entrepreneur in his decision to plan aes fonars saris *is output. In contrast the cast behaviour in the short-run fs an operating concept, inthe s in, the firm decides about the level of ‘operation of the existing plant. a i the desired level of The long run affords flexibility to the firm to choose the most suitable plant size for the de wave. AS ML creases,Managerial Econom) 222 7 duction factors (¢-g., capacity) will becom, . lant size, some of productio ift toa higher plant size, Th’ a in om ate i cir the long-run oy ie eost eure is denved from shor run average cn eaeroptnags small, a medium? A firm facesa chores of res methods of prodstion, each With 2 oc, and SAC, respectively, as shows! a large plant. These plants operate with the average costs of SAC), onding to lowest Point on its Guar Fig. 11.4. Each plant operates most efficiently at output level corresponeine, larger output is less ona bien average cost (known as design capacity) [fits found foe) nd SAC for output levels Q, and Q,), So, the lant, the fi t that bigger size (compare SAC, f in Fi r ick li firm roils fromnsacto SIC, andthen SAC This movement is shown in Figure 11.4 by the thick ine, which is called the long-run average cost curve (LAC). (C, Output (Q) Q, 2% % Fig, 11.4, SAC curves for three plant sizes. Now,, if we assume that there are many plant sizes, each suitable for a certain level of output, we will get many SAC curves intersecting each other. As the number of plant sizes increases, the points of intersection of SAC curve will come closer. And, if we assume that there are large number (say, infinite number) of plant sizes, the intersection points will be so nearto each other that we get almost a continuous curve. This continuous gheve is known as the Long-run Average Cost (LAC) curve or the Envelope curve (asit envelopes the family of short-run Average Cost Curves). This is shown in Fig. 11.5. Inthe traditional theory of the firm the LAC cucve is U-shaped. The U-shapedness ofthe LAC curve reflects the economies and diseconomies of scale. The cot Fete cae ty Smoertnn ti tanned afoul, Hat Gs strates af cate seat aly Up toa certain size of plant, known asthe optimum plant size where all poss ible economies of scale have been A Average cost (Rs.) a x x ~~ Beonomies of Scale Diseonomies of Scale Fig 11.5. Long-run Average Cost Curve or Envelope C ; uve.