COST CURVES

Introduction • The amount spent on the use of factor and non

factor inputs, inputs is called cost of production.

• Cost Function. The relation between output and cost is cost function. Cost functions are derived functions. These are derived from the production function. Enables the firm to determine its profit maximizing or loss minimizing output. Helps a firm in deciding whether it is profitable for it to continue production. Aids in estimating its profit – both per unit as well as total.

Concepts of Cost/Types of Cost.

• Money cost. The amount spent in terms of money for production of a commodity is called money cost. Money cost includes the following expenses. (i) Wages paid to labourers (ii) Interest on Loans (iii) Rent paid for premises (iv) Expenditure on raw materials and machinery (v) Insurance (vi) Taxes (vii) Payments for power, light, fuel. (viii) Transportation charges.

Real Cost

The mental and physical efforts and sacrifices undergone with a view to producing commodity are its real cost. Concept of real cost is a subjective concept (changing from person to person)

Accounting Cost or Business cost• Accounting cost refer to cash payments

which firms make for factor (land, labour, Capital) and non-factor inputs (Advertising), Depreciation and other booking entries.

Opportunity cost Cost of next best alternative use. Opportunity cost is the cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen).

Importance of Opportunity CostThe concept of opportunity cost serves as a useful economic tool in analyzing optimum resource allocation and rational decision making.

Determination of relative price of Goods. Is useful in explaining the determination of relative prices of different goods.

Determination of Normal Remuneration to a Factor. Sets the value of a productive factor for its best alternative use. (Attrition)

Decision – Making and Efficient Resource Allocation. The concept of opportunity cost is essential for rational decision making by the producer. (Smart = profit oriented)

Limitations.

Those factors which have only specific use have zero opportunity cost.

Assumes the perfect mobility of the factors (language is not same every where)

Assumes all factors of production are homogeneous.(all laborers are not alike)

To calculate accurate opportunity cost is difficult job.

Economic Cost.• Economic cost includes both accounting costs and

opportunity costs of self owned and self employed resources. Economic cost differs from accounting cost because it includes opportunity cost.

Ex:- If attending college has a direct cost of Rs.20,000 a year for four years, and the lost wages from not working during that period equals Rs.25,000 a year, then the total economic cost of going to college would be Rs.180,000 (Rs.20,000 x 4 years + the interest of Rs.20,000 for 4 years + Rs.25,000 x 4 years). The accounting cost of attending college includes tuition, room and board, books, food, and other incidental expenditures while there. The opportunity cost of college also includes the salary or wage that otherwise could be earning during the period

Social Cost.•Social cost is the total cost to society for

an economic activity (Pollution) Spend more on laundry, health, medical treatment.

•Private Cost. Private cost is the cost incurred by an individual form for producing a commodity. It includes both the explicit cost as well as implicit cost.

•Explicit Cost. The monetary payment which a firm makes to those outsiders who supply labour, services, material, fuel, transportation services. Also called “absolute costs or outlay costs or actual costs”

•Implicit Cost. Many inputs are self owned and self employed by the firm, the firm does not have to make any payment for them to anyone. It gives up the opportunity to receive payment from someone else to whom it could rent the building.

• Actual Costs, Business Costs and Full Costs. ▫ Actual cost. Includes all contractual payments made

in money like labour, raw material, fuel, transport.▫ Business Costs. Actual costs, amount of

depreciation on plant, machinery, fixed assets.▫ Full Costs. Actual costs, depreciation, implicit cost,

normal profits – minimum profit s necessary for the firm to remain in business.

• Direct Costs and Indirect Costs. Costs which can be directly attributed to the production of a unit of a given product, like – labour, raw materials machine hours are direct costs, this can easily be separated, to a unit of output. Also known as Traceable or Assignable costs. Indirect costs are those costs which can not be easily separated like fuel, power, office expenses, and depreciation. Also called Indirect or overhead or untraceable or un-assignable costs.

• Incremental Costs and Sunk Costs. Incremental costs are the added costs of a change in the level of production by adding a new product/machinery/system. Sunk Cost are those which are once incurred and will not be altered by the change in business activity. Cost incurred in constructing a factory.

• Historical Costs and Replacement Costs. Is the cost of an asset purchased in the past at the then prevailing price. Replacement cost is defined as the cost to be incurred for replacing the same asset at current level.

Past Cost and Future Costs•Past Costs. are those costs incurred in

the past. These costs are mentioned in the financial accounts.

•Future cost are those which are to be incurred in the near future and management can evaluate the desirability of that expenditure.

• Out-of-Pocket and Book Costs. Out of pocket costs are those expenses which are current cash payments to outsiders. Book costs are those business costs which do not involve any cash payments but for them a provision is made in the books of accounts.(depreciation, interest on owners capital)

Controllable and Uncontrollable Costs•Controllable costs are those costs which

are regulated by executive vigilance. Non controllable Costs are subject to administrative control and supervision. Most costs are controllable except obsolescence and depreciation

Urgent and Postponable costs•Urgent costs are those with out which

production activity would come to a stand still.

• Postponable Cost. Painting of factory building

•Shut down and Abandonment Costs. Shutdown costs are those which the firm incurs if it temporarily stops its operations.

•Abandonment Costs retiring the fixed asset altogether (war time factories)

Escapable and Inescapable CostsEscapable Costs discontinue sale of

products to wholesalers.

Inescapable Costs are costs which cannot be avoided at all. (Room mate cost)

SHORT RUN COST FUNCTION•In the short-run the firm cannot change or

modify overhead factors such as plant, equipment and scale of its organization. In the short-run output can be increased or decreased by changing the variable inputs like labour, raw material, etc.

•costs of production are segmented into fixed and variable costs. On the other hand, in the long-run all factors can be adjusted. Hence, in the long run all costs are variable and none are fixed.

•1) Total Cost: Fixed and Variable

•The total cost (TC) of the firm is a function of output (q). It will increase with the increase in output, that is, it varies directly with the output.

•In symbols, it can be written as

TC = ƒ(q)

Since the output is produced by fixed and variable factors, the total cost can be divided into two components: total fixed cost (TFC) and total variable cost (TVC).

•TC = TFC + TVC

•Fixed CostFixed costs are those which are independent of output. They must be paid even if the firm produces no output. They will not change even if output changes. They remain fixed whether output is large or small. Fixed costs are also called 'overhead costs', 'sunk costs' or

•'supplementary costs'. They comprise payments such as rent, interest, insurance, depreciation charges, maintenance costs, property taxes, administrative expense like manager’s salary and so on. In the short period, the total amount of these fixed costs will not increase or decrease when the volume of the firms output rises or falls