Cost of Production-Economics

8/9/2019 Cost of Production-Economics

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COSTS OF PRODUCTION

Group 5


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The short run period

Flexibility to change the rate of production by adjusting the variable costssuch as labour, raw materials, logistics etc

A clear distinction is made between variable costs and fixed costs.

The fixed factors of productions which incur fixed costs cannot bechanged.

Variable factors of production work with fixed factors to produce output.

A fixed cost does not rise or fall as the firms rate of production changes.


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The short run: costs and output

The relationship between costsand output in relation with short runcosts is between the relationshipsof units of variable factors andunits produced over a fixed timeperiod.

The average product is output

divided by the number of units ofthe variable factor employed. Themarginal product is the

change in output divided by thechange in the number of units ofthe variable factor.

The marginal product of an

incremental worker ischaracterized by three distinctstages of production.

Increasing marginal product

Diminishing marginal product

Negative returns to the variable

factor

Total

productoutput

Units of

variablefactor

Average

product

Marginal

product

0 0 0 0

20 1 20 20

35 2 17.5 15

45 3 15 10

54 4 13.5 9

61 5 12.2 7

65 6 10.833 4


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The Average Fixed Cost curvestarts from a height and goes ondeclining continuously as

production increases.

The Average Variable Costcurve, Average total Cost curveand the Marginal Cost curve startfrom a height, reach the minimum

points, then rise sharply andcontinuously.

The movement in the MarginalCost curve determines themovement and direction of theother curves.

The Marginal Cost curve alwayspasses through the minimumpoints of the Average VariableCost and Average Cost curves,though the Average Variable Cost

curve attains the minimum pointprior to that of the Average Cost


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Short-Run Costs and Output

Output Unitsof

Variable

factor

Average

Variable

cost

Variabl

ecost

Fixed

cost

Total

cost

Averag

e Total

cost

Margin

al Cost

0 0 20 0 100 100 - -

20 1 20 20 100 120 6 135 2 20 40 100 140 4 1.3

45 3 20 60 100 160 3.5 2

54 4 20 80 100 180 3.3 2.22

61 5 20 100 100 200 3.27 2.85

65 6 20 120 100 220 3.38 5

Average total cost=Total cost/the no of units produced

Marginal cost=change in total cost/change in output


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The firm should produce 61 units because the marginal costincreases from 2.85 for 61 units to 5 for 65 units, which is asignificant increase (i.e. for a increase of 4 units the marginal cost

rises by 2.15).


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Degree of operating leverage

Degree of operating leverage=%change in profits/%change in sales.

A value greater than one implies that the profits rise orfall proportionately faster than the sales.

The firm therefore is vulnerable to a sales slump.


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Degree of operating leverage=%change in profits/% change in sales

Assuming the sales rise from 45 units to 54 units with each unit of

output being sold at $5.

The operating leverage=38.4%/20%

=1.92


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If the operating leverage ratio is greater than 1 it indicates profits(rise or fall) proportionately faster than sales.

Firms with a high operating leverage ratio would reduce their

financial vulnerability by:--Offering discounts when sales weaken to quicken sales &

thereby increase profits.

-Hiring Part time workers overFull time workers


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Output Fixed Cost Variablecost Profit

0 100 0 0

20 100 20 -20

35 100 40 35

45 100 60 65

54 100 80 90

61 100 100 105

65 100 120 105

Profit=Revenue-(fixed cost + variable cost)

The price per unit is assumed to be $5


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The Very Long Run

A production time period in which all inputs are variable,including those under control of the firm and thosebeyond the control of the firm.

In this economic time period firms have the opportunityto respond to technologies not previously known.

The nature of very long run is such that cost and outputrelationships cannot be calculated


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Concentration ratio C

oncentration ratios are measures of the total output that isproduced in an industry by a given number of firms in the industry.

CR4 and CR8.

used to show

the extent of market control . to illustrate the degree to which an industry is oligopolistic.

Affected by geographic scope of market.

Typesofconcentrati

on

Noconcentrati

on

Totalconcentrati

on

Lowconcentrati

on

Mediumconcentrati

on

Highconcentrati

on

Percentage 0% 100% 0% - 50% 50% - 80% 80% - 100%

Explanation There is

perfectcompetition

Means an

extremelyconcentrate

Ranges from

perfectcompetition

Is likely an

oligopoly

Ranges from

oligopoly tomonopoly


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F

our firm concentration ratio

CR4

= output of the four largest firm

industry output


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J

ustifiable concentration ratio

Justifiable CR4 = 4(output at maximumefficiency)

industry output


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The ratio is (50% 35%) 15% less than the justifiable ratio(50%)that means the level of competition in the market is high.Hence more players in the market.

Also the industry output by the 4 biggest players is less thanexpected and the total industry output is more which includes these4 firms as well as other players


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Small firms.

Low concentration ratio.

The larger firms are not producing as much as they should produce.Hence, lesser economies of scale. Hence, the bigger players havemore scope for cost reduction compared to the smaller players.

Larger firms have capacity of reducing the cost and hence they canproduce more.

Small firms will enjoy small competitive price advantage.

Although they are enjoying small competitive price advantage. Smallfirms profit will decrease as they will have to sell more and will alsohave to accept the price which is set by larger firms.

As larger firms are setting price which small firms are accepting , apoint will come wherein the small firms will have to sell products fora price which brings a loss to them. Hence it will be difficult for themto sustain.


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The smaller firms should identify this cost disadvantage that thelarger firms are suffering and also cater to the balance 15% thatcould be supplemented by the bigger firms.

The larger firm should try to compete more in the market bybalancing and by generating the additional 15% output. By this theywill achieve larger economies of scale and higher market share.Thus profit will increase.


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Economies of scale

Economies of scale" is a long run concept which refers to reductionsin unit cost as the size of a facility and the usage levels of otherinputs increase.

Internal economies of scale relate to the lower unit costs a singlefirm can obtain by growing in size itself.

External economies of scale occur when a firm benefits from lowerunit costs as a result of the whole industry growing in size.

Diseconomies of scale occur when a business grows so large thatthe costs per unit increase.

Diseconomies of scale occur for several reasons, but all as a resultof the difficulties of managing a larger workforce.


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Competitive Strategy

Refers to a specific manner in which a firm tries to differentiate itselffrom the rivals.

Two generic strategic options are:

1.Price

2.Product differentiation


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X-Inefficiency

When a firm fails to produce on the lowest possible average andmarginal cost curves it is called as X-Inefficiency.

X-inefficiency is perhaps most likely in a situation where there is notenough competition, like monopoly.

In these circumstances firms may not be stretched as there is nocompetition and so some 'organisational slack' may creep in.

Thus resources are not being used as efficiently as possible.X

-inefficiency will increase costs because of a lack of competitivepressure.


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Economies and Diseconomies ofScale

The figure displays a series of sort-run average costs curves, eachreferring to different sizes andtechnologies of the fixed factors ofproduction.

Which makes up a long run averagecost curve

The long run average cost curveindicates the lowest possible averagecost for each rate of output.

The long run average cost curve is Ushaped reflecting economies anddiseconomies of scale.


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Learning curves economies

$20

$17

$14.45

100 200 400Cumulative output

Learning curves

Averagecost Fifteen percent learning curve

Learning curves portray the costs and benefits of experience when performingroutine or repetitive tasks.

Learning curves economies are derived from cumulative experience. That is, as cumulative output increases, learning and experience cause the cost

per unit to decrease.


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Management Implicationsforafirm

thatanticipatessignificantlearningcurveeconomies

From learning curve economies the management knows through theprevious experiences ,when to stop production even though the firm mightbe having additional unutilized capacity because at times if a firm produces

more it might be suffering a loss as the average cost per unit of output mayincrease instead of decrease with the increase of inputs.


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Marginal Product

The marginal product or marginal physical product is the extraoutput produced by one more unit of an input (for instance, thedifference in output when a firm's labour is increased from five to sixunits).

Output that results from one additional unit of a factor of production(such as a labor hour or machine hour), all other factors remainingconstant.

Whereas the marginal cost indicates the added cost incurred inproducing an additional unit of output, marginal product indicates the

added output accruing to an additional input. Since marginal product is measured in physical units produced, it is

also called marginal physical product.


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Economies of scope

Reduction in long-run average and marginal costs, due to theproduction of similar or related goods or services where the outputor provision of an item 'A' reduces the cost of item 'B.'

Economies of scope occur when a firm reduces costs through theproduction of multiple goods.

It affects the firms cost of production.


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Cost of Production-Economics

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