Costs Concepts Class Slides

8/9/2019 Costs Concepts Class Slides

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Costs concepts

Study of behavior of cost in relation toproduction, size of output, scale of

operations, prices of factors ofproduction.


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Determinants of costs

1. Laws of returns ie incase of incresing returnsthe cost is less and incase of decresing returnsit is incresing.

2. Costs is effected by the size of plant.3. Time period longer the time period costs would

rise slowly whereas in case of short runproduction the initial cost would be high.

4. Technology.5. Size of plant ,incase of bigger lot the cost per

unit would be less.


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Types of costs

1. Accounting costs

2. Opportunity costs

3. Fixed cost and the variable costs

4. Business costs -all costs incurred to carry the business, whereasthe full costs includes business ,opportunity, and the normal profit.

5. Incremental costs are the total additional costs needed to expandthe production.

6. Sunk costs are the costs which have already been incurred andcannot be recovered, nor altered ,increased or decreased byvarying the rate of output.

7. Private costs which are actually borne by the firm for the

production process whereas8. Social costs are the costs which the society has to bear while the

production process takes place eg effluents into the river by therifineries.


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Costs in the Short Run

The short run is a period of timefor which two conditions hold:1. The firm is operating under a fixed

scale (fixed factor) of production, and2. Firms can neither enter nor exit an

industry.

In the short run, all firms havecosts that they must bearregardless of their output. Thesekinds of costs are called fixedcosts.


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Costs in the Short Run

Fixed costis any cost that does not

depend on the firms level of output.

These costs are incurred even if the

firm is producing nothing.

Variable costis a cost that depends

on the level of production chosen.

TC TFC TVC ! Total Cost = Total Fixed + Total Variable

Cost Cost


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Fixed Costs

Firms have no control over fixedcosts in the short run. For thisreason, fixed costs aresometimes called sunk costs.

Average fixed cost (AFC) is thetotal fixed cost (TFC) divided by

the number of units of output (q):

AFCTFC

q!


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Short-Run Fixed Cost (Total and

Average) of a Hypothetical Firm

AFC falls as output

rises; a phenomenon

sometimes called

spreading overhead.

(1)q

(2)TFC

(3)AFC(TFC/q)

0 $1,000 $

1 1,000 1,000

2 1,000 500

3 1,000 333

4 1,000 250

5 1,000 200


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Variable Costs

The total variable cost curve is agraph that shows the relationship

between total variable cost and the

level of a firms output. The total variableThe total variable

cost is derived fromcost is derived from

productionproduction

requirements andrequirements andinput prices.input prices.


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Marginal Cost

Marginal cost (MC) is the increase in total cost thatresults from producing one more unit of output.

Marginal cost reflects changes in variable costs.

Change in fixed cost is zero in the short run.

MC TCQ

TFCQ

TVCQ

! !

(

(

(

(

(

(


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Derivation ofMarginal Cost from

TotalV

ariable CostUNITSOFOUTPUT

TOTAL VARIABLECOSTS ($)

MARGINALCOSTS ($)

0 0 0

1 10 10

2 18 8

3 24 6

Marginal costmeasures the

additionalcost of inputs required

to produce each successive unit of

output.


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The Shape of the Marginal Cost

Curve in the Short Run The fact that in the short run everyfirm is controlled by some fixed input

means that:

1. The firm faces diminishing returns to

variable inputs, and

2. The firm has limited capacity to

produce output. As a firm approaches that capacity,

it becomes increasingly costly to

produce successively higher levels

of out ut.


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The Shape of the Marginal Cost

Curve in the Short Run Marginal costs ultimately increase

with output in the short run.


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Graphing Total Variable Costs

andM

arginal Costs Total variable costsalways increase with

output. The marginal

cost curve shows how

total variable cost

changes with single unit

increases in total output.

Below 100

units of output,Below 100

units of output,TVCTVCincreases at aincreases at a

decreasing ratedecreasing rate. Beyond 100. Beyond 100

units of output,units of output, TVCTVCincreasesincreases

at anat an increasing rate.increasing rate.


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Average Variable Cost

Average variable cost (AVC) is

the total variable cost divided by

the number of units of output. Marginal cost is the cost ofone

additional unit. Average variable

cost is the average variable costper unit ofall the units being

produced.

Average variable cost follows

marginal cost, but lags behind.


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Total Costs

the total cost curve hasthe total cost curve has

the same shape as thethe same shape as the

total variable costtotal variable cost

curve; it is simplycurve; it is simply

higher by an amounthigher by an amount

equal toequal to TFCTFC..

TC TFC TVC !


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Average Total Cost

Average total cost(ATC) is total costdivided by the number

of units of output (q).ATC AFC AVC!

ATCTC

q

TFC

q

TVC

q

! !

BecauseBecause AFCAFCfalls withfalls withoutput, an everoutput, an ever--decliningdecliningamount is added toamount is added to AVCAVC..


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Relationship Between Average

Total Cost and Marginal Cost1. ATC is the summation

of AVC and AFC.

2.In the biggning AVCandAFC falls hence the

ATC falls sharply.3.MC also falls and is

below than AVC in theinitial stage,reches

minimum and thenrises.

4.ATC falls reachesminimum and then

rises.


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Output Decisions: Revenues,

Costs, and ProfitM

aximization In the short run, a competitive firm faces a

demand curve that is simply a horizontal

line at the market equilibrium price.


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Total Revenue (TR) and

Marginal Revenue (MR)

Total revenue (TR) is the total amount that

a firm takes in from the sale of its output.

TR P q! v

MRTR

q! !

P q

q

( )(

(

Marginal revenue (MR)Marginal revenue (MR) is the additional revenueis the additional revenue

that a firm takes in when it increases output bythat a firm takes in when it increases output by

one additional unit.one additional unit.

In perfect competition,In perfect competition, P= MRP= MR..

! P


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Comparing Costs and

Revenues toM

aximize Profit The profit-maximizing level of output forall firms is the output level where MR=MC.

In perfect competition, MR= P, therefore,the profit-maximizing perfectlycompetitive firm will produce up to thepoint where the price of its output is just

equal to short-run marginal cost. The key idea here is that firms will

produce as long as marginal revenueexceeds marginal cost.


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Profit Analysis for a Simple Firm

(1)q

(2)TFC

(3)TVC

(4)MC

(5)P= MR

(6)TR

(Px q)

(7)TC

(TFC+ TVC)

(8)PROFIT

(TR TC)

0 $ 10 $ 0 $ $ 15 $ 0 $ 10 $ -10

1 10 10 10 15 15 20 -52 10 15 5 15 30 25 5

3 10 20 5 15 45 30 15

4 10 30 10 15 60 40 20

5 10 50 20 15 75 60 15

6 10 80 30 15 90 90 0


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The Short-Run Supply Curve

At any market price, the marginal cost curve shows the

output level that maximizes profit. Thus, the marginal

cost curve of a perfectly competitive profit-maximizing firmis the firms short-run su l curve.

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