Types of costs

• Actual/acquisition/outlay costs and opportunity/alternative costs• Sunk costs and outlay costs• Explicit/paid out costs and implicit/imputed costs• Incremental/avoidable costs• Book costs and out of pocket costs• Accounting costs/actual costs and economic costs—future costs

Types of costs contd…

• Direct and indirect • Controllable costs and non-controllable• Replacement and historical• Shutdown costs and abandonment costs• Marginal, average and total costs• Fixed and variable• Short run and long run• Incremental and marginal costs

Output Total FC Total VC Total Cost

Avg FC Avg VC Avg TC Marginal Cost (change in TC/change in qty)

0 1000 0 1000 ---------- ---------- ---------- ---------

10 1000 400 1400 100 40 140 400/10=40

20 1000 700 1700 50 35 85 300/10=30

30 1000 930 1930 33.3 31 64.3 230/10=23

40 1000 1100 2100 25 27.5 52.5 170/10=17

50 1000 1400 2400 20 28 48 300/10=30

60 1000 1900 2900 16.7 31.7 48.4 500/10=50

70 1000 2500 3500 14.3 35.7 50 600/10=60

Determinants of cost function

• Relationship between cost and its determinants

• Size of plant—scale of operations• Output level—AC and MC first decline and

then increase with increase in output• Price of inputs• Technology—modern tech has higher capital

output ratio, cost saving• Managerial efficiency—difficult to quantify

Relationship between production and cost

• Cost function is the production function expressed in money terms

Units of variable input L

TP qty

Total VC L*wage rate

Marginal cost change in TVC/change in qty

Marginal product change in qty/change in L

0 0 0

1 10 100 10 10

2 22 200 8.33 12

3 40 300 5.55 18

4 55 400 6.67 15

5 62 500 14.33 7

6 65 600 33.33 3

7 60 700 -20 -5

Labour Cost

TP

TVC

TP qty

Short run cost function

• To expand output in short run, rate of utilization of assets to be changed

• Cost behaviour is an operating concept• Firm decides the level of operation of the

existing plant• Variable and fixed inputs• TC=TFC+TVC

TFC

TVC

TC

AFC

AVC

ATCMC

Q1 Q2

Long run cost function

• All factors variable• Entrepreneur has a no. of alternatives like

plant size, levels of output• Long run cost curve is called planning curve• Flexibility to choose the most suitable plant

size for the desired level of output

• Long run avg cost curve is derived from short run avg cost curves

• LAC is the envelope curve

Relation between short run and long run cost curves

• LRTC starts from origin, as there are no fixed costs in long run

Why is long run avg cost curve likely to be L shaped

• Long run costs—production costs and managerial costs

• All costs variable in long run• Prod costs fall continuously with increases in output• Managerial costs rise at very large scales of output• Fall in prod costs more than offsets increase in

managerial costs, LAC continuously falls with increase in scale

Economies of scale

• Lower repair costs attained if the firm reaches a certain size

• Vertical integration• Introduction of new techniques for larger

scales of output is of improved quality and thus cheaper to operate resulting in falling prod costs

Analysis of economies of scale

• Internal economies• External economies

Internal economies

• Real economies—qty of inputs for a given level of output decreases

• Pecuniary economies—savings in expenses which accrue to firm in the form of buying at relatively lower prices paid for inputs and lower costs of distribution

Real economies

• Production economies– DOL economies– Technical economies– Inventory economies

• Marketing economies• Managerial economies• Transport and storage economies

Pecuniary economies of scale

• Lower raw material prices due to bulk buying• Lower cost of capital• Lower rates of advt• Lower transportation costs• Savings on labour costs

External economies

• Expansion of industry

Diseconomies of scale

• Firm continues to expand in size, stage comes when diminishing returns to scale set in

• Human and behavioural problems set in• Message distortion and misinterpretation

Returns to scale

• Constant returns—an increase in all inputs leads to proportional increase in output or vice versa

• Increasing returns—an increase in all inputs leads to more than increase in output or vice versa

• Decreasing returns—an increase in all inputs leads to less than increase in output or vice versa

Economies of scope• A single firm producing multiple product can

together produce them cheaper compared to a situation where each product is produced by a separate firm, economies of scope exist

• Firm producing multi products, common production facilities and inputs

• Prod of one good results in by-products that can be sold, thereby gaining the cost advantage