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Theory of Costs

Maximization of profit is an
important business objective for
the firm
Profit = Revenue- Cost
Thus to know the profitability of
any decision we need to
understand the costs

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Total cost(TC) =Total Fixed Cost(TFC)
+Total variable costs (TVC)
• Total Fixed costs are the costs that do not vary
with the level of output.
• For eg., Cost incurred on account of fixed plant
and equipment, rent charges, advertisement
expenses, salaries of administrative staff
• Total fixed cost is the total cost of all the fixed
inputs employed in a production process( it
remains unchanged at all levels of output)

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Variable costs
• Variable costs represent those costs that
change directly with the change in output.
• Examples are cost of raw materials, Direct
labour, electricity charges, fuel charges
etc.

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Total Fixed, Variable and Total Cost Curves

Cost
Total Cost Curve

Total Variable
Cost Curve

TFC

Total Fixed Cost Curve

TFC
Quantity

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TVC- Inverse S- shape
• Total Variable Cost has an inverse S-shape-
reflecting the law of variable proportions( Law of
diminishing marginal returns)
• As per the law, at the initial stages of production
in a particular plant as more of the variable
factor (labour)is employed its productivity
increases initially( MP increases ) and the
average variable cost falls.

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Short run costs

Inputs Output Total Cost


Capital Labour TFC TVC TC
10 1 43 100 20 120
10 2 160 100 40 140
10 3 351 100 60 160
10 4 600 100 80 180
10 5 875 100 100 200
10 6 1152 100 120 220
10 7 1372 100 140 240
10 8 1536 100 160 260
10 9 1656 100 180 280
10 10 1750 100 200 300
10 11 1815 100 220 320
100
10 12 1860 100 240 340

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Short run average Costs
• Cost per unit or average costs are more
important for businessmen and economists.
• Average Fixed Costs(AFC):
• AFC is the total fixed cost divided by the number
of units of output produced.
• AFC= TFC/Output
• It is always falling as output increases, as fixed
costs are being spread over larger units of
output.
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Average Costs
• Average Total Costs is calculated as total
cost divided by the number of units
produced.

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Average and marginal costs
Output Average Cost Marginal Cost
AFC AVC ATC MC
43 2.326 0.465 2.791 0.465
160 0.625 0.250 0.875 0.171
351 0.285 0.171 0.456 0.105
600 0.167 0.133 0.300 0.080
875 0.114 0.114 0.228 0.073
1152 0.087 0.104 0.191 0.072
1372 0.073 0.102 0.175 0.091
1536 0.065 0.104 0.169 0.122
1656 0.060 0.109 0.169 0.167
1750 0.057 0.114 0.171 0.213
1815 0.055 0.121 0.176 0.308
1860 0.054 0.129 0.183 0.444

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Average fixed costs

0.8

0.6
COST

0.4 AFC

0.2

0
0 500 1000 1500 2000
OUTPUT

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Average total Cost (ATC) and
Average variable costs(AVC)

0.8

0.6
COST

AVC
0.4
ATC

0.2

0
0 400 800 1200 1600 2000
OUTPUT

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Marginal costs

0.8

0.6
AVC
COST

0.4 ATC
MC
0.2

0
0 500 1000 1500 2000
OUTPUT

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The supply schedule

 The firm’s supply schedule shows the quantities that


the firm is willing to offer at each market price

 Since a firm is presumed to operate for profits, then it


will only offer output when the market price is greater
than the cost of producing the last unit offered.

 Therefore, the firm’s supply schedule is also the


firm’s marginal cost curve, above the average
variable cost(when MC > AVC)

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Shut down of production

AC/AR

MC ATC

A (Rs.150)
AVC
BE (Rs.51)

B (Rs.45)
C (Rs.34)
Shut down
point
AFC
OUTPUT

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Shut down – Analysis of graph
 A(Rs.150); B (Rs.45); C(Rs.34) are the price/Average
revenue earned by the firm when the market price is
A, B or C.
 The minimum ATC is (Rs.51) and the minimum AVC
is (Rs.34) the firm is able to achieve (at a production
level of 180 units).
 The firm can cover its variable and fixed costs (that is
the total costs) if price is Rs.51; This is when
AR/Price is at least equal to the Average Total
Cost(ATC curve)
 The AR/Price should at least cover the Average
Variable Cost(AVC) for the firm to continue supply
in the short-run. If Price falls below AVC then the firm
will Shut-down. Hence if price is below Rs.34, firm
will not produce.
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Productivity and costs in the long
run
 In the long run both capital and labour are variable

 Firms can change the amount of machines or office


space that they use

 Therefore, the law of diminishing returns does not


determine the productivity of a firm in the long run

 In the long run productivity and costs are driven by


returns to scale

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Implications of factor substitution
(1)
COST

SRATC1

SRATC2

AC1
AC2
AC3

Q1 Q2 OUTPUT

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• When a firm substitutes labour with
machinery, and the investment makes the
firm more efficient, then the average cost
curve would move down to the right as in
the previous slide.
• If investment does not increase
productivity and does not change average
costs then the cost curve does not
change.
Implications of factor substitution
(2)

COST

SRATC1 SRATC2

AC1

Q1 Q2 OUTPUT

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Long run average cost curve
• The long run average cost curve is simply
a collection of short run average cost
curves, illustrating how average costs
change as fixed inputs (plant size, type
and number of machines etc) change.
The long run average cost curve

COST
PER UNIT
ATC3
ATC2
ATC1

LRAC

x1 x2 x3 OUTPUT

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LAC/ Envelope Curve
• The LAC is also called the planning curve
because it is a guide to the entrepreneur
for planning the future expansion of the
firm and choosing the optimal scale or
plant size for the production.
Long run averagre cost curves

COST PER
UNIT
LRAC

attainable
c1

c2

unattainable

Q1 OUTPUT

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Returns to scale

 Returns to scale measures the change in output for a


given change in inputs

 Increasing returns to scale exist when output grows


at a faster rate than inputs

 Decreasing returns exist when inputs grow at a faster


rate than outputs

 Constant returns to scale exist when inputs and


outputs grow at the same rate
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Returns to scale

COST
PER UNIT

LRAC

ng
inc

asi
rea

cre
sin

de
g

constant
MES
OUTPUT
Qm

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Importance of minimum efficient
scale (MES)
 MES is the size of operation with the lowest average
cost. If a factory operate at an output size where it is not
achieving MES, it would be incurring higher average
costs which would finally make it uncompetitive.
 MES is the size beyond which no significant economies
of scale can be achieved

 Cost advantage over rivals

 Firms may merge to achieve MES

 Firms may diversifyDTA- Managerial Economics


to avoid low cost competition
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Examples of economies of
scale

 Production techniques:
Maruthi Suzuki and Rolls Royce

 Indivisibilities: huge machinery

 Specialisation and division of labour

 By-products

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Costs in the Long Run
All inputs that are under the firm’s
control can be varied  there are no
fixed costs ( all inputs are flexible)

Long run is best thought of as a planning


horizon

Firms plan for the long run, but they


produce in the short run

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Long-Run Planning Curve

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Firm’s Long-Run Planning Curve

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Economies of Scale

Notice that the long-run average curve is


U-shaped, a result of economies and
diseconomies of scale

Economies of scale imply that long-run


average costs decline as output expands
while diseconomies of scale imply that
long-run average costs increase as output
increases 31
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Economies of Scale

 A larger size often allows for larger, more


efficient machines and allows workers a greater
degree of specialization  Production
techniques such as the assembly line can be
utilized only if the rate of output is large
enough

 Typically, as the scale of the firm increases,


capital substitutes for labor and complex
machines substitute for simpler machines
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Diseconomies of Scale

As a firm expands, diseconomies of scale,


eventually take over: long-run average
cost increase as output expands
Additional layers of management are
needed to monitor production
 The more levels of management in an
organization, the more difficult it is for top
management to communicate with those
that perform most of the production tasks
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A Firm’s Long-Run Average Cost Curve

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