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Session 6: COST ANALYSIS - I

2. 2.1 Post Work Learning Objective (i) (ii) (i) 2.2 2.2.1 to define and examine economic cost of inputs to develop cost output relationship framework for business decisions to derive firms supply curve in the short run

Summary Economic cost of inputs A business firms production function indicates how much of each input is required for producing various amounts of the product (Q). In determining the cost of producing the product, a business firm should be able to determine the true cost of the inputs used. A firm may be using both owned and purchased inputs in the production activity. While explicit expenditure is incurred for the

purchased inputs, costs have to be imputed for owned inputs based on opportunity cost principle.

The opportunity cost of an input may not be equal to the historical cost. Assume, a TV is bought for Rs. 10,000. Two months later prices fall to Rs. 8,000. In this case, Rs. 10,000 is the historical cost and Rs. 8,000 is the current opportunity cost of TV. In managerial decision making, current opportunity cost reflects the true value of the input used.

Since all resources/inputs used are scarce and have alternate uses, cost implications of production decisions, take into account the economic costs of production which covers both the explicit and implicit costs.


Cost output relationship framework Since the cost of all factor inputs are accounted for while defining Total Costs, normal profits i.e. the returns to entrepreneurship are included in the cost of production. For profit maximization, production decisions aim to maximize supernormal profits. In the short run, the cost determinants are the output (Q) to be produced and the quantum of inputs used. This would imply that as Q increases, Total Costs (TC) also rise. And, since fixed and variable inputs are used, correspondingly and Total Variable Costs (TVC). The increase in TC, TFC and TVC is not the same over the output range. Therefore, the cost implications of output decisions are based on Average Costs (AC), Average Fixed Cost (AFC) and Average Variable Cost (AVC). Average cost relationships are derived from the underlying average productivity of inputs, i.e. AFC, AVC, are inversely related to the average productivity of factor inputs. Output corresponding to we have, Total Fixed Costs (TFC)

minimum AC is defined as cost efficient output. A firm may decide to produce on the rising part of the AC curve under rising output price conditions. Similarly, a firm may decide to operate

on the falling part of the AC curve under declining output price conditions. This is referred to Excess capacity. 2.2.3 Firms supply curve The MC curve above the AVC represents the supply curve of the firm. The upward sloping MC curve reflects the incremental costs associated with increasing output (Q). If the market price corresponds to the firms MC curve above AC curve, then the firm would be earning supernormal profits. If the market price corresponds to the firms MC curve above the AVC, a firm will be minimizing the loss as a part of the fixed costs are recovered. 2.3 Readings 1. 2. 2.4 Handout 4: Opportunity Cost and the Supply of goods Text Book: Chapter 8

Learning Activities 1. Kevin Coughlin, a lawyer working for a large firm and earning $60,000 per year, is contemplating setting up his own law practice. He estimates that renting an office would cost $10,000 per year, hiring a legal secretary would cost $20,000 per year, renting the required office equipment would cost $15,000 per year, and purchasing the required supplies, paying for electricity, telephone, and so forth would cost another $5,000. The lawyer estimated that his total revenues for the year would be $100,000, and he is indifferent between keeping his present occupation with the large

law firm and opening his own law office. (a) How much would be the explicit costs of the lawyer for running his own law and office for the year? (b) How much would the accounting costs be? The

implicit costs? The economic costs? (c) Should the lawyer go ahead and start his own practice? 2. Indicate whether each of the following involves an upward or downward shift in the average cost curve or, instead, involves a leftward or rightward movement along a given curve. Also indicate whether each will have an increasing, or uncertain effect on the level of average cost. A. B. C. D. E. 3. A rise in wage rates A decline in output An energy-saving technical change A fall in interest rates An increase in learning or experience

Airway Express has an evening flight from Los Angeles to New York with an average of 80 passengers and a return flight the next afternoon with an average of 50 passengers. The plane makes no other trip. The charge for the plane remaining in New York

overnight is $1,200 and would be zero in Los Angeles. The airline is contemplating eliminating the night flight out of Los Angeles and replacing it with a morning flight. The estimated number of

passengers is 70 in the morning flight and 50 in the return afternoon flight. The one-way ticket for any flight is $200. The operating cost of the plane for each flight is $11,000. The fixed costs for the plane are $3,000 per day whether it flies or not. (a) Should the airline replace its night flight from Los Angeles with a morning flight? (b) Should the airline remain in business?