Cost concepts & its Analysis

Certain concept of cost

Opportunity cost is the cost concept most relevant to economic decisions. The OC of any decision is the value of the next best alternative that must be foregone. Explicit Cost are those costs that involve an actual payment to other parties Implicit costs represent the value of foregone opportunities but do not involve an actual cash payment Sunk cost are cost which cannot be recovered by renting or selling the productive resources.

Economic costs refers to the costs involved for all the factors of production including those purchased from outside as well as those owned by the firm. In other words, it is the normal returns to the management which is necessary to keep the resources from shifting to other firms Direct & Indirect cost Direct cost are directly associated with the production of a given product like labour cost , raw material etc. Indirect cost are cost which cannot be separated and are directly attributed to individual units of production like depreciation of plant & machinery, administrative charges etc

Fixed & Variable cost Fixed cost are cost that do not vary with the changes in the output of a product. These are associated with the existence of a firms plant and therefore, must be paid even if the firms level of output is zero.. Eg. Payment of interest, rent, salaries of top level management. Variable costs are those which varies with the level of output. Eg. Payment of raw materials, payment of wages

Short-run Cost Functions

In SR capital is fixed and labour is variable. Total cost = TC = TVC + TFC or, TC = wL+rK, rk is fixed or, TC = wL or, TC = TVC in short run ATC = TC/Q AVC = TVC/Q AFC = TFC/Q MC =d(TC)/dQ

Deriving TC curve from TP curve

TC, TVC & TFC Curves

Deriving AC & MC curve from TC curve

Relationship between the curves

ATC = AFC + AVC = (TFC/Q) + (TVC/Q) When MC<ATC, then ATC is falling When MC>ATC, then ATC is rising When MC<AVC, then AVC is falling When MC>AVC< then AVC is rising This implies that MC must intersect both ATC & AVC at their minimum points ATC reaches its minimum point at a larger output than AVC because ATC = AFC + AVC and so even when AVC has begun to rise, AFC is still declining, hence pulling ATC down. Eventually, the increase in AVC will offset the decrease in AFC and ATC will begin to increase.

Economies of Scale(ES) Internal economies of scale/ real economies of scale : This arise from an increase in the firms plant size. This can be in achieved through : Production economies of scale - labour economies - Technical economies - Inventory economies Selling economies are associated with the distribution of the product of a firm. The most important of these economies is advertising economies Advertising expenditure increase less than proportionately with ES.

Managerial economies arises for mainly two reasons - Specialization of management -Mechanization of managerial functions

Transport & storage economies : it comes down with increase in sales

Pecuniary economies of scale/ external economies of scale These are economies accruing to the firm due to the discounts it can obtain for its large scale operations. They can be achieved by : - Reduction in the prices of raw materials - Lower cost of external finance - Lower advertising rates - Lower transport rates - Using the monopoly power and paying less to the employees or using its prestigious position for giving less payment to the employees

Diseconomies of scale There is a limit to the gain achieved from large scale of operations, which means that there is an optimum level of capacity and any increase in the scale beyond this level leads to diseconomies of scale They can arise from managerial difficulties, low employee morale, higher input price etc.

Long run cost functions

L= g1(Q) K = g2(Q) C = Lw + Kr or, C = wg1(Q) + rg2(Q) or, C=C(Q) LRAC = C/Q , LRMC = dC /dQ

Long-run Cost curves

LRAC = TC/Q , LRMC = d(TC) /dQ Lo

Equiliburium Condition
LRAC = SRAC LRMC = SRMC