Theory of Costs - Introduction to Costs

Theory of Costs - Introduction to Costs Nitish Kumar Arya M.A. Economics Banaras Hindu University Varanasi 221005

Why Study Costs?: 

Why Study Costs? Whatever may be the type of firm, it is important to ascertain that it is not incurring losses Decisions relating to expansion (or otherwise), new product development, forecasting and policy making, etc can be taken only after considering costs Concept of cost is closely related to production theory Cost function is the relationship between a firm’s costs and the firm’s output The production function combined with input prices yields the firm’s cost function

Cost Concepts: 

Cost Concepts Money costs (Actual Costs) are the total money incurred by a firm in producing a commodity or service wages and salaries, cost of raw materials, expenses on machines/buildings/capital goods, power charges, transportation, advertisement, interest expenses, taxes, depreciation etc Implicit costs are the imputed value of the entrepreneurs own resources and services Variable costs are costs that vary with the volume of output Fixed costs do not vary with output in the short-run

Cost Concepts: 

Cost Concepts Opportunity cost is the cost of missed opportunity or alternative forgone in having one thing rather than the other (since resources are limited they cannot be used to produce all things simultaneously) Actual Cost Vs Opportunity Cost Measurement of opportunity cost is difficult Marginal Cost is the addition to the total cost by producing an additional unit of out put MC = change in TC/change in TO

Costs: 

Costs

Cost Curves: 

Cost Curves

Cost Concepts: 

Cost Concepts TC=TFC+TVC AFC=TFC/Total Output AVC=TVC/Total Output AC=TC/Q = (TVC+TFC)/Q = AVC+AFC MC = change in TC/change in TO

Short-run and Long-run: 

Short-run and Long-run Meaning of Short-run and Long-run in Economics Short-run is defined as a time period during which some factors of production are fixed and others are variable In the Long-run all factors of production are variable It is important to note that these periods are not defined by any specified length of time but instead are determined by the variability of factors of production

PowerPoint Presentation: 

MC ATC AVC AFC cost output

Short-run Cost Curves: 

Short-run Cost Curves AFC+AVC= ATC and therefore, ATC curve lies above both AFC and AVC AFC curve does not touch Y and X axes. Because the total FC is constant and increased output is accomplished by falling AC MC curve cuts AVC and ATC curves from below at the lowest points of both the curves

Why Short-run Avg Cost curve U shaped?: 

Why Short-run Avg Cost curve U shaped? Average Cost curve is made of of AFC and AVC AFC and AVC both slopes downwards in the initial stages (therefore, AC) After a particular point, AVC starts raising (rate which more than offsets the rate of fall in AFC) This results in U shaped Average Cost curve fixed factor better utilized as output increases marginal cost increases - therefore average cost

Long-run Average Cost: 

Long-run Average Cost SAC1 SAC2 SAC3 SAC4 SAC5 LAC

Long-run Average Cost: 

Long-run Average Cost In the long-run all factors of production are variable LAC can only be tangential to an SAC, because long-run cost can not be higher than short-run LAC is also known as planning curve Shape of LAC depends on the returns to scale (if returns are constant LAC will be parallel to X axis. If increasing returns then, LAC will be falling downward and if diminishing returns LAC will move upwards)

PowerPoint Presentation: 

MC ATC AVC AFC cost output

Law of Variable Proportions: 

Law of Variable Proportions “as the quantity of a variable input is increased by equal doses, keeping the quantities of other inputs constant, the total product will increase, but after a point, at a diminishing rate” In other words, when more and more units of the variable factor is used (holding the quantities of other factors constant), a point is reached beyond which the marginal product, then the average product and finally the total product will diminish This law is also known as law of diminishing returns

Law of Diminishing Returns: 

Law of Diminishing Returns

PowerPoint Presentation: 

Law of Diminishing Returns

Importance of Law: 

Importance of Law It applies to not only agriculture but also industry - universal applicability By substituting one factor in place of other, efficiency (or higher levels of production and productivity) can be achieved Remember the importance of capital and labour as factors of production in developing nations

Law of Returns to Scale: 

Law of Returns to Scale What happens when all the inputs are increased in the same proportion? The scale of production will increase - but effect on production shows three stages Increasing Returns to Scale Constant Returns to Scale Diminishing Returns to Scale

Law of Returns to Scale: 

Law of Returns to Scale

Production Function Isoquant and Isocost Approach: 

Production Function Isoquant and Isocost Approach An isoquant is a curve on which the various combinations of labor and capital show the same output. This curve is also known as production indifference curve

Production Function Isocost Approach: 

Production Function Isocost Approach Isocost curves are also known as outlay lines, price lines, input-price lines, factor-cost lines, constant-outlay lines etc. Each isocost line represents the different combinations of two inputs that a firm can buy for a given sum of money at the given price of each point.

Equilibrium of Firm -What is equilibrium?: 

Equilibrium of Firm -What is equilibrium? Firms will produce in such a way that the profit is maximized Firms will not change the production function at equilibrium output Profit = TR-TC TR = P x Q (price x quantity) AR = TR/Q = (P x Q)/Q = P therefore, AR curve showing different values of AR at various levels of output is same as the demand curve faced by an individual firm (latter shows quantities)

Shape of Demand Curve: 

Shape of Demand Curve Relationship between AR and Q is shown by the shape of the demand or AR curve AR upward sloping or rising left to right AR downward sloping AR horizontal to X axis First possibility is unlikely - a firm may not be able to sell larger and larger output by charging higher and higher price The second and third depends on the type of market

Marginal Revenue: 

Marginal Revenue MR= TR (N+1) - TR (N) or change in total revenue upon change in quantity Therefore, MR is equal to the slope of TR curve Relation between AR and MR MR = change TR/change Q MR = change (PxQ)/change Q = change (ARxQ)change Q =AR(change Q/change Q) + Q (change AR/change Q) MR=AR+Q(change AR/change Q) therefore (MR-AR) = Qx(slope of AR curve) MR = AR when AR is horizontal and MR is <AR when AR is downward sloping

Thank You: 

Thank You Nitish Kumar Arya M.A. Economics Banaras Hindu University Varanasi 221005