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
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