Theory of cost.pptx.pdf
- 1. Theory of cost • Economic theory of cost distinguishes between short-run costs and long-run costs. Short-run costs are the costs over a period during which some factors of production (usually capital equipment and management) are fixed. C = ƒ(X, T, Pf , K)
- 2. Theory of cost • where C = total cost • X = output • T — technology • Pf = prices of factors • K = fixed factor(s)
- 3. Theory of cost • The long-run costs are the costs over a period long enough to permit the change of all factors of production. In the long run all factors become variable. Both in the short run and in the long run, total cost is a multivariable function, that is, total cost is determined by many factors. • C = ƒ(X, T, Pf , K) where • C = total cost • X = output • T — technology • Pf = prices of factors
- 4. Theory of cost • Fixed and variable costs • Fixed costs (FC) - costs that do not change as production is increased or decreased. They have to be paid in advance of production. They exist even if output is zero. • Variable costs (VC) - costs that vary with output. • Total, average and marginal cost • Total costs (TC) - the sum of fixed costs and variable costs at a particular level of output. So TC = TFC + TVC. • Marginal costs (MC) - the cost of one more unit of output. In other words the increase in total cost from producing one more unit of output. • Average costs (AC) - total costs divided by the level of output. There are three aspects of average cost: average total cost (ATC) which is total cost divided by the level of output, average fixed cost (AFC) which is total fixed cost divided by the level of output and average variable cost (AVC) which is total variable cost divided by the level of output. • These costs all relate to operations at a point in time, but they can all vary with time.
- 5. Theory of cost • Fixed costs • These costs are those that remain unchanged as the output level of the firm changes. It does not matter what level of output the firm produces (even zero output makes no difference), any cost which is a fixed cost will remain the same. Common examples of fixed costs are as follows: • Examples of fixed costs • Rent • Interest on loans • Insurance • Depreciation
- 7. Theory of cost • Variable costs • Any cost which varies directly with the level of output would be classified as a variable cost. Varying directly means that the total variable cost will be dependent on the level of output. Common examples of variable costs are as follows: • Example of variable costs • Direct labour • Raw materials and components • Packaging costs • Heating and lighting • Variable costs can be represented on a graph and this would appear as follows:
- 9. Theory of cost • Short Run Total Costs Curves • The total cost (TC) of business is the sum of the total variable costs (TVC) and total fixed costs (TFC). Hence, we have • TC = TFC + TVC • The following diagram represents the TC, TFC, and TVC (short-run total costs)
- 10. Theory of cost
- 11. Theory of cost • As we can see, the TFC curve starts from a point on the Y-axis and is parallel to the X-axis. This implies that even if the output is zero, the firm incurs a fixed cost. • The TVC curve, on the other hand, rises upwards. This implies that TVC increases as the output increases. This curve starts from the origin which shows that variable costs are nil when the output is zero. • The total cost curve (TC) is obtained by adding the TFC and TVC vertically.
- 12. Theory of cost • Short Run Average Costs • 1. Average Fixed Cost (AFC) • The average fixed cost is the total fixed cost divided by the number of units produced. Hence, if TFC is the total fixed cost and Q is the number of units produced, then • AFC=TFCQ • Therefore, AFC is the fixed cost per unit of output. • Example: The TFC of a firm is Rs. 2,000. If the output is 100 units, the average fixed cost is, • AFC=TFCQ=2000100=Rs.20
- 13. Theory of cost • If the output is increased to 200 units, then • AFC=TFCQ=2000200=Rs.10 • Since TFC is constant, any increase in output decreases the AFC. Note that, while the AFC can become really small, it is never zero.
- 14. Theory of cost • 2. Average Variable Cost (AVC) • The second aspect of short-run average costs is an average variable cost. Average variable cost is the total variable cost divided by the number of units produced. Hence, if TVC is the total fixed cost and Q is the number of units produced, then • AVC =TVC/Q • Therefore, AVC is the variable cost per unit of output. • Usually, the AVC falls as the output increases from zero to normal capacity output. Beyond the normal capacity, the AVC rises steeply due to the operation of diminishing returns.
- 15. Theory of cost • 3. Average Total Cost (ATC) • The average total cost is the sum of the average variable cost and the average fixed costs. That is, • ATC = AFC + AVC • In other words, it is the total cost divided by the number of units produced. • The diagram below shows the AFC, AVC, ATC, and Marginal Costs (MC) curves: •
- 16. Theory of cost
- 17. Theory of cost • It is important to note that the behaviour of the ATC curve depends upon that of the AVC and AFC curves. Observe that: • In the beginning, both AVC and AFC curves fall. Hence, the ATC curve falls as well. • Next, the AVC curve starts rising, but the AFC curve is still falling. Hence, the ATC curve continues to fall. This is because, during this phase, the fall in the AFC curve is greater than the rise in the AVC curve. • As the output rises further, the AVC curve rises sharply. This offsets the fall in the AFC curve. Hence, the ATC curve falls initially and then rises.
- 18. Average fixed cost • Fixed cost per unit of output denotes average fixed cost.
- 20. Theory of cost • Marginal Cost (MC) • Another concept to learn in short-run average costs is Marginal Cost. Marginal cost is the addition made to the cost of production by producing an additional unit of the output. In simpler words, it is the total cost of producing t units instead of t-1 units. Let’s look at an example to understand this better: • A firm produces 5 units at a total cost of Rs. 200. For some reasons, it is required to produce 6 units instead of 5 and the total cost is Rs. 250. Therefore, the marginal cost is Rs. 250 – Rs. 200 = Rs. 50. • A note about marginal costs: It is independent of fixed costs. This is because fixed costs do not change with the output. On the other hand, in the short run, the variable costs change with the output. Hence, marginal costs are due to changes in variable costs. Therefore, • MC=ΔTCΔQ • … where ΔTC is the change in the total cost and ΔQ is the change in the output. This equation can also be written as:MCn = TCn – TCn-1 • In the Fig. 1 above, you can see that the MC curve falls as the output increases in the beginning and starts rising after a certain level of the output. This is because of the influence of the law of variable proportions. Since the marginal product rises first, reaches a maximum and then declines, the marginal costs decline first, reaches its minimum and then rises.
- 21. Theory of cost • Relationship between Average Cost and Marginal Cost • If the average cost falls due to an increase in the output, the marginal cost is less than the average cost. • If the average cost rises due to an increase in the output, the marginal cost is more than the average cost. • Marginal cost is equal to the average cost when the marginal cost is minimum. You can see in Fig. 1 that the MC curve cuts the ATC curve at its minimum or optimum point.
- 22. Theory of cost • Solved Question on Short Run Average Costs • Q1. Which of the following statements is true of the relationship between the average cost functions in short run average costs? • ATC = AFC – AVC. • AVC = AFC + ATC. • AFC = ATC + AVC. • AFC = ATC – AVC. • Answer: By the definition of the Average Total Cost (ATC), we know that • ATC = AFC + AVC • Therefore, from the options given above, option d is the current answer. That is, • AFC = ATC – AVC