Average & Marginal Cost Schedules

Total Cost Curves

Average & Marginal Cost Curves

1
Short Run Cost Curve Relations

 AFC decreases continuously as output increases

 Equal to vertical distance between ATC & AVC

 AVC is U-shaped

 Equals SMC at AVC’s minimum

 ATC is U-shaped

 Equals SMC at ATC’s minimum

 SMC is U-shaped

 Intersects AVC & ATC at their minimum points

 Lies below AVC & ATC when AVC & ATC are falling

 Lies above AVC & ATC when AVC & ATC are rising

Graphing Per Unit Output Cost Curves

The Shapes of Cost Curves

 The variable and total cost curves have the same shape

 Increasing output increases VC and TC

• The fixed cost curve is always constant

• Increasing output doesn’t change FC

• The marginal cost, average variable cost, and average total cost curves are U-shaped

• Increasing output initially leads to a decrease in MC, AVC, and ATC but
eventually they increase

• The U-shape of ATC and AVC curves is due to:

• When output is increased in the short run, it can only be done by increasing
the variable input

• The law of diminishing productivity causes marginal and average

2
 • As average and marginal productivities fall, average and marginal costs rise

• The marginal cost curve goes through the minimum points of the ATC and AVC curves

The Relationship Between

Marginal Cost and Average Cost

 If MC > ATC, then ATC is rising

 If MC > AVC, then AVC is rising

 If MC < ATC, then ATC is falling

 If MC < AVC, then AVC is falling

 If MC = AVC and MC = ATC, then AVC and ATC are at their minimum points

Relations Between Short-Run Costs & Production

 When marginal product (average product) is increasing, marginal cost (average cost) is
decreasing

 When marginal product (average product) is decreasing, marginal cost (average variable
cost) is increasing

 When marginal product = average product at maximum AP, marginal cost = average
variable cost at minimum AVC

Concept of revenue is divided into total revenue , marginal revenue , average revenue

Concepts of Revenue defined

 Total Revenue: Sum of all sale receipts or income of a firm.

TR=PхQ where P stands for Price of the product & Q stands for Quantity

 Marginal Revenue: Change in TR which results from the sale of one more or one less unit of
output. ∆TR/ ∆Q or MR=TRn – TRn-1

 Average Revenue: Per unit revenue received from the sale of a commodity.
AR=TR/Q=PQ/Q=P

Relationship : AR and MR under Perfect Competition

 Perfect Competition is a market situation where single price prevails and it has no tendency
to change.

3
  Since under Perfect Competition, price of commodity remains constant. Therefore AR curve
of firm is parallel to X axis.

 When AR is parallel to X axis, MR = AR. Meaning that MR is also parallel to X axis.

Table: AR, MR under Perfect Competition

TR, AR and MR curves under Perfect Competition

Relationship : AR and MR under Imperfect Competition

 imperfect competition is a market situation where the firm is price maker and it knows that
it must reduce price if it wants to sell more.

 Therefore, AR curve of the firm is downward sloping. This leads to downward slope of MR
curve also.

 But the slope of MR curve is double the slope of AR curve.

4
AR and MR curves under Monopoly

AR and MR curves under Monopoly

AR and MR under Imperfect Competition

 Following results emerge:

1. Both AR and MR are derived from TR

2. AR and MR are both downward sloping.

3. Slope of MR is double the slope of AR

4. AR is always positive but same is not true about MR as MR may be positive, zero or even
negative

5
Cost

Long-Run Costs

 A firm adjusts all its inputs so its cost of production is as low as possible.

 If capital and other variable costs can be varied, LR fixed costs equal zero (F = 0).

 Thus LR total cost = LR variable cost:

C = VC

The Long-Run Cost Function

 In the long run, all inputs to a firm’s production function may be changed.

 Because there are no fixed inputs, there are no fixed costs.

 The firm’s long run marginal cost pertains to returns to scale.

 First, increasing returns to scale.

 As firms mature, they achieve constant returns, then ultimately decreasing returns
to scale.

 When a firm experiences increasing returns to scale:

 A proportional increase in all inputs increases output by a greater proportion.

 As output increases by some percentage, total cost of production increases by some

The Relationship Between Optimal Input Choice And Long-run Costs

 Increasing returns to scale - long-run total cost rises less than in proportion to increases in
output

 Constant returns to scale - long-run total costs are thus exactly proportional to output.

 Decreasing returns to scale - a given proportional increase in output requires a greater

Chapter summery

• The law of diminishing marginal productivity states that as more of a variable input is added
to a fixed input, the additional output will eventually be decreasing

6
 • Costs are generally divided into fixed costs, variable costs, and marginal costs

• TC = FC + VC

• MC = ΔTC/ΔQ

• AFC = FC/Q

• AVC = VC/Q

• ATC = AFC + AVC

• AVC and MC are mirror images of the average and marginal products

• The law of diminishing marginal productivity causes marginal and average costs to rise

• MC goes through the minimum points of the AVC and ATC

• If MC > ATC, then ATC is rising

• If MC = ATC, then ATC is constant

• If MC < ATC, then ATC is falling

Economies of Scale (Increasing Returns

 Internal – advantages that arise as a result of the growth of the firm

 Technical

 Commercial

 Financial

 Managerial

 Risk Bearing

 External economies of scale – the advantages firms can gain as a result of the growth of the
industry – normally associated with a particular area

 Supply of skilled labour

 Reputation

 Local knowledge and skills

 Infrastructure

Training facilities

 There are economies of scale in production when the long run average cost decreases as
output increases.

7
  Economies of scale (increasing returns to scale) are cost savings associated with larger scale
of production.

In the longer run all inputs are variable, so only economies of scale can influence the shape of the
long run cost curve

 Economies of scale occur whenever inputs do not need to be increased in proportion to the
increase in output.

 As output increases, cost per unit falls in the long run, so this can also be seen as an increase
in productivity.

 Internal: Technical

 Specialisation – large organisations can employ specialised labour

 Indivisibility of plant – machines can’t be broken down to do smaller jobs!

 Principle of multiples – firms using more than one machine of different capacities -
more efficient

 Increased dimensions – bigger containers can reduce average cost

 Indivisibility of Plant:

 Not viable to produce products like oil, chemicals on small scale – need large amounts of
capital

 Agriculture – machinery appropriate for large scale work – combines, etc.

 Principle of Multiples:

 Some production processes need more than one machine

 Different capacities

 May need more than one machine to be fully efficient

 Commercial

 Large firms can negotiate favourable prices as a result of buying in bulk

 Large firms may have advantages in keeping prices higher because of their market power

 Financial

 Large firms able to negotiate cheaper finance deals

 Large firms able to be more flexible about finance – share options, rights issues, etc.

8
  Large firms able to utilise skills of merchant banks to arrange finance

 Managerial

 Use of specialists – accountants, marketing, lawyers, production, human resources,

 Risk Bearing

 Diversification

 Markets across regions/countries

 Product ranges

R&D

Increasing Returns to Scale (IRTS)

 Increasing returns to scale is where long run average total costs fall as output increases.

 It is shown by the decreasing portion of the LRAC curve.

 Constant returns to scale is where long run average total costs do not change as output
increases.

 It is shown by the flat portion of the LRAC curve.

Diseconomies of Scale

 There are limits to the amount a business can grow

 If businesses grow to large they start to suffer from Diseconomies of Scale

 These diseconomies happen because the larger the business the more difficult it becomes to
manage

Decreasing Returns to Scale (DRTS)

 Decreasing returns to scale or diseconomies of scale refer to decreases in productivity

 Decreasing returns to scale occur where the long run average cost curve is upward sloping,
meaning that average cost is increasing.

 The disadvantages of large scale production that can lead to increasing average costs

 Problems of management

9
  Maintaining effective communication

 Co-ordinating activities – often across

 De-motivation and alienation of staff

 Divorce of ownership and control

Decreasing Returns to Scale

 Diseconomies occur for a number of reasons as the firm increases its size

 Coordination of a large firm is more difficult

 Information costs and communication costs increase as firm increases

 Monitoring costs increase

 Team spirit may decrease

Summary of Returns to Scale

Economies and Diseconomies of Scale

Importance of Economies of Scale

Economies and diseconomies of scale play important roles in real-world long run production
decisions

10
 Long run cost function

 Economies of Scale: situation where a firm’s long-run average cost (LRAC) declines as output
increases.

 Diseconomies of Scale: situation where a firm’s LRAC increases as output increases.

In general, the LRAC curve is u-shaped

Economies of Scale

Long run cost function

 Reasons for Diseconomies of Scale

 Scale of production becomes so large that it affects the total market demand for
inputs, so input prices rise.

 Transportation costs tend to rise as production grows.

 Handling expenses, insurance, security, and inventory costs affect

 Reasons for Diseconomies of Scale

 Scale of production becomes so large that it affects the total market demand for
inputs, so input prices rise.

 Transportation costs tend to rise as production grows.

 Handling expenses, insurance, security, and inventory costs affect

The Long-run Average Cost Curve

The long-run average cost curve shows the minimum average cost at each output level when all
inputs are variable, that is, when the firm can have any plant size it wants.

There is a relationship between the LRAC curve and the firm's set of short-run average cost curves.

SR and LR Average Costs

 Economists use the term “plant size” to talk about having a particular amount of fixed
inputs. Choosing a different amount of plant and equipment (plant size) amounts to
choosing an amount of fixed costs.

 Economists want you to think of fixed costs as being associated with plant and equipment.
Bigger plants have larger fixed costs.

11
 If each plant size is associated with a different amount of fixed costs, then each plant size for
a firm will give us a different set of short-run cost curves.

 Choosing a different plant size (a long-run decision) then means moving from one short-run
cost curve to another.

 Here, each short-run cost curve corresponds to a particular amount of fixed inputs.

 As the fixed input amount increases in the long run, you move to different SR cost curves,
each one corresponding to a particular plant size.

 In the graphs of LRAC curves presented so far that the curves have been drawn to be U-
shaped. That is, when output is increasing LRAC at first falls, and then eventually rises.

 The overall shape of the long-run average cost curve depends on the technology of
production.

Long run cost

12
13
 The Envelope of
Short-Run Average Total Cost Curves

Costs per
unit

LRATC
SRATC1 SRATC4
SRMC1 SRMC4
SRATC2
SRMC2 SRATC3
SRMC3

Q
The long-run average total
cost curve (LRATC) is an
envelope of the short-run
average total cost curves
(SRATC14)

The Envelope /Planning CurvE

• Long-run costs are always less than or equal to short-run costs because:

• In the long run, all inputs are flexible

• In the short run, some inputs are fixed

14
 • There is an envelope relationship between long-run and short-run average total costs. Each
short-run cost curve touches the long-run cost curve at only one point.

• In the short run all expansion must proceed by increasing only the variable input

• This constraint increases cost

Long-Run Average Total Cost

 Long-run average total cost (LRATC): the lowest-cost combination of resources with which
each level of output is produced when all resources are variable.

 The long-run average total cost curve gets its shape from economies and diseconomies of
scale.

Shape of LRATC

 If producing each unit of output becomes less costly there are economies of scale.

 If producing each unit of output becomes more costly there are diseconomies of
scale.

 If unit costs remain constant as output rises there are constant returns to scale.

 Break-Even Analysis

 Break-Even Analysis is used to

 predict future profits/losses

 predict results eg produce Product A or Product B

 Break-Even Point is when Sales Revenue equals Total Costs

 at this point no profit or loss is incurred

 the firm merely covers its total costs

 Break-Even Point can be shown in graph form or by use of formulae

Algebraic Solution

 Equate total revenue and total cost functions and solve for Q

TR = P x Q

TC = FC + (VC x Q)

TR = TC

P x QB = FC + VC x QB

15
(P x QB) – (VC x QB) = FC

QB (P – VC) = FC

QB = FC/(P – VC)

Breakeven Chart

Assumptions of Breakeven Analysis

1. Costs can be reasonably subdivided into fixed and variable components.

2. All cost-volume-profit relationships are linear.

3. Sales prices will not change with changes in volume.

Limitations of Break Even Analysis

 Some costs cannot be identified as precisely Fixed or Variable

 Semi-variable costs cannot be easily accommodated in break-even analysis

 Costs and revenues tend not to be constant

 With Fixed costs the assumption that they are constant over the whole range of output
from zero to maximum capacity is unrealistic

Limitations Continued

16
  Price reduction may be necessary to protect sales in the face of increased competition

 The sales mix may change with changes in tastes and fashions

 Productivity may be affected by strikes and absenteeism

 The balance between Fixed and Variable costs may be altered by new technology

Breakeven Applications

Major applications:

1. New product decisions

2. Pricing decisions

3. Modernization or automation decisions.

4. Expansion decisions.

5. Sales Volume Decisions

6. Product-Mix decisions

Forecast Profit

Breakeven Applications

1. New product decisions

 Determine sales volume required for firm (or individual product) to break even,
given expected sales and expected costs

2. Pricing decisions

 Study the effect of changing price and volume relationships on total profits

3. Modernization or automation decisions

 Analyze profit implications of a modernization or automation program

 In this case, firm substitutes fixed costs (i.e. capital equipment costs) for variable
costs (i.e. direct labour)

4. Expansion decisions

 Study aggregate effect of general expansion in production and sales

 In this case, relationships between total Rupee sales for all products and total
Rupee costs for all products are examined in order to indentify potential changes
in these relationships

17
18