Scribd
Upload
83 views26 pages

The Theory and Estimation of Cost: Unit-IV

The document discusses the relationship between production and costs in the short-run and long-run. In the short-run, costs are comprised of fixed and variable costs. Average and marginal costs are defined. In the long-run, all costs are variable and the long-run average cost curve is U-shaped, initially falling with economies of scale then rising with diseconomies of scale.

Uploaded by

Surya Narayana
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
83 views26 pages

The Theory and Estimation of Cost: Unit-IV

The document discusses the relationship between production and costs in the short-run and long-run. In the short-run, costs are comprised of fixed and variable costs. Average and marginal costs are defined. In the long-run, all costs are variable and the long-run average cost curve is U-shaped, initially falling with economies of scale then rising with diseconomies of scale.

Uploaded by

Surya Narayana
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 26

The Theory and

Estimation of Cost

Unit-IV
The Relationship Between
Production and Cost
 Cost function is simply the production
function expressed in monetary rather
than physical units.
 Assume the firm is a “price taker” in the
input market.
The Relationship Between
Production and Cost

 Total Variable Cost (TVC): the cost


associated with the variable input, determined
by multiplying the number of units by the unit
price.
 Marginal Cost (MC): the rate of change in
total variable cost. TVC
MC 
Q
 The law of diminishing returns implies that
MC will eventually increase
The Short-Run Cost Function
 For simplicity the following assumptions are made:
 The firm employs two inputs, labor and capital.
 The firm operates in a short-run production period where labor is
variable, capital is fixed.
 The firm uses the inputs to produce a single product.
 The firm operates with a fixed level of technology.
 The firm operates at every level of output in the most efficient
way.
 The firm operates in perfectly competitive input markets and
must pay for its inputs at a given market rate. It is a “price taker”
in the input markets.
 The short-run production function is affected by the law of
diminishing returns.
The Short-Run Cost Function
 Standard variables in the short-run cost function:
 Quantity (Q): the amount of output that a firm can
produce in the short run.
 Total fixed cost (TFC): the total cost of using the fixed
input, capital (K)
 Total variable cost (TVC): the total cost of using the
variable input, labor (L)
 Total cost (TC): the total cost of using all the firm’s
inputs, L and K.
TC = TFC + TVC
The Short-Run Cost Function
 Standard variables in the short-run cost function:
 Average fixed cost (AFC): the average per-unit cost of using the
fixed input K.
AFC = TFC/Q
 Average variable cost (AVC): the average per-unit cost of using
the variable input L.
AVC = TVC/Q
 Average total cost (AC) is the average per-unit cost of using all
the firm’s inputs.
AC = AFC + AVC = TC/Q
 Marginal cost (MC): the change in a firm’s total cost (or total
variable cost) resulting from a unit change in output.
MC = TC/Q = TVC/Q
The Short-Run Cost Function
 Graphical example of the cost variables
The Short-Run Cost Function
 Important Observations
 AFC declines steadily over the range of
production.
 When MC = AVC, AVC is at a minimum.

 When MC < AVC, AVC is falling.

 When MC > AVC, AVC is rising.

 The same three rules apply for average cost


(AC) as for AVC.
The Short Run Cost Function
 Important Map Observations
 AFC declines steadily over the range of
production. Why?

 In general, ATC is u-shaped. Why?

 MC intersects the minimum point (q*) on


ATC. Why?
The Short Run Cost Function
 Important Map Observations
 What is the economic significance of q*?
The Short Run Cost Function
 Average total cost (ATC) is the average
per-unit cost of using all of the firm’s inputs
(TC/Q)
 At Q* - ATC is minimized or inputs are
used most efficiently given the
production function
The Short Run Cost Function

 A change in input
prices will shift the
cost curves.
 Iffixed input costs are
reduced then ATC
will shift downward.
AVC and MC will
remain unaffected.
The Short Run Cost Function

 A change in input
prices will shift the
cost curves.
 Ifvariable input
costs are reduced
then MC, AVC, and
AC will all shift
downward.
The Short-Run Cost Function
 A reduction in the firm’s fixed cost would
cause the average cost line to shift
downward.
 A reduction in the firm’s variable cost
would cause all three cost lines (AC, AVC,
MC) to shift.
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.
The LR Relationship Between
Production and Cost

 In the long run, all inputs are variable.


 What makes up LRAC?
The Long-Run Cost Function

 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 lesser
percentage.
The 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.
The Long-Run Cost Function
 In long run, the firm can
choose any level of capacity.
 Once it commits to a level of
capacity, at least one of the
inputs must be fixed. This then
becomes a short-run problem.
 The LRAC curve is an
envelope of SRAC curves, and
outlines the lowest per-unit
costs the firm will incur over a
range of output.
The Long-Run Cost Function

 LRAC is made up
for SRACs
 SRAC curves represent
various plant sizes
 Once a plant size is
chosen, per-unit
production costs are
found by moving along
that particular SRAC
curve
Short-Run & Long-Run Marginal Cost
Curves
$/output unit
SRACs

LAC

y
Short-Run & Long-Run Marginal Cost
Curves
$/output unit
SRMCs

LAC

y
Short-Run & Long-Run Marginal Cost
Curves
$/output unit
SRMCs LMC

LAC

y
thelong-run MC equals the
MC for the short-run chosen by the firm.
The Long-Run Cost Function

 Reasons for Economies of Scale…


 Increasing returns to scale
 Specialization in the use of labor and capital
 Economies in maintaining inventory
 Discounts from bulk purchases
 Lower cost of raising capital funds
 Spreading promotional and R&D costs
 Management efficiencies
The 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 transportation costs.

You might also like