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COST THEORY
and ESTIMATION THE NATURE OF COSTS Explicit Costs The actual expenditures of the firm to hire, rent, or purchase the inputs it requires in production.
Implicit Costs The value of the inputs owned and used by the firm in its own production activity
Accounting costs The firm’s actual expenditures or explicit costs incurred for purchased or rented inputs. Economic costs Explicit plus implicit costs
Marginal Costs The additional costs incurred in producing an additional unit of output
Incremental costs The change in total costs from implementing a particular management decision such as introduction of new product line, the undertaking of new advertising campaign.
Sunk costs Costs that are not affected by the management decisions Short-Run Costs Functions: Total Fixed Costs (TFC) The cost of the fixed inputs used by the firm in producing a particular unit of output TFC = TC – TVC TFC = Pfi x Qfi
Total Variable Costs (TVC)
The cost of variable inputs used by the firm in producing aa particular unit of output. TVC = TC – TFC TVC = Pvi x Qvi Total Costs (TC) The cost incurred in producing a particular unit of output. TC = TFC + TVC TC = ATC x Q Average Variable Cost (AVC) The cost of variable input per unit of output AVC = TVC/Q AVC = ATC –AFC Average Fixed Cost (AFC) The cost of fixed input per unit of output AFC = TFC/Q AFC = ATC - AVC Average Total Cost (ATC) The cost per unit of output ATC = TC/Q ATC = AFC + AVC
Marginal Cost (MC)
The additional cost incurred in producing an additional unit of output. MC = ∆TC/ ∆Q = TC₂ - TC₁/Q₂ - Q₁ Ex. Given below is a hypothetical Short- Run cost schedules. Q1. Complete the schedule
Q TFC TVC TC AFC AVC ATC MC
0 60 - - -
1 80
2 90
3 105
4 140
5 195 Analysis: At zero output, TVC is zero At zero output, there is fixed cost At zero output, TC = TFC
As output increases or decreases, TFC is constant
As output increases, TVC increases and vice versa As output increases, TC increases and vice versa
As output increases, AFC decreases and increases as output decreases
As output increases, AVC, ATC and MC decreases until it reaches the minimum point, then it increases. Long-run Total Cost Curves Derived from the firm’s expansion path and shows the minimum long-run total costs of producing various levels of output. The firm’s long-run average and marginal costs are derived from the firm’s long-run total cost.
LRMC = LRTC/Q LRATC = LRTC/Q Scale Economics 1. Economies of scale the cost advantage experienced by a firm when it increases its level of output. LRATC decreases as output increases
2. Diseconomies of scale LRATC increases as output increases
3. Constant economies of scale
LRATC is constant as output increases LRATC
LRATC 9
15 Q 1 5 10 Economies of Scope The lowering of costs that a firm often experiences when it produces two or more products together rather than each alone. ex. Commuter airline
Learning Curves Shows the decline in the average input cost of production with rising cumulative total output over time Ex. It take 1000 hours to assemble 100th aircraft but only 700 hours to assemble the 200th aircraft – because managers and workers become more efficient as they gain production experience.
