Theory of Demand and Supply

UNIT 2 : THEORY OF COST

At the end of this Unit, you should be able to:

1. Explain the Meaning and Different Types of Costs.

2. Define Cost Function and Explain the Difference between a Short-Run and Long-Run Cost Function.

3. Explain the linkages between the Production Function and the Cost Function.

4 Explain Economies and Diseconomies of Scale and Reasons for Their Existence

SUMMARY

• Cost analysis refers to the study of behaviour of cost in relation to one or more production criteria. It is concerned with the financial aspects of production.

• Accounting costs are explicit costs and includes all the payments and charges made by the entrepreneur to the suppliers of various productive factors.

• Economic costs take into account explicit costs as well as implicit costs. A firm has to cover its economic cost if it wants to earn normal profits.

• Outlay costs involve actual expenditure of funds.

• Opportunity cost is concerned with the cost of the next best alternative opportunity which was foregone in order to pursue a certain action.

• Direct costs are those which have direct relationship with a component of operation. They are readily identified and are traceable to a particular product, operation or plant.

• Indirect costs are those which cannot be easily and definitely identifiable in relation to a plant, product, process or department. They not visibly traceable to any specific goods, services, processes, departments or operations.

• Incremental cost refers to the additional cost incurred by a firm as a result of a business decision.

• Sunk costs are already incurred once and for all, and cannot be recovered.

• Historical cost refers to the cost incurred in the past on the acquisition of a productive asset.

• Replacement cost is the money expenditure that has to be incurred for replacing an old asset.

• Private costs are costs actually incurred or provided for by firms and are either explicit or implicit.

• Social cost, on the other hand, refers to the total cost borne by the society on account of a business activity and includes private cost and external cost.

• The cost function refers to the mathematical relation between cost and the various determinants of cost. It expresses the relationship between cost and output.

• Economists are generally interested in two types of cost functions; the short run cost function and the long run cost function.

• Short-run cost functions are

• Fixed or constant costs which are not a function of output. These are inescapable or uncontrollable.

• Variable costs are a function of output in the production period.

• Short run is a period of time in which output can be increased or decreased by changing only the amount of variable factors such as, labour, raw material, etc. ,

• Long run is a period of time in which the quantities of all factors may be varied. In other words, all factors become variable in the long run.

• Semi-variable costs are neither perfectly variable, nor absolutely fixed in relation to the changes in the size of output.

• Stair-step costs remain fixed over certain range of output; but suddenly jump to a new higher level when output goes beyond a given limit.

• Total cost of a business is defined as the actual cost that must be incurred for producing a given quantity of output.

• AFC is obtained by dividing the total fixed cost by the number of units of output produced.

• Average variable cost is found out by dividing the total variable cost by the number of units of output produced.

• Average total cost is the sum of average fixed cost and average variable cost.

• Marginal cost is the addition made to the total cost by the production of an additional unit of output.

• Long run cost of production is the least possible cost of producing any given level of output when all individual factors are variable.

• A long run cost curve depicts the functional relationship between output and the long run cost of production.

• The long run average cost curve, often called a planning curve, is so drawn as to be tangent to each of the short run average cost curves.

• LAC curve is not tangent to the minimum points of the SAC curves.

• Empirical evidence shows that the state of technology changes in the long-run. Therefore, modern firms face ‘L-shaped’ cost curve over a considerable quantity of output.

• Economies of scale are of two kinds - external economies of scale and internal economies of scale.

• External economies of scale accrue to a firm due to factors which are external to a firm.

• Internal economies of scale accrue to a firm when it engages in large scale production.

• Increase in scale, beyond the optimum level, results in diseconomies of scale.