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• Economists suggests that costs incurred in the past generally are irrelevant for
decision making. The above analytical conclusion can vary upon considering
this view.
Economic Concepts of Cost
Sunk Costs
• These represents the expenditures that have been made in the past or that
must be paid in the future as part of a contractual agreement.
• Examples: Cost of inventory and future rental payments that must be paid a
part of a long-term lease.
Monthly rental payments on the warehouse is Rs. 1000, but the firm finds it no
longer needs the space. The firm offers to sub-lease space but finds that the best
offer is for Rs. 800 per month. Is the offer worth accepting?
• Economic approach determines the cost as the difference between the market
value of the asset at the beginning and the end of the period.
• Under this approach, it is possible for some assets to actually increase in value
over time, implying that their cost was negative for that period.
Production and Cost
• Cost function relates cost to the rate of output. The production function and
the prices of inputs forms the basis for a cost function.
• Minimum cost of given rate of output can be derived by multiplying the
efficient rate of each input by their respective prices and summing the costs.
CMin = Kor + Low
C: Cost, Ko: Optimum level of capital input, Lo: Optimum level of labor input
• A production function Q = 100K0.5L0.5 has an Expansion Path K = (w/r)L.
• In other words, if the price of labor is Rs. 2 and the price of capital is Rs. 1, the
expansion path will be K = 2L, and the firm would expand by adding inputs at
the rate of 2 units of capital for each additional unit of labor
Minimum point of AVC occurs when AVC = MC, thus equating AVC and MC functions and
solving for Q as below.
10 – 0.9Q + 0.04Q2 = 10 – 1.8Q + 1.12Q2
-0.08 Q2 + 0.9 Q = 0
Q(-0.08Q + 0.9) = 0
Alternative approach is identifying minimum point of AVC by setting first derivative of AVC
(with respect to Q) equal to zero and solving for Q.
d(AVC)/d(Q) = - 0.9 + 0.08Q = 0 or 0.08Q = 0.9 or Q = 11.25
Long-Run Cost Functions
• Firms operate in the short-run but plan in the long-run.
• At any point in time, firm has one or more fixed factors of production. Thus,
the production decisions are arrived at using short-run cost curves.
• However, most firms can change the scale of their operation in the long-run by
varying all factor inputs, and in doing so, move to a preferred short-run
function.
• Example: If returns to scale are increasing, inputs are increasing less than in
proportion to increases in output. Given the fact that input prices are constant, TC
also increases less than in proportion to the output.
Increasing Returns to Scale Cost Increases at Decreasing Rate
Decreasing Returns to Scale Cost Increases at Increasing Rate
Constant Returns to Scale Cost Increases at Constant Rate
Long-Run Cost Functions
Long-Run Cost Functions
• The production process of majority of the firms is initially marked by increasing
returns to scale and thereafter by decreasing returns to scale.
• Owing to this, long-run total cost curve first increases at a decreasing rate and
then increases at an increasing rate
• Such nature of total cost curve is associated with a U-shaped long-run average
cost curve.
Long-Run Cost Functions
• A firm can possibly pursue different scales of operation adopting different plant
sizes.
• The short-run average cost curves associated with each scale of operation can
be graphically depicted as below.
Long-Run Cost Functions