Cost Analysis

Chapter Objectives
Examine the nature of costs of production Derive firms short run Total, Average and Marginal Cost curves. Derive firms long run Total, Average and Marginal Cost curves. Examine
Plant size and economies of scale Economies of scope Learning curve

Examine CVP analysis and operating leverage

Cost Concepts
Explicit costs Actual expenditures of the firm to hire, rent or purchase inputs Wages, rent, interest, cost of raw materials etc. Implicit costs value of the inputs owned and used by the firm in its own production activity.

 Historical cost is incurred at the time of procurement Replacement cost is necessary to replace inventory Opportunity cost is the value that is forgone in choosing one activity over the next best alternative Out-of-pocket cost is actual transfer of value that occur

 Incremental cost varies with the range of options available in the decision making process. Sunk cost does not vary with decision options

SR Relationship Between Production and Cost

A firms cost structure is related to its production process.
Costs are determined by the production technology and input prices.
Assuming that the firm is a price taker in the input market.

Short Run Costs -Total Costs

Total Fixed Cost (TFC)
associated with the fixed input

Total Variable Cost (TVC)

associated with the variable input

Total Cost (TC)

associated with all of the inputs. It is the sum of TVC and TFC.

TC = TFC+TVC

Out put 0 1

TFC (Rs.) 60 60

TVC (Rs.) 100 100

TC (Rs.) 60 160

2
3 4 5 6

60
60 60 60 60

180
240 340 500 720

240
300 400 560 780

TFC
70 60

50

40

30

20

10

0
1 2 3 4 5 6 7

TVC
800 700 600 500 400 300

200
100 0 1 2 3 4 5 6 7

TVC (Rs.)

TC
800 700 600 500 400 300

200
100 0 1 2 3 4 5 6 7

TVC (Rs.)

Short Run Costs- Average Costs

Average Fixed Cost (AFC)
average per-unit cost of using the firms fixed inputs (TFC/Q)

Average Variable Cost (AVC)

average per-unit cost of using the firms variable inputs (TVC/Q)

Average Total Cost (ATC or AC)

average per-unit cost of using all of the firms inputs (TC/Q)

AC = AFC+AVC

Out put 0 1 2 3 4 5 6

TFC (Rs.) 60 60 60 60 60 60 60

TVC (Rs.) 100 100 180 240 340 500 720

TC (Rs.) 60 160 240 300 400 560 780

AF C (Rs.)

AVC (Rs.)

AC (Rs.)

AFC
70 60

50

40

30

20

10

0
1 2 3 4 5 6 7

AFC
AFC approaches X axis as output increases. It approaches (but does not meet) the vertical and the horizontal axis.

AVC
140 120

100

80

60

40

20

0 1 2 3 4 5 6

AVC
AVC declines first, reaches its minimum and then raise. (U-shape) Reason: operation of the Law of Variable Proportions.

AC
180 160

140

120

100

80

60

40

20

0 1 2 3 4 5 6

SAC
Sum of AFC and AVC Shape of AFC depends on AVC Distance between AC and AVC is equal to AFC. AC falls initially and then rises. (U -shaped)

Marginal cost (MC)

MC is the change in total cost associated a change in output.
TC MC Q
TC (TFC TVC ) TFC TVC TVC MC 0 Q Q Q Q Q

Out put 0 1 2 3 4 5 6

TFC (Rs.) 60 60 60 60 60 60 60

TVC (Rs.) 100 100 180 240 340 500 720

TC (Rs.) 60 160 240 300 400 560 780

MC (Rs.)

MC
250 200

150

100

50

0 1 2 3 4 5

Relationship between SAC and AVC

Difference between SAC and AVC is only that of AFC. The vertical distance of SAC and AVC is AFC at various levels of output. The vertical distance of SAC and AVC becomes lesser and lesser as output increases Reason: AFC falls as output increases Both SAC and AVC are U shaped

Relationship between AVC and MC

When AVC is falling MC is always lower than AVC. When AVC falls, MC falls faster. When AVC is raising MC is always higher than AVC. When AVC raises, MC raises faster. MC cuts the AVC at its lowest point from below.

250

200

150 MC AVC 100

50

0 1 2 3 4 5 6 7

Relationship between AC and MC

Both are derived from TC When AC is falling MC is always lower than AC. When AC falls, MC falls faster. When AC is raising MC is always higher than AC. When AC raises, MC raises faster. MC cuts the AC at its lowest point from below.

250

200

150 AC MC 100

50

0 1 2 3 4 5 6 7

AVC, MC, AC
250 200

150 AC MC 100

AVC

50

0 1 2 3 4 5 6 7

AVC, MC, AC