Production Function (Cost)

Different Types of Costs

Opportunity Costs: value of the next best alternative that was sacrificed Explicit and Implicit Costs: explicit costs involve an actual payment to other parties while implicit costs represent value of foregone opportunities but do not involve an actual cash payment, eg. cost of capital or entrepreneurship provided by the owner himself Sunk Costs :already incurred in the past and must be paid in future as part of a contractual agreement; these have to be paid irrespective of any revenues generated on it, like plant and machinery, building taken on lease etc.

Different Types of Costs

Marginal costs :change in total cost associated with one unit change in output: concept relevant for short run decisions, mostly related to a variable input eg. cost of producing one more car Incremental costs :total additional cost of implementing a managerial decision, eg. adding a product line, setting up a new R&D department etc. Direct and Indirect costs: direct costs are those which are directly attributed to production of a particular product like raw materials, labour; indirect costs cannot be separated and attributed to individual units of production like administration costs, electricity etc.

Different Types of Costs

Fixed and Variable costs: FCs are those incurred even if output is zero, not related to level of production like plant and machinery, interest on capital borrowed; VCs change with change in output like cost of raw material, labour etc. Short run and Long run costs : SR when some factors of production are fixed, in LR all factors are variable Total and average costs : Average is TC/ Q

Short Run Cost Functions

TC = TFC + TVC; FCs expressed as fixed amount, VCs expressed in per unit basis Total fixed cost is fixed for all levels of output and hence is a straight line parallel to X axis (cost on Y axis and output on X axis) TVC curve starts from origin and is upward sloping TC curve starts from intercept of FC curve and is upward sloping

SATC = SAVC + SAFC AFC is falling because TFC are fixed SAVC declines initially due to better utilisation of fixed assets, then rises due to lack of optimum proportion of variable to fixed resources, is a U shaped curve: law of variable proportions SATC is also U shaped and is above the SAVC curve At the minimum point of cost curves, variable and fixed factors are in optimum/ correct proportion When MC is below SAVC, SAVC curve is falling, when MC is above SAVC, SAVC curve starts to rise Hence MC curve intersects both ATC curve and AVC curve at their minimum points For decision making purposes, per unit or average costs are useful

Long Run cost curves

LRAC cost curves derived from SRAC cost curves, optimal cost/ plant size for a range of output determined from SRAC cost curve; LRAC function is the envelope curve consisting of points or arcs on a number of SRAC curves Useful for planning optimal scale of plant size, therefore also called planning curve Importance of cost in management decision making: to increase profits

Profit Maximization

Where MC = MR Corresponding output is profit maximization output Corresponding point on the demand (AR) curve is the optimal price for the product In this situation, TP i.e difference between TR and TC (as taken from the AC curve) will be greatest