THEORY OF COST PART 1

• THEORY OF COST PART 1
• MICRO ECONOMICS
• BY DR. SHASHI
• COST OF PRODUCTION
• COST OF PRODUCTION IS A FUNCTION OF OUTPUT. THE RELATION BETWEEN COST AND OUTPUT IS CALLED COST FUNCTION OR COST ANALYSIS.
• C=f(Q)
• COST OF PRODUCTION OF A COMMODITY MEANS THE PAYMENTS MADE TO THE FACTORS OF PRODUCTION.
• COST ANALYSIS IS OF TWO TYPES:-

1. TRADITIONAL APPROACH OF COST CURVES
2. MODERN APPROACH OF COST

• COST CLASSIFICATION
• MONEY COST :- THE MONEY COST OF PRODUCING A CERTAIN OUTPUT OF A COMMODITY IS THE SUM OF ALL PAYMENTS TO THE FACTORS OF PRODUCTION ENGAGED IN THE PRODUCTION OF THAT COMMODITY.
• THE FOLLOWING EXPENSES WILL INCLUDE IN THE MONETARY COST:-

1. COST OF RAW MATERIAL
2. INTEREST
3. RENT/WAGES/SELLING COSTS
4. TRANSPORT COSTS/PACKING CHARGES/INSURANCE CHARGES

·         ELEMENTS OF TOTAL COST:-

• EXPLICIT COSTS IS CALLED OUT OF POCKET COST. ALL THOSE EXPENSES THAT FIRMS INCURS TO MAKE PAYMENTS TO OTHERS ARE CALLED EXPLICIT COSTS.ACCORDING TO LEFTWITCH,” EXPLICIT COSTS ARE THOSE CASH PAYMENTS WHICH FIRMS MAKE TO OUTSIDERS FOR THEIR SERVICES AND GOODS. LIKE WAGES PAID TO THE LABOURERS,RENT PAID FOR THE USE OF BUILDING,INTEREST ON LOAN ETC
• IMPLICIT COSTS COST OF SELF SUPPLIED FACTORS. ARE THE COSTS OF ENTRPRENEUR’S OWN FACTORS OR RESOURCES. LEFTWITCH,” IMPLICIT COSTS ARE COSTS OF SELF WONED AND SELF EMPLOYED RESOURCES.
• LIKE IMPLICIT COST REFERS TO INTEREST ON ENTREPRENUR’S OWN CAPITAL,RENT OF HIS OWN LAND,WAGES OF HIS OWN LABOUR

• MONEY COST
• EXPLICIT COSTS:- ARE THOSE CASH PAYMENTS WHICH FIRMS MAKE TO OUTSIDERS FOR THEIR SERVICES AND GOODS.
• IMPLICIT COST:- COST OF SELF OWNED AND SELF EMPLOYED RESOURCES
• TOTAL COST = EXPLICIT COST+ IMPLICIT COSTS
• OPPORTUNITY COST
• OPPORTUNITY COST : COST OF NEXT BEST ALTERNATIVE FORGONE.
• ACCORDING TO THIS CONCEPT IN AN ECONOMY SUPPLY OF ECONOMIC RESOURCES IS LIMITED RELATIVE TO THEIR DEMAND . AS SUCH WHEN RESOURCES ARE USED FOR PRODUCING A GIVEN COMMODIY THEN SOME AMOUNT OF OTHER COMMODITIES IN WHOSE PRODUCTION THESE RESOURCES COULD HAVE BEEN HELPFUL HAS TO BE SACRIFICED
• EVERY VARIABLE FACTOR MUST BE PAID WHAT IT RECIEVES IN NEXT BEST ALTERANTIVE THAT IS THE OPPROTUNITY COST
• THE OPPORTUNITY COST OF PRODUCING ONE UNIT OF X COMMODITY IS THE AMOUNT OF Y COMMODITY THAT MUST BE SACRIFICED.

• REAL COST
• REFER TO THOSE PAYMENTS WHICH ARE MADE TO FACTORS OF PRODUCTION TO COMPENSATE FOR THE TOTAL SACRIFICE AND EFFORTS IN RENDERING THEIR SERVICES. THE CONCEPT OF REAL COST, HOWEVER DOES NOT CARRY ANY SIGNIFICANCE IN THE COST OF PRODUCTION BECAUSE IT IS A SUBJECTIVE CONCEPT AND LACKS PRECISION
• REAL COST IS COMPUTED IN TERMS OF  THE PAIN AND DISCOMFORT INVOLVED FOR LABOUR WHEN IT IS ENGAGED IN PRODUCTION AND ALSO THE ABSTINENCE AND SACRIFICE INVOLVED IN CAPITAL ACCUMULATION.
• COST FUNCTION
• COST FUNCTION EXPRESSES THE RELATION BETWEEN COST AND ITS DETERMINANTS
• C =f( S,O,P,T-----)
• WHERE C =COST  F =FUNCTION, S = SIZE OF PLANTS
• O = LEVEL OF  OUTPUT
• PRICE = PRICE OF INPUTS
• T = TECHNOLOGY

• DETERMINANTS OF COST FUNCTION
• SIZE OF THE PLANT : SIZE OF THE PLANT OR SCALE OF OPERATIONS ARE INVERSELY RELATED TO COST.
• OUTPUT LEVEL:-TOTAL OUTPUT AND TOTAL COSTS ARE POSITIVELY RELATED TO EACH OTHER.DOES NOT APPLY TO AC AND MC. AS THE LEVEL OF OUTPUT INCREASES MC AND AC DECLINE INITIALLY AND RISE  THERAFTRE
• PRICES OF OUTPUT:-POSITIVELY RELATED TO OUTPUT
• :-ALSO INFLUENCE COST
• STATE OF TECHNOLOGY
•  MANAGERIAL AND ADMINISTRATIVE EFFICIENCY
• TYPES OF COSTS

1. COST IN THE SHORT RUN
2. COSTS IN  THE LONG RUN

• THEORY OF COST
• TRADITIONAL APPROACH
• MODERN APPROACH
• THEORY OF  COST TRADITIONAL APPROACH
• SHORT RUN COST
• TOTAL COST=TOTAL FIXED COST +TOTAL VARIABLE COST

• COST FUNCTION

1. SHORT RUN IS THAT PERIOD IN WHICH AT LEAST ONE OR SOME OF THE FIRM’S INPUTS ARE FIXED AND SOME ARE VARIABLE.
2. LONG RUN ALL THE INPUTS ARE VARIABLE

• COSTS IN THE SHORT RUN
• FIXED COSTS:- EXPENSES INCURRED ON FIXED FACTORS ARE CALLED THE FIXED COSTS. THESE COSTS DO NOT CHANGE WITH CHANGES IN THE QUANTITY OF OUTPUT. FIXED COST INCLUDE THE FOLLOWING EXPENSES:-
• RENT OF LAND AND BUILDING,
• SALARY OF PERMANENT STAFF,
•  INTEREST ON FIXED CAPITAL,
• LICENCE FEES ,
• INSURANCE PREMIUM AND NORMAL PROFITS ETC

• FIXED COST
• 
  
• VARIABLE COSTS
• VARIABLE COSTS ARE THOSE COST WHICH VARY AS THE LEVEL OF OUTPUT VARIES. THE RATE OF INCREASE OF TOTAL VARIABLE COST IS DETERMINED BY THE LAWS OF RETURNS. THESE ARE CALLED PRIME COSTS,DIRECT COSTS OR SPECIAL COSTS
• DOOLEY, VARIABLE COSTS ARE THOSE COSTS WHICH VARY AS THE LEVEL OF OUTPUT VARY
• VARIABLE COSTS INCLUDE :-

1. EXPENSES ON RAW MATERIAL
2. FUEL AND POWER
3. WAGES TO TEMPORARY LABOUR
4. TRANSPORT COST

• VARIABLE COSTS
• DIAGRAM
• 
  

            

·                               

• TOTAL COST

·         TOTAL COST = TOTAL FIXED COSTS + TOTAL VARIBLE COST

• TOTAL COSTS
• DIAGRAM

•           
  
  
  
  
  
  
  
                                        
•                
•                                                              

•   

•        SIGNIFICANCE

1. SHUT DOWN DECISIONS
2. CONTROL OVER COSTS
3. BREAK POINT

• AVERAGE COST
• THE AVERAGE COST OF PRODUCTION IS THE TOTAL COST OF PRODUCTION PER UNIT OF OUTPUT. DOLLEY,” THE AVERAGE COST OF PRODUCTION IS THE TOAL COST PER UNIT OF OUTPUT
• AC = TC/Q
• AC= AFC +AVC
• AVERADGE FIXED COST:- THE AVERAGE COST OF PRODUCTION CAN ALSO BE OBTAINED BY TOTAL FIXED COST BY TOTAL OUTPUT
• TFC/TQ
• AVERAGE FIXED COST IS THE PER UNIT COST OF THE FIXED FACTOR OF PRODUCTION.
• TABLE
• 
• DIAGRAM
• D
  
• AVERAGE VARIABLE COST
• THE AVERAGE VARIABLE COST IS FOUNDED BY DIVIDING THE TOTAL VARIABLE COST BY THE TOTAL UNITS
• AVC=TVC/TQ
• AVERAGE VARIABLE COST
• DIAGRAM
•  
•                                           

                           

•                  
• AVC IS DISH SHAPED OR SIMILAR TO LETTER U

1. FALLING IT MEANS AVC IS DIMINISHING AS OUTPUT INCREASES
2. IT BEGINS TO RISE IT MEANS AVC IS RISING

• SHAPE OF AC
• 
  
• 
  
• REALTIONSHIP BETWEEN AC,AFC,AVC
• D
  
• REALTION
• 

1. GEOMETRICALLY AC IS OBTAINED BY ADDING AFC AND AVC
2. AT EACH LEVEL OF OUTPUT AC LIES ABOVE AVC AT A DISTANCE EQUAL TO CORRESPONDING HEIGHT OF AFC
3. AC TENDS TO CLOSER TO AVC BUT IS NEVER TOUCHES THE LATTER
4. THE MINIMUM POINT ON AC IS REACHED FOR A LARGER OUT PUT THAN THE MINIMUM POINT ON AVC

• SHAPE OF AC IS U SHAPED
• WHY AC IS U SHAPED

1. BEHAVIOUR OF AVERAGE FIXED COST AND AVERAGE VARIABLE COST
2. LAW OF VARIABLE PROPORTIONS