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    Cost

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    Atanu Pramanik

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    Cost

    Uploaded by

    Atanu Pramanik
    1 views13 pages

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    Cost

    Uploaded by

    Atanu Pramanik

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    © All Rights Reserved
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    of 13

    Cost Analysis

    1st Year 2nd Sem


    Measuring Cost: Which Cost Matter?

    Economic Cost versus Accounting Cost


    • Financial accountants are usually concerned with keeping track of assets and liabilities
    and reporting past performance while economists are concerned with the allocation of
    scarce resources.

    • The economists care about what cost is likely to be in the future and the ways firms
    can reallocate resources to reduce cost and improve profitability.

    Opportunity Cost
    • It is the cost associated with opportunities that are forgone by not putting the firm’s
    resources to their next best alternative use.

    Sunk Cost
    • An expenditure that has been made and cannot be recovered.
    Total Cost (TC)

    Total Fixed Cost Total Variable Cost


    (TFC) (TVC)

    Fixed versus Sunk Cost


    • Fixed costs can be avoided if the firm goes out of business while sunk cost once
    incurred cannot be recovered.
    Average and Marginal Cost

    • Average Total Cost, also known as average economic cost, is the firm’s total cost
    𝑇𝐶
    divided by its level of output. 𝐴𝑇𝐶 =
    𝑄

    • Average Fixed Cost, is the firm’s total fixed cost divided by its level of output.
    𝑇𝐹𝐶
    𝐴𝐹𝐶 = 𝑄

    • Average Variable Cost, is the firm’s total variable cost divided by its level of
    𝑇𝑉𝐶
    output. 𝐴𝑉𝐶 =
    𝑄

    • Marginal Cost, also called incremental cost, is the increase in total cost that results
    Δ𝑇𝐶 Δ𝑇𝑉𝐶
    from producing one extra unit of output. 𝑀𝐶 = Δ𝑄 = Δ𝑄
    Cost in the Short Run

    • Change in variable cost is the per-unit extra labour 𝑤 times the amount of extra
    Δ𝑇𝑉𝐶 wΔ𝐿
    labour needed to produce the extra output. 𝑀𝐶 = =
    Δ𝑄 Δ𝑄

    Δ𝑄 𝑤
    • Since, 𝑀𝑃𝐿 = Δ𝐿
    , so, 𝑀𝐶 = 𝑀𝑃
    𝐿

    • We know, diminishing marginal returns means that the marginal product of labour
    declines as the quantity of labour employed increases. So, due to this diminishing
    marginal returns, marginal cost increases as the output increases.
    Average-Marginal Relationship

    • 𝑀𝐶 < 𝐴𝐶, 𝐴𝐶 diminishes as output increases

    • 𝑀𝐶 = 𝐴𝐶, 𝐴𝐶 is minimum as output increases

    • 𝑀𝐶 > 𝐴𝐶, 𝐴𝐶 rises as output increases

    • The minimum point of the ATC curve must lie above and to the right of the
    minimum point of the AVC curve.
    Cost in the Long Run

    • Long run is a period of time of such length when all inputs are variable. It is also called a
    planning horizon

    • All production, indeed all economic activity takes place in the short run.

    • The “long run” refers to the fact that the economic agents – consumers and producers – can
    plan ahead and choose many aspects of the “short run” in which they will operate in the future.

    • With reference to the average cost curve, long run average cost (LAC) curve is also known as
    the envelope curve as it envelopes all the short run average cost curve.

    • Long Run Average Cost (LAC) Curve: It is the locus of points representing the least unit
    cost of producing the corresponding output.

    • Long Run Marginal Cost (LMC) Curve: It is the change in long run total cost which results
    from producing one extra unit of output.
    Relationship between Short Run Marginal Cost and Long Run Marginal
    Cost
    SMC
    • At output Q’’, 𝑆𝑀𝐶 < 𝐿𝑀𝐶 LMC

    LAC
    • At point A, where LMC and SMC cuts the LAC curve at

    Cost
    its minimum point, 𝑆𝑀𝐶 = 𝐿𝑀𝐶 A

    • At out put Q’, 𝑆𝑀𝐶 > 𝐿𝑀𝐶


    Q’’ Q Q’ Output
    Expansion Path

    • The long run expansion path tells us how optimal input usage changes in
    response to a change in output.

    • In the long run expansion path, we assume that there is enough time to adjust the
    quantities of both the input in order to produce the optimal level of output

    • The shape of the long run expansion path is a straight line starting from the
    origin.

    • In the short run, as we assume the capital to be fixed so the expansion path will
    be a horizontal straight line.
    Returns to Scale

    • The word scale of production or simply scale mean the absolute level of
    capital and labour employed to produce the maximum level of output.

    • The word “to scale” mean change in all inputs by the same proportion. The
    word “return to scale” mean by how much output changes when all inputs are
    simultaneously increased by the same proportion.

    • Three types of return to scale are:


    (i) Increasing Returns to Scale
    (ii) Constant Returns to Scale
    (iii) Decreasing Returns to Scale
    Economies of Scale

    • As the size of plant and the scale of operation becomes larger, considering
    expansion from the smallest possible plant, certain economies of scale are
    usually realized.

    • Reasons for this economies of scale given by Adam Smith are: specialization
    and division of labour.

    • If s plant is very small and employs only a small number of workers, each
    worker will usually have to perform several different jobs. In doing so, the
    worker have to move about the plant, change tools, and so on.

    • Due to this not only workers are specialized but a part of their work time is
    consumed in moving about and changing tools.
    • A larger plant with larger work force may permit each worker to specialize in
    one job.

    • Technological factors constitute the second force which contributes towards


    economies of scale.
    Diseconomies of Scale

    • The rising portion of the LAC is attributed to “diseconomies of scale”, which


    essentially means limitation to efficient management.

    • As the scale of plant expands beyond a certain point, top management


    necessarily has to delegate responsibility and authority to lower-echelon
    employees.

    • Contact with the daily routine of operation tends to eb lost and efficiency of
    the operations decline

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