COST ANALYSIS

The Concept of Cost Expenses incurred on the factors of production are known as the cost of production, or simply costs On the other hand, the producer receives payments from the sale of goods produced. Such sale proceeds are referred to as Revenue The aim of the producer is to maximize its profit. Since profit is the difference between revenue and cost, , profit maximization amounts to maximization of the difference between revenue and cost. Therefore, a profit maximizing firm needs to monitor revenue and cost continuously. Thus, the concepts of cost and revenue are very important in price theory

The Cost Function: The Cost-Output Relations The theory of cost deals with the behavior of cost in relation to a change in output The basic principal of the cost behavior is that total cost increases with increase in output

The Cost Function Cost function is derived from the production function which describes the technically efficient method of producing a commodity at any one time TIME FACTOR: Short run is a time period when some factors of production are fixed in supply, whereas long run is a time period which permits changes in ALL factors of production

Both in the short-run and long-run, cost is a multi-variate function. Symbolically, it is given as, C = f (X, T, Tf) Where, C = Cost X = Output T = Technology Pf = Price of Factors

Different Cost Concepts

Opportunity Cost Opportunity cost or alternative cost is the cost of alternative opportunity sacrificed or given up It arises because resources are scarce and they have alternative uses For example, I have two investment options to choose from, one of which gives me Rs.1000 per month as returns and the other gives me Rs.1250 as returns. If I choose the second option, Rs. 1000 would be my opportunity cost

Explicit Cost vs Implicit Cost Explicit cost or direct cost is the actual expenditure incurred by a firm to purchase or hire the inputs it needs in the production process These include wages, rent, interest, payment of power, insurance, advertising, etc. Explicit costs are ‘out-of-pocket’ costs and accounting costs as they are shown in the company’s books Implicit cost or imputed cost is the cost of inputs owned by the firm and used by the firm in its own production process It includes payment for owned premises, self-invested capital and depreciation of capital equipment

Explicit Cost Implicit Cost It includes actual money expenditure incurred by a firm in hiring or buying the factors it needs in the production process It is not actual money expenditure but is the cost of factors owned by the firm and used by the firm in its production process It is explicitly shown in the firm’s books of accounts and is thus, called accounting costs It does not enter in the firm’s books of accounts It is a payment concept It is a receipt concept, i.e., the payments are received by producer for supplied services Examples: Wages, rent, interest, insurance, etc Examples: Wages of self labor, rent for self owned premises, etc

Private Cost vs. Social Cost Private cost is money cost incurred by a firm in producing a commodity It does not include the effect of the produced commodity on the society, i.e., externalities Social Cost Social cost is cost of producing a commodity to the society as a whole It includes real cost which is borne by the society, directly or indirectly, due to the produced commodity This cost is not included in the money cost of producing that commodity

Short Run Cost vs. Long Run Cost Short-run costs are costs over a period during which some factors are in fixed supply, like plant, machinery, etc Long run costs are costs over a period long enough to permit changes in all factors of production

Fixed Cost vs. Variable Cost Fixed cost or supplementary cost is the cost that does not change with change in output It is incurred irrespective of the amount of goods produced Examples: Salaries, depreciation of machinery, insurance premium, etc Variable cost is that cost which vary with the quantity of output produced Includes cost of labor (wages), cost of raw materials, power, fuel, etc It is also called Prime cost

Costs in the Short-Run

1. TOTAL COST Total cost of production (TC) is divided into two parts, total fixed cost (TFC) and total variable cost (TVC), TC = TFC + TVC

Total Fixed Cost In the short-run, at least one input is fixed in supply and its price constitutes the fixed cost Fixed cost is defined as that cost which does not vary with the output Examples: Salaries, depreciation of machinery, building and land etc Cost TFC X

Total Variable Cost Variable cost is the cost that varies with the quantity of output produced Variable cost includes cost of direct labor (wages), cost of raw material and running expenses

Short Run Cost Curves TC TVC Cost TFC Output

2. AVERAGE COST Average cost is cost incurred per unit of output TC = TFC + TVC X X X AC = AFC + AVC

3. MARGINAL COST Marginal cost is the change in total cost when one additional unit is manufactured MC = ΔTC ΔX

Costs in the Long-Run

In the long run, all inputs are variable In the long run, there are no constraints facing a firm A firm attempts to maximize long run profits by selecting a short run production technology (or scale of plant) that minimizes cost The firm has to very carefully decide the short run plant size it wants to build on the basis of the future demand of the product, developments in technology and changes in the price of inputs

Long Run Average Cost The LAC shows the average cost of production when all factors are in variable supply The LAC curve is derived from the short run AC (SAC) curves. LAC curve is a curve tangent to all SAC curves M Xm

The firm has infinite methods of production available in the long run, each represented by a different pant size. Each plant size is represented by a different SAC curve For output levels less than Xm, the LAC curve is tangent to the SAC curves to the left of their minimum points. For output levels greater than Xm, the LAC is tangent to the SAC curves to the right of their minimum points At Xm level of output, the LAC is tangent to SAC4 at its minimum point, M. Point M is the minimum point of the LAC curve also The plant size whose costs are denoted by SAC4 is called the optimum scale of plant

Economies and Diseconomies of Scale

As we have seen, long run average costs decreases with the expansion of production up to a limit and then it begins to rise This behavior of LAC is caused by economies and diseconomies of scale Economies of scale result in cost saving and diseconomies lead to a rise in cost Economies of scale are cost reductive and give rise to increasing returns to scale. Economies of scale refer to the advantages which accrue to the firm when it expands its output

Internal or Real Economies External or Pecuniary Economies Economies of Scale Internal or Real Economies External or Pecuniary Economies

A. Internal Economies Internal economies, also called ‘real economies’, are those which arise from the expansion of the plant-size of the firm and are internalized

Economies in Production Economies in Marketing Managerial Economies Internal Economies Economies in Production Economies in Marketing Managerial Economies Economies in Transport and Storage