COST ANALYSIS

1. COST ANALYSIS

2. 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

3. 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

4. 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

5. 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

6. Different Cost Concepts

7. 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

8. 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

10. Private Cost vs. Social Cost

11. 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

12. Fixed Cost vs. Variable Cost • 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 • 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

13. Costs in the Short-Run

14. 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

15. 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

16. 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

17. Short Run Cost Curves TC TVC Cost TFC Output

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

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

21. Costs in the Long-Run

22. 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

23. 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

24. 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

25. Economies and Diseconomies of Scale

26. 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

28. 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