PAN African e-Network Project

Diploma in Business Management

Managerial Economics
Session - 4

Ms. Tavishi

Cost Analysis
.

The Nature of Costs

Money Cost
The money cost of producing a certain
output of a commodity is the sum of all
the payments to the factors of
production engaged in the production of
that commodity

 Explicit cost : they are those cash

payments which firms make to outsiders
for their services and goods

Implicit costs
They are the cost of self owned and self
employed resources

Opportunity cost
The opportunity cost of producing one unit
of X commodity is the amount of Y
commodity that must be sacrificed.

Real cost
According to Marshall the extension of all
the different kinds of labour that are
directly or indirectly involved in making it,
together with the abstinences or rather the
waiting required , for saving capital used in
making it , all these sacrifices together will
be called real cost of production of the
commodity.

External cost
A cost that is not borne by the firm , but is
incurred by others in society is called
external cost

Determinants of Cost
Size of the plant: the size of the plant or
the scale of operation is inversely related
to cost.
Output level: Total output and total cost
are positively related to each other.

Continued
Price of inputs: they are positively related
to cost.
Technology: the impact of technology on
cost is generally expressed in terms of
capital output ratio.

Short-Run Cost Functions

Total Cost = TC = f(Q)
Total Fixed Cost = TFC
Total Variable Cost = TVC
TC = TFC + TVC

Difference between FC and VC

Relation with the quantity production:
Fixed cost has nothing to do with the
quantity of output production may be more
or less the fixed cost remains the same.
Conversely variable costs are directly
related to the quantity of output.

Continued
To become zero: even if the production is
zero the fixed cost remains the same . In
case the production has stopped , variable
cost will come down to zero.
Avarage fixed cost and Average variable
cost: the former (AFC) falls with increase
in quantum of output , but latter falls less
than AFC with increase in production.

Continued
Determinants of factors:
Fixed cost includes rents of buildings and
premises , interest on capital, wages paid
to permanent employees, license fee etc
Variable cost includes the cost of raw
material, coal , power and wages to the
temporary staff etc.

Short-Run Cost Functions

Average Total Cost = ATC = TC/Q
Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = TC/Q = TVC/Q

Marginal cost
It is the addition made to the total cost by
the production of one more unit of a
commodity.

Average Cost
Average cost of production is the total cost
per unit of output.
AC = AFC+ AVC
AFC = total fixed cost divided by the total
output.
AVC= Total variable cost divided by total
units of output.

Relationship between AC and

MC
Both AC and MC are derived from TC.
When AC falls , MC is also falling
When AC is rising MC is also rising
MC begins to rise at a lesser level of
output than AC
MC cuts AC at its minimum.

Short-Run Cost Functions

Average Variable Cost
AVC = TVC/Q = w/APL
Marginal Cost
TC/Q = TVC/Q = w/MPL

Long-Run Cost Curves

Long-Run Total Cost = LTC = f(Q)
Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = LTC/Q

Why Lac curve is L shaped?

Technological progress:
Modern economists consider the vital role
played by the technological progress as a
cost minimizing and output maximizing
function. The existence of technological
progress confirms the L shaped of the
long run AC cure.

Continued
Economies from further decentralization
and improvement in skills
Lower repair costs, which may be attained
if the firm reaches a certain size.
The firm may itself undertake the
production of the materials and
equipments which it needs rather than
buying then from the market also known
as vertical integration.

Average Cost of Unit Q = C = aQb

Estimation Form: log C = log a + b Log Q

Minimizing Costs Internationally

Foreign Sourcing of Inputs

New International Economies of Scale
Immigration of Skilled Labor
Brain Drain

Logistics or Supply Chain

Management
Merges and integrates functions
Purchasing
Transportation
Warehousing
Distribution
Customer Services

Source of competitive advantage

Logistics or Supply Chain

Management
Reasons for the growth of logistics
Advances in computer technology
Decreased cost of logistical problem solving

Growth of just-in-time inventory management

Increased need to monitor and manage input and
output flows

Globalization of production and distribution

Increased complexity of input and output flows

Cost-Volume-Profit Analysis
Total Revenue = TR = (P)(Q)
Total Cost = TC = TFC + (AVC)(Q)
Breakeven Volume TR = TC

(P)(Q) = TFC + (AVC)(Q)

QBE = TFC/(P - AVC)

P = 10
TFC = 200
AVC = 5
QBE = 40

Empirical Estimation
Data Collection Issues
Opportunity Costs Must Be Extracted
from Accounting Cost Data
Costs Must Be Apportioned Among
Products
Costs Must Be Matched to Output Over
Time
Costs Must Be Corrected for Inflation

Empirical Estimation
Functional Form for Short-Run Cost Functions

Theoretical Form

Linear Approximation

TVC aQ bQ 2 cQ 3

TVC a bQ

TVC
2
AVC
a bQ cQ
Q

a
AVC b
Q

MC a 2bQ 3cQ 2

MC b

Economies of Scale
There are economies of scale in
production when the long run average cost
decreases as output increases.
Economies of scale (increasing returns to
scale) are cost savings associated with
larger scale of production.

Individual Setup Costs

An indivisible setup cost is the cost of
an indivisible input for which a certain
minimum amount of production must be
undertaken before the input becomes
economically feasible to use.

Individual Setup Costs

Indivisible setup costs are the source of
many real-world economies of scale.
The cost of a blast furnace or an oil
refinery is an example of an indivisible
setup cost.

Economies of Scale
In the longer run all inputs are variable, so
only economies of scale can influence the
shape of the long run cost curve.

Economies of Scale
Economies of scale occur whenever
inputs do not need to be increased in
proportion to the increase in output.
As output increases, cost per unit falls in
the long run, so this can also be seen as
an increase in productivity.

Economies of Scale
Doubling the inputs more than doubles the
output, when there are economies of
scale.
Firms can economize on management
cost, or they can take advantage of
specialized labour and specialized capital.

Economies of Scale
Because of the importance of economies
of scale, business people often talk of a
minimum efficient scale of production.

Minimum Efficient Scale

The minimum efficient scale of
production is the amount of production
that spreads setup costs out sufficiently for
firms to undertake production profitably.

Minimum Efficient Scale

The minimum efficient scale (MES) of
production is reached once the size of the
market expands to a size large enough so
that firms can take advantage of all
economies of scale.

Typical Long Run Average Total

Cost Curve
Costs per unit
$64
Economies
62
of scale
60
58
56
54
52
50
48

Constant
returns
to scale

Diseconomies
of scale

Minimum efficient scale

of production

Long run
average
total cost

11 12 13 14 15 16 17 18 19 20 Quantity

Economies of Scale
The minimum efficient scale of production
will be at the beginning of the constant
returns portion of the average cost curve
where average total costs are at a
minimum.

Economies of Scale
The implication of economies of scale is
that in some industries firms must be of a
certain size to be able to compete
successfully.

Increasing Returns to Scale

(IRTS)
Increasing returns to scale is where long
run average total costs fall as output
increases.
It is shown by the decreasing portion of
the LRAC curve.

Constant Returns to Scale

(CRTS)
Constant returns to scale is where long
run average total costs do not change as
output increases.
It is shown by the flat portion of the LRAC
curve.

Decreasing Returns to Scale

(DRTS)
Decreasing returns to scale or diseconomies
of scale refer to decreases in productivity which
occur when there are equal increases of all
inputs.
Decreasing returns to scale occur where the
long run average cost curve is upward sloping,
meaning that average cost is increasing.

Monitoring Costs
As the size of the firm increases,
monitoring costs generally increase.
Monitoring costs are those incurred by
the organizer of production in seeing to it
that the employees do what they are
supposed to do.

Decreasing Returns to Scale

Diseconomies occur for a number of
reasons as the firm increases its size
Coordination of a large firm is more difficult
Information costs and communication costs
increase as firm increases
Monitoring costs increase
Team spirit may decrease

Decreasing Returns to Scale

Team spirit is the feelings of friendship and

being part of a team that brings out peoples
best effort.

Summary of Returns to Scale

Returns to scale

Doubling inputs
results in:

Slope of the
LRAC

Increasing returns
to scale (IRTS;
economies of
scale)

Output more than

doubles.

downward

Constant returns to Output exactly

scale (CRTS)
doubles.

horizontal

Decreasing returns Output less than

to scale (DRTS;
doubles.
diseconomies of
scale)

upward

Economies and Diseconomies of

Scale

Costs per unit

$64
62
60
58
56
54
52
50
48

Increasing
Returns to
Scale

Constant
returns
to Scale

Decreasing
Returns to
Scale
Long run
average
total cost

11 12 13 14 15 16 17 18 19 20 Quantity

Importance of Economies of
Scale
Economies and diseconomies of scale
play important roles in real-world long run
production decisions.

Importance of Economies of
Scale
The long run and the short run average
cost curves have the same U-shape, but
the underlying causes of these shapes
differ.

Long Run Average Cost Curve

Economies and diseconomies of scale
account for the shape of the long run total
cost curve.

Envelope Relationship
In the long run all inputs are flexible, while
in the short run some inputs are not
flexible.
As a result, long run cost will always be
less than or equal to short run cost.

Envelope Relationship
In the short run the firm faces an
additional constraint all expansion must
proceed using only the variable input.
These additional constraints increase cost.

Envelope Relationship
The envelope relationship explains that:
At the planned output level, short run average
total cost equals long run average total cost.
At all other levels of output, short run average
total cost is higher than long run average total
cost.

Envelope of Short Run Average

Total Cost Curves
Costs per unit

LRATC

SRMC1

SRATC4

SRATC1
SRMC2

SRMC4
SRATC2 SRATC3
SRMC3

Q*

Quantity

Industry with Strong Economies of

Scale

Entrepreneurial Activity and the

Supply Decision
Profit is what underlies the dynamics of
production in a market economy.
The expected price must exceed the
opportunity cost of supplying the good for
a good to be supplied.

Entrepreneurial Activity and the

Supply Decision
The greater the difference between price
and average total cost, the greater the
entrepreneurs incentive to tackle the
organizational problems and supply the
good.

Entrepreneurial Activity and the

Supply Decision
An entrepreneur is an individual who
sees an opportunity to sell an item at a
price higher than the average cost of
producing it.

Entrepreneurial Activity and the

Supply Decision
Entrepreneurs organize production.
They visualize the demand and convince
the individuals who own the factors of
production that they want to produce those
goods.

Using Cost Analysis in the Real

World
Some of the problems of using cost
analysis in the real world include the
following:
Economies of scope.
Learning by doing and technological change.
Many dimensions.
Unmeasured costs.

Economies of Scope
The cost of production of one product
often depends on what other products a
firm is producing.

Economies of Scope
There are economies of scope in
production when the costs of producing
goods are interdependent so that it is less
costly for a firm to produce one good when
it is already producing another.

Economies of Scope
Firms look for both economies of scope
and economies of scale.
Economies of scope play an important
role in firms decisions of what
combination of goods to produce.

Economies of Scope
Globalization has made economies of
scope even more important to firms in
their production decisions.

Thank you
For Queries mail at
tavishie@amity.edu