COST FUNCTIONSFUNCTIONS-Derived from production functions.

SHORT RUN:- Some factors of production RUN:(usually capital equipment and management) are fixed.

LONG RUN:- Long enough to permit the RUN:change in all factors of production.

LONG RUN COST FUNCTION:- c=f (x, T, pf) FUNCTION:SHORT RUN COST FUNCTION:- c=f (x, T, pf, k) FUNCTION:Where c= total cost x= output T= technology pf= price of factors k= fixed factors (s)

Short Run Cost of Traditional Theory

Two groups- total fixed cost and total groupsvariable cost. TC = TFC + TVC

Fixed Costs include:

a) b) c) d)

Salaries of administrator staff Depreciation (wear & tear of machinery) Expenses for building depreciation & repairs. Expenses for land maintenance & depreciation (if any)

Variable Cost Include

a) b) c)

Raw materials The cost of direct labour The running expenses of fixed capital such as fuel, ordinary repairs and routine maintenance.

TFC- graphicallyTFC- graphically- denoted by a straight line parallel to output axis TVCTVC- broadly an inverse S shape- reflects law of shapevariable proportions. LAWLAW- initial stages of production- as more variable productionfactor (s) is employed- productivity increasesemployedincreasesAVC falls - Continues-until the optimal combination of fixed Continuesand variable factor is reached. - Beyond this point increased quantities of variable factors are combined with fixed factor (s). - Productivity declines (AVC rises)

TC TVC

TVC

TFC

TFC

x 0

x 0

TFC + TVC = TC
From TC- obtain average cost curves TCAFC = TFC x

Graphically AFC is a rectangular hyperbola showing all its points the same magnitute that is the level of TFC AVC= TVC x

AFC

GraphicallyGraphically-AVC at each level of output is derived from the slope of a line drawn from the origin to a point on TVC curve corresponding to a particular level of output. c (a)
TVC

(b) d
a d

SAVC

a b
0 x
1

c
x
4

x1

x2

x3

x4

In the figure -AVC at x1 is the slope of the ray 0a -AVC at x2 is the slope of the ray 0b & so on -slope of ray through origin decline continuously until the ray becomes tangent to the TVC curve a C. -to the right of this point -the slope of rays through the origin starts increasing. Thus SAVC falls initially as productivity of the variable factor (s) increases.

-reaches a minimum when the plant is operated optimally. -and rises beyond that point (figure b).

The ATC is obtained ATC = TC = TFC + TVC = AFC + AVC X X

Graphically ATC derived same way as SAVC the ATC at any level of output is the slope of the straight line from the origin to the point on the TC curve corresponding to a particular level of outputs.
c

(a)
b M

TC L

(b)
SATC a L b M

x1 x2

xN xL

x x1 x2 xM xL

Both ATC & AVC is U shaped Initially ATC declines, it reaches a minimum level of the optimal operation of the plant (xM) and subsequently rises again as shown in figure (b). The marginal cost is defined as the change in total cost which results from a unit change in output. Denoting total cost by c and output by x, we have MC = dc dx

Graphically the MC is the slope of the TC curve - The slope of a curve at any of its point is the slope of the tangent at that point. With an inverse S shape of the TC (& TVC) the MC curve will be U shaped.
c

TC

SMC

x x dx dx

xA

xA

In the figure

Slope of the tangent to the TC curve declines gradually until it becomes parallel to x axis (with its slope being equal to zero at this point and then starts running). MN curve is U shaped

LONG RUN COSTS OF THE TRADITIONAL THEORYTHEORY- THE ENVELOPE CURVE

-

All factors are assumed to become variable Long run cost curve planning curve Guide to the entrepreneur in his decision to plan the future expansion of his output. LAC curve- derived from short run cost curvecurves Each point on a LAC curve corresponds to a point an a short run cost curve, which is tangent to LAC at that point,m

Assume that the available technology to the firm at a particular point of time includes three methods of production each with a different plant size.

- a small plant - a medium plant - a large plant

c
SATC1
c1 c2 c2 c3

c1

SATC2 SATC3

The small plant Operates with costs denoted by the curve SATC1

x3

0
-

x1 x 1 x

x2 x

Medium - SATC2 Large - SATC3

If the firm plans to produce output x1 choose the small plant If produce x2 choose medium plant If produce x3 choose large plant

If the firm starts with the small plant and its demand gradually increases it will produce at lower costs (up to level x 1) beyond this costs start. If its demand reaches the level x 1, the firm can either continue to produce with the small plant or it can install the medium size plant. The decision at this point depends not on costs but on the firms expectations about its future dd. If the firm expects that the dd will expand further than x 1, it will install medium size plant because with this plant outputs larger than x 1 are produced with lower cost. Similar conditions hold for the decision of the firm when it reaches the level x 2.

If it aspects its demand to stay constant at this level, the firm will not install large plant, given that it involves a larger investment which is profitable only if dd expands x 2 For. E.g.. The level of output x3 is produced at a cost c3 with the large plant while it costs c 2 if produced with medium size plant ( c 2>c3).

Assume a very large no. of plants (infinite nos.) of plants - Obtain a continuous curve which is planning LAC curve of the firm. - Each point of this curve shows the minimum (optimal) cost for producing the corresponding level of output.

The LAC curve is the lows of point denoting the least cost of producing the corresponding output. It s a planning curve based on this, firm decides what plant to set up in order to produce optimally (at minimum cost) the excepted level of output. The firm chooses the short run plant which allows it to produce the anticipated (in the long run) output at the least possible cost. In the traditional theory LAC curve is U shaped often called envelope curve because it envelopes the SRC curves.

SHORT RUN COSTS IN MODERN MICROECONOMICAL THEORY

-

Short run- distinguished- AFC & AVC run- distinguishedAFCAFC- cost of indirect factors Planning of the plant- consists in deciding the fixed plantindirect factors- which determine the size of the factorsplantplant- because they set limits to its production. PlanningPlanning- with a figure for the level of outputoutputHe will choose the size of plant which will allow him to produce this level. The plant will have a capacity larger the expected average level of sales because the businessman wants to have some reserve capacity for various reasons:

a) b) c) d) e)

To meet seasonal and cyclical fluctuations. To work with more shifts and with lower costs than a stock-piling capacity. stockGreater flexibility for responses of brokenbrokendown machinery. To meet the anticipated increases in demand Gives him flexibility for minor alterations of his products.

Technology usually makes it necessary to build into the plant some reserve capacity Will buy machinery- which allows flexibility machineryIn view- future growth in dd. viewSome reserve capacity- allowed in land & buildings capacityReserve capacity on the organizational and administrative level In summary- businessman will not necessarily summarychoose that plant- while give him today the lowest plantcostcost- but rather that equipment- allow more equipmentflexibility For minor alterations of his product or his technique.

a b

xA

xB

The firm has largest capacity units of machinery - Set an absolute limit to short run expansion (boundary B) - Also small unit machinery which sets to limit the expansion (boundary A)

This is not absolute limit- because the firm limitcan increase its output in the short run (until the absolute limit- B is encountered) limitEither by paying overtime to direct labour of working longer hours

In this case AFC is shown by the dotted line Or by buying some additional small unit types of machinery AFC curve shifts upwards and starts falling again as shown by the line AB in the figure

THE AVERAGE VARIABLE COST

IN MODERN THEORY - Shape saucer type- broadly U shaped- has a flat typeshapedstretch over a range of output. - Over this stretch- SAVC is equal to the MC- both stretchMCbeing constant per unit of output - To the left of flat stretch- MC lies below the SAVC stretch- While to the right- MC rises above SAVC right- The falling part of the SAVC shows the reduction in cost due to better utilization of fixed factors

Consequent increases in skills and productivity of variable factor (labour) Wastes in the raw material- being reduced materialbetter utilization of the whole plant. Increasing part of SAVC reflects Reduction in labour productivity Increase in cost of labour Overtime payment Wastes in materials More frequent break down Operates overtime- more shifts overtime-

SAC MC

MC

SAVC = MC

Modern micro economics- SAVC- flat stretch economics- SAVCover a certain range of output - Reserve capacity- possible to have capacityconstant SAVC within a certain range of output

THE AVERAGE TOTAL COST

Obtained by adding AFC + AVC at each level of output - ATC fall continuously up to level of output (xA) - At which reserve capacity is exhausted - Beyond- ATC starts rising Beyond- NC will interact the ATC curve at its minimum point ( which occurs to the right of the level of output xA at which the flat stretch of AVC ends

SATC NC SAVC

MC AFC

xA

LONG RUN COSTS- MODERN ECONOMIC COSTSTHEORY L shaped curve - distinguished in to production costs and managerial costs. - All costs are variables- roughly L shaped variables- Production costs fall smoothly at very large scales - Managerial costs may rise only slowly at very large scales

- Modern theories seem to accept that the fall in technical costs more than offsets the provable rise of managerial costs, so that LRAC curve falls smoothly or remain constant at very large scales of output.