UNIT – IV
TRADITIONAL THEORY OF COST
Traditional theory distinguishes between the short run and the long run. The short
run is the period during which some factors is fixed; usually capital equipment and
entrepreneurship are considered as fixed in the short run.
The long run is the period over which all factors become variable.
SHORT-RUN TRADITIONAL THEORY OF COST
According to the traditional theory of the costs, the costs are divided into three
types:
· Total Cost
· Average Cost
· Marginal Cost
TOTAL COST
Total cost is the total expenditure incurred by a firm during the production process.
Total cost will change with the change in the ratio of output to input. Such changes
may be the result of the changes in the efficiency of conversion process or changes
in the prices of inputs. Total cost is a positively sloped curve.
Total cost to a producer for the various levels of output is the sum of total fixed
cost and total variable cost, i.e.,
TC = TFC + TVC.
TOTAL FIXED COST: Total fixed costs refer to those costs which are unable to
vary. For example: land, buildings, machinery etc. Even the output is zero fixed
costs will be there. Because, this cannot be variable with respect to the level of
production. So, it is also called invariable cost. Since fixed costs are fixed or rigid
it can be represented through a curve having horizontal shape to output axis. This
can be shown with the help of following diagram:
TOTAL VARIABLE COST: Variable cost is incurred on the employment of variable
factors like raw materials, direct labour, power, fuel, transportation, sales
commission, depreciation charges associated with wear and tear of assets, etc. It
varies directly with output.The curve of variable cost can be shown as follows:
From the curves of fixed cost and variable costs, the total cost can be derived as
follows:
AVERAGE COST
Average total cost is the sum of the average fixed cost and average variable cost.
Alternatively, ATC is computed by dividing total cost by the number of units of
output.
Therefore,
ATC or AC = AFC + AVC
=TC/Q
Average cost is also known as unit cost, as it is cost per unit of output produced. It
can be shown as follows:
Average cost is inclusive of Average Fixed Cost and Average Variable Cost.
AVERAGE FIXED COST: AFC is the average of total fixed costs. AFC can be
obtaining by dividing the total fixed cost by total quantity of output each time
produced. Mathematically,
AFC = TFC /quantity
TFC will be always fixed. So AFC will reduce and never reaches zero. Its curve is
as follows:
AVERAGE VARIABLE COST: AVC is the average of total variable cost. It can
be find out by using the following formula.
AVC = TFC / quantity
AVC curve will be a ‘U’ shaped which is showing that when the output is raises
the cost will decline, but after a certain level the cost starts to increases. That is
why due to the variable proportion.
WHY AC IS U SHAPED?
In the short-run average cost curves are of U-shape. It means, initially it falls and
after reaching the minimum point it starts rising upwards. It can be on account of
the following reasons:
1. BASIS OF AVERAGE FIXED COST AND AVERAGE VARIABLE COST
Average cost is the aggregate of average fixed cost and average variable cost (AC
= AFC + AVC). To begin with, as production increases, initially the average fixed
cost and average variable cost falls. But after a minimum point, average variable
cost stops falling but not the average cost. It is due to this reason that average
variable cost reaches the minimum before AC.
The point, where AC is minimum is called the optimum point. After this point, AC
begins to rise upward. The net result is the increase in AC. Therefore, it is only due
to the nature of AFC and AVC that AC first falls, reaches minimum and afterwards
starts rising upward and hence assume the U-shape.
2. BASIS OF THE LAW OF VARIABLE PROPORTION
The law of variable proportion also results in U-shape of short run average cost
curve. If in the short period variable factors are combined with a fixed factor,
output increases in accordance with the law of variable proportions. In other
words, the law of ‘Increasing Returns’ applies.
Similarly, if employ more and more variable factors are employed with fixed
factors the law of Diminishing Returns is said to apply. Thus, it is due to the law of
variable proportions that the average cost curve assumes the shape of U.
3. INDIVISIBILITIES OF THE FACTORS
Another reason due to which the average cost curve forms U-shape is the
indivisibilities of factors. When in the short-run a firm increases its production due
to indivisibilities of fixed factors, it gets various internal economies. It is these
economies which cause the average cost curve to fall in the initial stage. Generally,
there are three types of internal economies which help to bring down the cost viz.,
technical economies, marketing economies and managerial economies.
MARGINAL COST
It is the addition to total cost required to produce one additional unit of a
commodity. It is measured by the change in total cost resulting from a unit increase
in output. For example, if the total cost of producing 5 units of a commodity is Rs.
100 and that of 6 units is Rs. 110, then the marginal cost of producing 6 th unit of.
Commodity is Rs. 110 – Rs. 100 = Rs. 10. The formula for marginal cost is
MCn =TCn –TCn-1,
It means that marginal, cost of ‘n’ units of output (MCn) can be obtained by
subtracting the total cost of production of ‘n-l’ units (TCn-1) from the total cost of
production of ‘n’ units (TCn). Alternatively, marginal cost can be expressed as
MC=∆TC/∆Q.
Here, ∆TC stands for change in total cost and ∆Q stands for change in total output.
This can be shown as follows:
LONG RUN COSTS OF TRADITIONAL THEORY
In the long run all factors are assumed to become variable. Long-run cost curve is a
planning curve, in the sense that it is a guide to the entrepreneur in his decision to
plan the future expansion of his output. The long-run average-cost curve is derived
from short-run cost curves.
The long run costs are categorised as follows:
· Long run total cost
· Long run average cost
· Long run marginal cost
LONG RUN TOTAL COST
Long run Total Cost (LTC) refers to the minimum cost at which given level of
output can be produced. According to Leibhafasky, “the long run total cost of
production is the least possible cost of producing any given level of output when
all inputs are variable.” LTC represents the least cost of different quantities of
output. LTC is always less than or equal to short run total cost, but it is never more
than short run cost.
This can be shown as follows:
LONG RUN AVERAGE COST
Long run Average Cost (LAC) is equal to long run total costs divided by the level
of output. The derivation of long run average costs is done from the short run
average cost curves. In the short run, plant is fixed and each short run curve
corresponds to a particular plant. The long run average costs curve is also called
planning curve or envelope curve as it helps in making organizational plans for
expanding production and achieving minimum cost.
LONG RUN MARGINAL COST
Long run Marginal Cost (LMC) is defined as added cost of producing an additional
unit of a commodity when all inputs are variable. This cost is derived from short
run marginal cost. On the graph, the LMC is derived from the points of tangency
between LAC and SAC.
MODERN THEORY OF COST
Modern economists including Stigler, Andrews and Friedman have questioned
the validity of U-shaped cost curves both theoretical as well as on empirical
grounds. Also the long run costs in modern theory are not U- shaped but L- shaped.
The Modern theory suggests the existence of ‘built- in- reserve capacity ‘which
imparts flexibility and enables the plant to produce larger output without adding to
the costs. Built –in- reserve capacity are planned by firms.
The short-run cost curve has a saucer- type shape whereas the long-run Average
cost curve is either L-Shaped or inverse J-shaped.
The Modern theory of cost stresses on the role of economies of scale, which
significantly enables the firm to continue production at the lowest point of average
cost for a considerable period of time. The firm checks dis-economies of scale by
planning in advance and enjoys the gains of production in comparison to the
traditional theory where the average cost rises after the firm reaches the optimal
level of output.
TYPES OF COSTS AS PER MODERN THEORY
SHORT RUN COSTS
AVERAGE FIXED COST
The fixed costs include the costs for:
· The salaries and other expenses of administrative staff.
· The wear and tear of machinery.
· The expenses for maintenance of building.
· The expenses for the maintenance of land on which the plant is installed or
operates.
As in the traditional theory of cost, the average fixed costs in modern
microeconomics, also plots as a rectangular hyperbola. This is shown as follows:
AVERAGE VARIABLE COST
In modern theory, Average variable cost is not U shaped rather it is saucer shaped
and has a flat stretch over a range of output. This flat stretch represents the ‘built in
reserve capacity’ of the firm to meet seasonal and cyclical changes in the demand.
The average variable cost curve is as follows:
AVERAGE COST
The short-run Average costs consist of the Average fixed costs and Average
variable costs. The short-run average variable cost curve at each level of
output. The smooth and continuous fall in the average cost curve is due to the fact
that the AFC curve is a rectangular hyperbola and the AVC curve first falls and
then becomes horizontal within the range of reserve capacity. Beyond that it starts
rising steeply. The curve of average cost is as follows:
LONG RUN COSTS
LONG RUN AVERAGE COST
Modern economists divide long run costs into production costs and managerial
costs/ In the long run, all costs are variable and they given rise to a long run
average cost curve which is roughly L- shaped. This curve rapidly slopes
downwards in the beginning but later remains flat or slopes gently downwards at
its right-hand cost. The long run average cost curve is as follows:
The Long run average costs curve has two main features:
· It does not rise at every large scale of output.
· It does not envelope the Short run Average Cost but intersects them.
LONG RUN MARGINAL COST
According to modern theory, shape of long-run marginal cost curve corresponds to
the shape of long-run average cost curve. The given figure shows that when LAC
is L- shaped and LAC curve is falling then LMC curve will also be falling and its
falling portion will be below the falling portion of LAC curve.
ANALYSIS OF ECONOMIES OF SCALE
What are Economies of Scale?
Economies of Scale refer to the cost advantage experienced by a firm when it
increases its level of output. The advantage arises due to the inverse relationship
between per-unit fixed cost and the quantity produced. The greater the quantity of
output produced, the lower the per-unit fixed cost. Economies of scale also result
in a fall in average variable costs (average non-fixed costs) with an increase in
output. This is brought about by operational efficiencies and synergies as a result
of an increase in the scale of production.
Economies of scale can be implemented by a firm at any stage of the production
process. In this case, production refers to the economic concept of production and
involves all activities related to the commodity, not involving the final buyer.
Thus, a business can decide to implement economies of scale in its marketing
division by hiring a large number of marketing professionals. A business can also
adopt the same in its input sourcing division by moving from human labor to
machine labor.
Effects of Economies of Scale on Production Costs
1. It reduces the per-unit fixed cost. As a result of increased production, the
fixed cost gets spread over more output than before.
2. It reduces per-unit variable costs. This occurs as the expanded scale of
production increases the efficiency of the production process.
The graph above plots the long-run average costs faced by a firm against its level
of output. When the firm expands its output from Q to Q2, its average cost falls
from C to C1. Thus, the firm can be said to experience economies of scale up to
output level Q2. (In economics, a key result that emerges from the analysis of the
production process is that a profit-maximizing firm always produces that level of
output which results in the least average cost per unit of output).
Types of Economies of Scale
1. Internal Economies of Scale
This refers to economies that are unique to a firm. For instance, a firm may hold a
patent over a mass production machine, which allows it to lower its average cost of
production more than other firms in the industry.
2. External Economies of Scale
These refer to economies of scale enjoyed by an entire industry. For instance,
suppose the government wants to increase steel production. In order to do so, the
government announces that all steel producers who employ more than 10,000
workers will be given a 20% tax break. Thus, firms employing less than 10,000
workers can potentially lower their average cost of production by employing more
workers. This is an example of an external economy of scale – one that affects an
entire industry or sector of the economy.
Sources of Economies of Scale
1. Purchasing
Firms might be able to lower average costs by buying the inputs required for the
production process in bulk or from special wholesalers.
2. Managerial
Firms might be able to lower average costs by improving the management
structure within the firm. The firm might hire better skilled or more experienced
managers.
3. Technological
A technological advancement might drastically change the production process. For
instance, fracking completely changed the oil industry a few years ago. However,
only large oil firms that could afford to invest in expensive fracking equipment
could take advantage of the new technology.
Diseconomies of Scale
Consider the graph shown above. Any increase in output beyond Q2 leads to a rise
in average costs. This is an example of diseconomies of scale – a rise in average
costs due to an increase in the scale of production.
As firms get larger, they grow in complexity. Such firms need to balance the
economies of scale against the diseconomies of scale. For instance, a firm might be
able to implement certain economies of scale in its marketing division if it
increased output. However, increasing output might result in diseconomies of scale
in the firm’s management division.
Frederick Herzberg, a distinguished professor of management, suggested a reason
why companies should not blindly target economies of scale:
“Numbers numb our feelings for what is being counted and lead to adoration of the
economies of scale. Passion is in feeling the quality of experience, not in trying to
measure it.”
PRICE AND OUTPUT DETERMINATIO UNDER PERFECT
COMPETITION
