10B11PD311 Economics Cost Theory and Estimation. 10B11PD311 Economics Cost of Production: Costs...

10B11PD311 Economics

Cost Theory and Estimation

10B11PD311 Economics

Cost of Production: Costs incurred on factor inputs

Explicit Costs:Actual money spent in purchasing or hiring

services of factor inputsAccounting Costs

Economic Costs: Implicit Costs: Cost of self-owned and self-

employed resourcesAlternative or Opportunity Costs: value of an

input in its next best alternative use

10B11PD311 Economics

Fixed costs:Costs which do not change with change in the

quantity of output

Variable or Prime costs:Costs which change with change in level of

output

Cost of long-lived Assets during a period:Traditional approach: depreciationEconomic approach: change in the market value

from the beginning to the end of the period

10B11PD311 Economics

Sunk Costs:Expenditures that have been made in the past

or that must be made as part of a contractual agreement

Marginal cost:Change in total cost associated with a one-unit

change in output Incremental Costs:

Total additional cost of implementing a managerial decision

10B11PD311 Economics

Average Fixed Cost = AFC = TFC/Q

Average Variable Cost = AVC =TVC/Q

Average Total Cost = ATC = TC/Q

Average Total Cost = AFC + AVC

Marginal Cost = TC/Q = TVC/Q

Total Cost = TC = f(Q)

TC = TFC + TVC

Total Fixed Cost = TFC &

Total Variable Cost = TVC

10B11PD311 Economics

Average Variable Cost

AVC = TVC = w L

Q Q

= w = w

Q/L APL

Marginal Cost

TC/Q = TVC/Q = (w L)/Q

= w = w

Q/L MPL

10B11PD311 Economics

Q TFC TVC

0 $60 $0

1 60 20

2 60 30

3 60 45

4 60 80

5 60 135

10B11PD311 Economics

Q TFC TVC TC AFC AVC ATC MC

0 $60 $0 $60 - - - -

1 60 20 80 $60 $20 $80 $20

2 60 30 90 30 15 45 10

3 60 45 105 20 15 35 15

4 60 80 140 15 20 35 35

5 60 135 195 12 27 39 55

10B11PD311 Economics

0

50

100

150

200

250

0 1 2 3 4 5 6Output

Output

Cost

Cost

Total Cost Function

Per Unit Cost Function

0

10

20

30

40

50

60

70

80

90

0 1 2 3 4 5 6

T C

A V C

A C

M C

T F C

T V C

10B11PD311 Economics

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q

Long-Run Marginal Cost = LMC = LTC/Q

10B11PD311 EconomicsDerivation of Long-Run Cost Curves

10B11PD311 Economics

Relationship Between Long-Run and Short-Run Average Cost Curves

10B11PD311 Economics

Possible Shapes of the LAC Curve

10B11PD311 Economics

Economies of Scale(output grows proportionately faster than inputs)

Indivisibility

Specialization

EquipmentMaintenance

Due to large plant Due to large firm

Innovation

Funds raising

Quantity discounts

Management

Technological forces/Plant economies

Financial forces/Firm economies

ProductivitySales promotion

10B11PD311 Economics

Diseconomies of Scale

Transportation cost

Imperfection inlabor market

Due to large plant Due to large firm

Coordination andcontrol

10B11PD311 Economics

Utility of Learning Curves• To forecast needs of

– personnel– machinery– raw materials

• Scheduling production• Determining Selling price of product

10B11PD311 Economics

Employee turnover Production interruptions Ability to transfer knowledge from

other products

Average cost typically declines by 20-30% for each doubling of cumulative output for many firms

10B11PD311 Economics

Total Revenue = TR = (P)(Q)

Total Cost = TC = TFC + (AVC)(Q)

Profit = TR –TCProfit = = PQ - [TFC + (AVC)(Q)]

Q = TFC +

P - (AVC)

Profit contribution = P- AVC

QBE = TFC

(P - AVC)

At Breakeven point,TR = TC = TR - TC = 0

10B11PD311 Economics

P = 10

TFC = 200

AVC = 5

Shortcomings•Assumes constant prices •Assumes constant AVC•Firm produces a single product or a constant product mix of products

10B11PD311 Economics

MA Inc. specializes in the production and mail-order distribution of computer programs. The development and production costs (in $) are:

Development Costs:Program Development 10000Manual preparation and typesetting 3000Advertising 10000

Distribution Costs/ unit.Blank Disk 2Loading Cost 0.5Postage and Handling 1.25Printing of manual 2.75

Price of one program with manual = $40a). Determine breakeven no. of programs and TR at this

volume.b). If Profit target = $40,000, determine the unit and dollar

volume of sales.c). If price falls by 25%, determine the new breakeven unit and

dollar volume.

10B11PD311 Economics

a). Determine breakeven no. of programs and TR at this volume.

Qe = 23000/ (40-6.5) = 686.6 unitsTR at Qe = 40*686.6 = $27,464

b). If Profit target = $40,000, determine the unit and dollar volume of sales.

Q40000 = (23000+40000) / (40-6.50) = 1880.6 unitsTR = $75, 224

c). If price falls by 25%, determine the new breakeven unit and dollar volume.

Qe = 978.7 unitsTR = 30* 978.7 = $29,361

Q = TFC +

P - (AVC)

10B11PD311 Economics

TC’ has a higher DOL than TC and therefore a higher QBE

High Operating leverage means:

•substituting fixed for variable costs.

•profits are becoming more sensitive to Q.

DOL: Degree of operating leverage

10B11PD311 Economics

Foreign Sourcing of Inputs New International Economies of Scale

product developmentpurchasingproductiondemand managementorder fulfillment

Immigration of Skilled LaborBrain Drain

10B11PD311 Economics

Core Competencies Outsourcing of Non-Core Tasks Learning Organization Efficiency and Flexibility Agility in Responding to Market

Forces Location Near Markets