By Rohit Chauhan ECE
COST CURVES
Cost function : The general name for the relation between output and cost is cost
function. Cost functions are
derived functions. These are derived from the production function,which
describes the available efficient methods of production at any one time.
Concepts of cost: The concept of cost is used in a variety of ways .Important
concepts of cost are as follows-
1)
Money cost: The
amount spent in terms of money for the production of a commodity is called
money cost.
2)
Real cost: The mental and physical efforts and
sacrifices undergone with a view to producing a commodity are its real cost
3)
Accounting cost:
accounting cost refer to cash payments which firms make for factor and
non-factor inputs, depreciation and other book keeping entries.
4)
Opportunity cost:
Opportunity cost of a particular product is the value of the foregone alternative
product that resources used in its production.
5)
Economic cost:
In the economic analysis , economic cost includes both accounting costs and
opportunity costs of self owned and self
– employed resources.
6)
Social cost: the
social cost is the total to society of an economic activity. the economic
organisation of every society is characterised by certain social cost such as
pollution and noise which are not taken by firms in determining their price
levels. Social cost is the opportunity cost rather than just one firm or
individual.
7)
Private cost:
private cost is the cost incurred by an individual firm for producing
commodity. It includes both the explicit cost as well as implicit cost.
8)
Explicit cost:
explicit costs are those cash payments which firms make to outsiders who supply
labour services, material, fuel, transportation services, power and so forth
are called explicit costs.
9)
Implicit cost:
Implicit costs are costs of self-owned or self-employed.
10)
Past and future costs: Past costs are actual costs incurred in the past. These
costs are mentioned in the accounts. Future costs are those costs which are to
be incurred in the near future. This is only a forecast. Future costs matter
for managerial decision because, the management can evaluate the desirability
of that expenditure. Since the past costs
are costs that have already been incurred, there is no scope for
managerial decision.
Cost curve
In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of
production (minimising cost), and profit maximizing firms can use them to decide output quantities to
achieve those aims. There are various types of cost curves, all related to each
other, including total and average cost curves, and marginal ("for each
additional unit") cost curves, which are the equal to the differential of the total cost curves. Some are applicable to the short run, others to the long run.
There are two types of cost curve
which are given below-
A (I) Short-run average variable cost curve (SRAVC)
Average variable cost (which is a
short-run concept) is the variable cost (typically labour cost) per unit of
output: SRAVC = wL / Q where w is the wage rate, L is the quantity of labour
used, and Q is the quantity of output produced. The SRAVC curve plots the
short-run average variable cost against the level of output, and is typically
drawn as U-shaped.
(II) Short-run average total cost curve (SRATC or SRAC)
short run average cost curve
The
average total cost curve is constructed to capture the relation between cost
per unit of output and the level of output, ceteris
paribus. A perfectly competitive and productively efficient firm
organizes its factors of production in such a way that the average cost of production is at the lowest point.
In the short run,
when at least one factor of production is fixed, this occurs at the output
level where it has enjoyed all possible average cost gains from increasing
production. This is at the minimum point in the diagram on the right.
Short-run
total cost is given by
STC
= PKK+PLL,
where PK is the unit price of using physical
capital per unit time, PL is
the unit price of labor per unit time
(the wage rate), K is the quantity of physical capital used, and L is the
quantity of labor used. From this we obtain short-run average cost, denoted
either SATC or SAC, as STC / Q:
SRATC
or SRAC = PKK/Q + PLL/Q = PK / APK + PL / APL,
where APK = Q/K is the average product of
capital and APL = Q/L
is the average product of labor.
Short
run average cost equals average fixed costs plus average variable costs.
Average fixed cost continuously falls as production increases in the short run,
because K is fixed in the short run. The shape of the average variable cost
curve is directly determined by increasing and then diminishing marginal
returns to the variable input (conventionally labour)
(III) Short-run marginal cost curve (SRMC)
Typical marginal cost curve
A
short-run marginal cost curve graphically represents the
relation between marginal (i.e., incremental) cost incurred by a firm in the
short-run production of a good or service and the quantity of output produced.
This curve is constructed to capture the relation between marginal cost and the
level of output, holding other variables, like technology and resource prices,
constant. The marginal cost curve is U-shaped. Marginal cost is relatively high
at small quantities of output; then as production increases, marginal cost
declines, reaches a minimum value, then rises. The marginal cost is shown in
relation to marginal revenue, the incremental amount of sales revenue that an
additional unit of the product or service will bring to the firm. This shape of
the marginal cost curve is directly attributable to increasing, then decreasing
marginal returns (and the law of diminishing marginal returns). Marginal cost
equals w/MPL. For most
production processes the marginal product of labour initially rises, reaches a
maximum value and then continuously falls as production increases. Thus
marginal cost initially falls, reaches a minimum value and then increases. The
marginal cost curve intersects both the average variable cost curve and
(short-run) average total cost curve at their minimum points. When the marginal
cost curve is above an average cost curve the average curve is rising. When the
marginal costs curve is below an average curve the average curve is falling.
This relation holds regardless of whether the marginal curve is rising or
falling.
B (I) Long-run average cost curve (LRAC)
long run average cost curve
The
long-run average cost curve depicts the cost per unit of output in the long
run—that is, when all productive inputs' usage levels can be varied. All points
on the line represent least-cost factor combinations; points above the line are
attainable but unwise, while points below are unattainable given present
factors of production. The behavioural assumption underlying the curve is that
the producer will select the combination of inputs that will produce a given
output at the lowest possible cost. Given that LRAC is an average quantity, one must not confuse it with
the long-run marginal cost curve, which is the cost of one
more unit. The LRAC curve is created as an envelope of an infinite number of short-run average total cost
curves, each based on a particular fixed level of capital usage. The typical LRAC curve is U-shaped,
reflecting increasing returns of
scale where
negatively-sloped, constant returns to scale where horizontal and decreasing
returns (due to increases in factor prices) where positively sloped. Contrary to Viner’s, the envelope is
not created by the minimum point of each short-run average cost curve This mistake is recognized as Viner's Error.
In a
long-run perfectly competitive environment, the equilibrium level of
output corresponds to the minimum efficient scale, marked as Q2 in
the diagram. This is due to the zero-profit requirement of a perfectly
competitive equilibrium. This result, which implies production is at a level
corresponding to the lowest possible average cost, does not imply that production levels
other than that at the minimum point are not efficient. All points along the
LRAC are productively efficient, by definition, but not all are equilibrium
points in a long-run perfectly competitive environment.
In some
industries, the bottom of the LRAC curve is large in comparison to market size
(that is to say, for all intents and purposes, it is always declining and
economies of scale exist indefinitely). This means that the largest firm tends
to have a cost advantage, and the industry tends naturally to become a
monopoly, and hence is called a natural
monopoly. Natural monopolies tend to exist in industries with high
capital costs in relation to variable costs, such as water supply and electricity supply.
B(II) Long-run marginal cost curve (LRMC)
The
long-run marginal cost curve shows for each unit of output the added total cost
incurred in the long run,
that is, the conceptual period when all factors of production are variable so
as minimize long-run average total cost. Stated otherwise, LRMC is the minimum
increase in total cost associated with an increase of one unit of output when
all inputs are variable.
The
long-run marginal cost curve is shaped by economies and diseconomies of scale,
a long-run concept, rather than the law of diminishing marginal returns, which is a
short-run concept. The long-run marginal cost curve tends to be flatter than
its short-run counterpart due to increased input flexibility as to cost
minimization. The long-run marginal cost curve intersects the long-run average
cost curve at the minimum point of the latter. When long-run marginal costs are below
long-run average costs, long-run average costs are falling (as to additional
units of output). When long-run
marginal costs are above long run average costs, average costs are rising.
Long-run marginal cost equals short run marginal-cost at the
least-long-run-average-cost level of production. LRMC is the slope of the LR
total-cost function.
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