Overview

Theory of Demand and SupplyUNIT 2: THEORY OF COSTAt the end of this Unit, you should be able to: 1. Explain the Meaning and Different Types of Costs. 2. Define Cost Function and Explain the Difference between a Short-Run and Long-Run Cost Function. 3. Explain the linkages between the Production Function and the Cost Function. 4 Explain Economies and Diseconomies of Scale and Reasons for Their ExistenceSUMMARY• Cost analysis refers to the study of behaviour of cost in relation to one or more production criteria. It is concerned with the financial aspects of production. • Accounting costs are explicit costs and includes all the payments and charges made by the entrepreneur to the suppliers of various productive factors. • Economic costs take into account explicit costs as well as implicit costs. A firm has to cover its economic cost if it wants to earn normal profits. • Outlay costs involve actual expenditure of funds. • Opportunity cost is concerned with the cost of the next best alternative opportunity which was foregone in order to pursue a certain action. • Direct costs are those which have direct relationship with a component of operation. They are readily identified and are traceable to a particular product, operation or plant. • Indirect costs are those which cannot be easily and definitely identifiable in relation to a plant, product, process or department. They not visibly traceable to any specific goods, services, processes, departments or operations. • Incremental cost refers to the additional cost incurred by a firm as a result of a business decision. • Sunk costs are already incurred once and for all, and cannot be recovered. • Historical cost refers to the cost incurred in the past on the acquisition of a productive asset. • Replacement cost is the money expenditure that has to be incurred for replacing an old asset. • Private costs are costs actually incurred or provided for by firms and are either explicit or implicit. • Social cost, on the other hand, refers to the total cost borne by the society on account of a business activity and includes private cost and external cost. • The cost function refers to the mathematical relation between cost and the various determinants of cost. It expresses the relationship between cost and output. • Economists are generally interested in two types of cost functions; the short run cost function and the long run cost function.• Short-run cost functions are • Fixed or constant costs which are not a function of output. These are inescapable or uncontrollable. • Variable costs are a function of output in the production period. • Short run is a period of time in which output can be increased or decreased by changing only the amount of variable factors such as, labour, raw material, etc. , • Long run is a period of time in which the quantities of all factors may be varied. In other words, all factors become variable in the long run. • Semi-variable costs are neither perfectly variable, nor absolutely fixed in relation to the changes in the size of output. • Stair-step costs remain fixed over certain range of output; but suddenly jump to a new higher level when output goes beyond a given limit. • Total cost of a business is defined as the actual cost that must be incurred for producing a given quantity of output. • AFC is obtained by dividing the total fixed cost by the number of units of output produced. • Average variable cost is found out by dividing the total variable cost by the number of units of output produced. • Average total cost is the sum of average fixed cost and average variable cost. • Marginal cost is the addition made to the total cost by the production of an additional unit of output. • Long run cost of production is the least possible cost of producing any given level of output when all individual factors are variable. • A long run cost curve depicts the functional relationship between output and the long run cost of production. • The long run average cost curve, often called a planning curve, is so drawn as to be tangent to each of the short run average cost curves. • LAC curve is not tangent to the minimum points of the SAC curves. • Empirical evidence shows that the state of technology changes in the long-run. Therefore, modern firms face ‘L-shaped' cost curve over a considerable quantity of output. • Economies of scale are of two kinds - external economies of scale and internal economies of scale. • External economies of scale accrue to a firm due to factors which are external to a firm. • Internal economies of scale accrue to a firm when it engages in large scale production. • Increase in scale, beyond the optimum level, results in diseconomies of scale.

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