Cost mms 10

Cost behavior

Cost analysis

Types of costs:- Behavior of cost in the short run Behavior of cost in the long run Economies of scale Vs Economies

of scope

Costs in the Short run Fixed costs and variable costs

Total costs total fixed cost (TFC)

total variable cost (TVC)

total cost (TC = TFC + TVC)

fig

0

20

40

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0 1 2 3 4 5 6 7 8

Output(Q)

01234567

TFC(£)

1212121212121212

Total costs for firm XTotal costs for firm X

fig

0

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40

60

80

100

0 1 2 3 4 5 6 7 8

TFC

Output(Q)

01234567

TFC(£)

1212121212121212

Total costs for firm XTotal costs for firm X

fig

0

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40

60

80

100

0 1 2 3 4 5 6 7 8

TFC

Total costs for firm XTotal costs for firm X

Output(Q)

01234567

TFC(£)

1212121212121212

TVC(£)

010162128406091

fig

0

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80

100

0 1 2 3 4 5 6 7 8

TVC

Output(Q)

01234567

TFC(£)

1212121212121212

TVC(£)

010162128406091

TFC

Total costs for firm XTotal costs for firm X

fig

0

20

40

60

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100

0 1 2 3 4 5 6 7 8

TVC

TFC

Total costs for firm XTotal costs for firm X

Output(Q)

01234567

TFC(£)

1212121212121212

TVC(£)

010162128406091

TC(£)

12222833405272

103

fig

0

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0 1 2 3 4 5 6 7 8

TCOutput

(Q)

01234567

TFC(£)

1212121212121212

TVC(£)

010162128406091

TC(£)

12222833405272

103

TVC

TFC

Total costs for firm XTotal costs for firm X

fig

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TC

TVC

TFC

Total costs for firm XTotal costs for firm X

Costs start increasing at an increasing rate here

Costs in the Short run

Average cost

average fixed cost (AFC)

average variable cost (AVC)

average (total) cost (AC)

Relationship between average and marginal cost

figOutput (Q)

Co

sts

(£)

MC

x

Average and marginal costs

figOutput (Q)

Co

sts

(£)

MC

x

Average and marginal costsAverage and marginal costs

Diminishing marginalreturns set in here

figOutput (Q)

Co

sts

(£)

AFC

AVC

MC

x

AC

z

y

Average and marginal costs

Marginal Costs

MC depends only on variable costs Shows cost impact of change in

production – fixed costs have no relevance to cost consequence of output change.

Marginal Costs

MC is change in total cost as result of one unit change in output, TC(N) - TC(N-1)

Rate of change of total cost with respect to output:

MC=TC/N FC/N + VC(N)/N

VC(N)/N

What is the relationship between average and marginal costs?

If MC < AC, then AC is falling

If MC > AC, then AC is rising

If MC = AC, then AC is constant

COST BEHAVIOR

LONG RUN COSTS

fig

Deriving long-run average cost curves: factories of fixed sizeDeriving long-run average cost curves: factories of fixed size

SRAC3

Co

sts

OutputO

SRAC4

SRAC5

5 factories

4 factories3 factories2 factories

1 factory

SRAC1 SRAC2

fig

SRAC1

SRAC3

SRAC2 SRAC4

SRAC5

LRAC

Co

sts

OutputO

Deriving long-run average cost curves: factories of fixed sizeDeriving long-run average cost curves: factories of fixed size

fig

Deriving a long-run average cost curve: choice of factory sizeDeriving a long-run average cost curve: choice of factory size

Co

sts

OutputO

Examples of short-runaverage cost curves

fig

LRAC

Co

sts

OutputO

Deriving a long-run average cost curve: choice of factory sizeDeriving a long-run average cost curve: choice of factory size

Economies of Scale

The advantages of large scale production that result in lower unit (average) costs (cost per unit)

AC = TC / Q Economies of scale – spreads total

costs over a greater range of output

Economies of Scale (internal)

Internal – Advantages that arise as a result of the growth of the firm Technical Commercial Financial Managerial Risk Bearing

Economies of Scale Internal: Technical

Specialisation – large organisations can employ specialised labour

Indivisibility of plant – machines can’t be broken down to do smaller jobs!

Increased dimensions – bigger containers can reduce average cost

Economies of Scale

Indivisibility of Plant: Not viable to produce products

like oil, chemicals on small scale – need large amounts of capital

Agriculture – machinery appropriate for large scale work – combines, etc.

Economies of Scale

Commercial

Large firms can negotiate favourable prices as a result of buying in bulk

Economies of Scale Financial

Large firms able to negotiate cheaper finance deals

Large firms able to be more flexible about finance – share options, rights issues, etc.

Economies of Scale

Managerial

Use of specialists – accountants, marketing, lawyers, production, human resources, etc.

Economies of Scale

Risk Bearing Markets across regions/countries Product ranges R&D

Economies of Scale (external) External economies of scale :– The advantages firms can gain as a

result of the growth of the industry – normally associated with a particular area

Supply of skilled labour Local knowledge and skills Infrastructure Training facilities

Diseconomies of Scale The disadvantages of large scale

production that can lead to increasing average costs Problems of management Maintaining effective communication Co-ordinating activities – often across

the globe! De-motivation and alienation of staff Divorce of ownership and control

More concepts :-

Stigler’s survivorship technique Economies of scope:-