Costs of production© Unit 03 1 RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
Costs of production©
Unit 03
1RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
Prepared by; RASHAIN PERERA077 059 37 [email protected]
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INTRODUCTION Section 01
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Business objectives Profit maximization is the fundamental
objective of a business Profit is the excess of income over
expenses Income is mainly through selling goods
and services There are various components of costs
such as variable costs, fixed costs and overhead costs.
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Other business objectives Maximizing earning per share Satisfying customers Quality products Continuous improvement Satisfactory service Business social responsibility (CSR) Growth and development Research and development AND other financial and non financial
objectives5RASHAIN PERERA CIMA Adv. Dip. MA,
UOR (Mgt)
The production process Conversion of raw materials to finished
goods could be simply known as the production process.
Conversion process, transformation process are some of the similar terms that are used by various parties for production process
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Production process involves inputs and its outcome could be termed as output
Therefore it is clear that there’s a direct relationship between inputs and outputs
This relationship could be shown in terms of the production function
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Production Function The production function shows the
relationship between the inputs and the outputs of a particular production process.
The production function can be presented as below
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Q = f{L/M, K}
In some processes some inputs might be fixed.
For example if capital is fixed the production function could be re stated as
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Q = f { L/M, K }
Short run Vs Long run
Short Run Short run is a time period in which both variable
factors and fixed factors exists. In the short run some factors remain fixed while
some of the factors can be changed in line with the requirement.
For example suppose that you need to park 4 cars in your garden but you don’t have enough space to do so. In the short run you garden space remains fixed while in the long run you can change it either by buying the land next to your house or by building an underground car park
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Long Run In the long run all factors are variable
and no fixed factors can be seen
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Variable factors Vs Fixed factors
Variable Factors Variable factors are the inputs/ factors
which change if the activity level or output changes
For example if we consider a tuition class, the tutorial cost would be variable
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Fixed Factors These are the factors or inputs that stay
the same or constant regardless of the output produced or activity level
Considering the same example mentioned in the previous slide, the fixed factor is the building that is being used to deliver the lecture
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SHORT RUNSection 02
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Short run production function
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Q = f { L/M, K }
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TP
MP
AP
Law of diminishing marginal returns This says that proportion of one factor
in a combination of factors is increased, after a certain point first the marginal then the average product of that factor will diminish
In other words total output will increase at a decreasing rate when more and more variable factors are assigned to a fixed input
Refer notes for graphical presentation19RASHAIN PERERA CIMA Adv. Dip. MA,
UOR (Mgt)
Short run revenue functions Revenue is the income gained by selling
goods and services Key formulas;
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TR = P X Qty
AR= TR/Qty
MR= change in TR/change in Qty
Short run cost functions There are 7 types of short run costs
Fixed costs Variable costs Total costs Average fixed cost Average variable cost Average total cost Marginal cost
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Fixed costs This is the cost that stays a same
regardless of the output level
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TFC
Cost
Qty
Variable costs The costs that changes with the activity
level or output level
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Cost
Qty
TVC
Total costs This is the totality of variable and fixed
costs
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TC = VC + FC
Average fixed costs
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AFC = TFC / QtyCost
Qty
TFC
AFC
Average variable costs
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AVC = TVC / QtyCost
Qty
AVC
Average total costs
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ATC = AFC + AVC Cost
Qty
AVC
ATC
AFC
Marginal costs
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MC = Chg TC/Chg QCost
Qty
AVC
ATCMC
Cost functions VS production functions
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Short run profit functions Profit the excess of revenue over
expenditure
Where TR is a function of price and quantity sold
TC is a function of variable, fixed costs and overheads
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Profit = TR - TC
Types of profits Accountants profit
Economists profit
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= TR – explicit costs
= TR – implicit – explicit costs
Explicit costs Explicit costs are the costs that can be
accountant in monetary terms. For example electricity paid 10 000
Implicit costs These are the opportunity costs or
unseen decision costs.
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Types of economic profits Normal profit
The minimum required by a firm to be in operation
Here the economic profit = 0 Abnormal profit/supernormal profit
This is an excess Here economic profit > 0
Subnormal profit Is an actual loss Here economic profit < 0
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LONG RUNSection 03
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Long run production function Is a time period where only variable
factors exists Long run production function can be
explained with the help of economies of scale
Economies of scale refers to an advantageous situation derived by a firm with increase in capacity, size and production
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Envelop curve It is said that LRAC is made of several
SRAC curves. LRAC is derived by joining the optimums of those SRAC curves as shown below.
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LRAC
SRAC 1 SRAC 2
Economies of scale and LRAC curve
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Optimum level
EOSDEOS
Returns to scale and LRAC curve
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Increasing returns to scale
constant returns to
scale
Decreasing returns to scale
Increasing returns to scale Firms experience this if their average cost
per unit in production falls as the firms expand in size/ activity level
Reasons Bulk buying Spreading overheads Risk bearing economies Financial economies Marketing economies of scale Specialization
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Decreasing returns to scale Reasons
Depreciation of resources Stress Lack of control Poor communications in the large firm Weaknesses in the management and
coordination.
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MARKET STRUCTURES Section 04
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Characterization of markets Number of firms? Size of firms? Type of product? Barriers to entry and exit? Information availability?
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Perfect competition Characteristics
Large number of small firms Homogenous or identical product No/low barriers to entry and exit Perfect information available for both
consumers and producers No advertising can be seen A price taker Faces a perfectly elastic demand curve No/low competition Ex; paddy farmers, wheat farmers etc
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Industry VS firms demand curve (price taker)
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Industry Firm
P
S
D
P=D=AR=MR
Price = demand = AR = MR
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Price Demand
TR AR MR
10 1 10 10 1010 2 20 10 1010 3 30 10 1010 4 40 10 10
P=D=AR=MR 10
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D=AR=MR=P
MC
AC
Short run equilibrium- abnormal profit
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D=AR=MR=P
MC
AC
Short run equilibrium-sub normal profit
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D=AR=MR=P
MC
AC
Long run equilibrium- normal profit
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D=AR=MR=P
MC
AC
Shut down point- case 1since AVC can be covered the firm will continue its operations
AVC
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D=AR=MR=P
MC
AC
Shut down point- case 2since AVC can not be covered the firm will shut down or discontinue
AVC
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D=AR=MR=P
MC
AC
Supply curve of a perfect competitive firm- case 1
AVC
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MC
AC
AVC
Supply curve of a perfect competitive firm- case 2
Monopoly Characteristics
Only one firm Sells a unique product High entry and exit barriers Less or no information available for customers No need to advertise Faces a normal downward sloping demand
curve A price maker No competition Ex; CGR
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MR=0.5AR
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Short/long run equilibrium-abnormal profit
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D=ARMR
MC
AC
Monopolistic competition Characteristics
Large number of small and large firms Homogenous or heterogeneous product Barriers to entry and exit are comparatively high Imperfect information Faces a normal downward sloping demand curve Advertising can be seen Can be a price taker or a maker Brand competition can be seen Ex; soft drinks, soap, tooth paste
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Short run equilibrium-abnormal profit
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D=ARMR
MC
AC
Long run equilibrium-normal profit
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D=ARMR
MC
AC
Oligopoly Characteristics
Few large firms Differentiated inter dependent product High barriers to entry and exit Mutually interdependent Advertising can be seen Faces a kinked demand curve High competition Ex; television broadcasting, newspaper
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Kinked demand curve
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Competition methods Price competition
Decreasing the price to increase sales discounts
Non price competition Advertising Internet shopping Extension of opening hours Home delivery Cash on delivery COD
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Price leadership When one firm has a dominant position
in the industry, that firm will be able to control the prices of other firms in the industry up to a certain extent. The dominant firm is named as price leader.
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The bad of oligopolies Inefficient in allocation of resources In equal distribution of income
The good of oligopolies Widen the product range Benefits the customer with innovative
products Can take advantage of economies of
scales
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Types of barriers to entry and exit Barriers to entry
Economies of size Capital intensive Intellectual property High switching cost of barriers Established brand loyalty Legal requirements Government standards
Barriers to exit Investment in specialized equipment Specialized skills High fixed costs
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