Cost of Production free essay sample

Costs of Production July 2011 Topics to be Discussed Measuring Cost: Which Costs Matter? How do Cost Curves Behave? – Cost in the Short Run – Cost in the Long Run How to Minimize Cost? How to draw Implications for Business Strategy? Topics to be Discussed Production with Two Outputs: Economies of Scope Dynamic Changes in Costs: The Learning Curve Estimating and Predicting Cost Measuring Cost: Which Costs Matter? Accountants tend to take a retrospective view of firms’ costs, whereas economists tend to take a forward-looking view Accounting Cost – Actual expenses plus depreciation charges for capital equipment Economic Cost – Cost to a firm of utilizing economic resources in production, including opportunity cost Costs as Opportunity Costs Accountants measure the explicit costs but often ignore the implicit costs. Economists include all opportunity costs when measuring costs. Accounting Profit = TR Explicit Costs Economic Profit = TR Explicit Costs Implicit Costs Explicit and Implicit costs The firm’s costs include Explicit Costs and Implicit Costs: – Explicit Costs: costs that involve a direct money outlay for acquiring factors of production. – Actual expenditure incurred by firm for hire, rent or purchase of the inputs so as to undertake production. (Exp: Wages to hire labour, rental price of capital, equipment and buildings and purchase price of raw materials and semi finished products). – Implicit Costs: Costs that do not involve a direct money outlay – (Ex. Opportunity costs of the owner’s own inputs used Implicit wages, implicit rent, cost of capital). Opportunity Cost Economic costs distinguish between costs the firm can control and those it cannot Opportunity cost – Cost associated with opportunities that are foregone when a firm’s resources are not put to their highest-value use Opportunity cost of an action is the value of the next best alternative forgone. For an Input: What the input could have earned from best alternative use (outside the firm). SUNK COST Although opportunity costs are hidden and should be taken into account, sunk costs should not Sunk Cost – EXPENDITURE THAT HAS BEEN MADE AND CANNOT BE RECOVERED – Firm buys a piece of equipment that cannot be converted to another use Cost that is committed but can not be avoided – Should not influence a firm’s future economic decisions Sunk Cost From a firm’s point of view it is the cost that arises when an investment in an asset can not be recovered by subsequent resale. Firm can neither sell nor lease it to any other person and even cannot be used for other alternative purposes. Investment is a SUNK COST when its OPPORTUNITY COST is zero. Fixed Cost versus Sunk Cost Fixed Cost – Cost paid by a firm that is in business regardless of the level of output Fixed costs can be avoided if the firm goes out of business (say key executives will not be needed) Sunk Cost – Cost that has been incurred and cannot be recovered Ex: Cost of factory with specialized equipment which is of no use in another industry Exception: Something can be recovered if it is sold for scrap. Family of Total Costs Total Fixed Costs (TFC) Total Variable Costs (TVC) Total Costs (TC) TC = TFC + TVC Short Run Costs Fixed Costs: – Those costs that do not vary with the amount of output produced or level of output. – Total obligations of the firm per given period (time) for all fixed inputs (Land, Building, Capital Equipment). – Exp: Payment for renting the plant and equipment if firm owns it, insurance, property taxes, salaries (for top management fixed by contract and to be paid during the period of contract irrespective of going for production or not) – -Annual allowances made for depreciation (wear and tear) and expenditure on maintenance Variable Cost Those costs that do vary with the amount of output produced. – Obligations of the firm per period for all variable inputs – (Exp. Payment for Raw materials and fuels, expense on power and water supply, wages of labour) Family of Average Costs. . . Average Costs: Specific Cost / Output Level Average Fixed Costs (AFC) = Total Fixed Costs / output (Q) Average Variable Costs (AVC) = Total Variable Cost / output (Q) Average Total Costs (ATC) = Total Cost / Output (Q) Marginal Cost: â€Å"How much does it cost to produce an additional unit of output? Marginal Cost (MC): â€Å"The extra or additional cost of producing one more unit of output. † MC = TC ? Q Determinants of Short Run Costs INCREASE in OUTPUT leads to INCREASE in TOTAL COST. HOW does it MOVE? Extent of Rise in Cost Depends on the nature of the PRODUCTION PROCESS – Extent to which production involves DIMINSHING RETURNS to VARIABLE FACTORS If MARGINAL PRODUCT OF LABOUR DECREASES signifi cantly as more labor is hired – Costs of production increase rapidly – Greater and greater expenditures must be made to produce more output Determinants of Short Run Costs Assume Labour: only Variable Input Assume the wage rate (w) is fixed relative to the number of workers hired Variable costs is the per unit cost of extra labor times the amount of extra labor: wL ?VC w? L MC = = ? Q ? Q A Firm’s Short Run Costs Inference: MC decreases initially with increasing returns (0 through 4 units of output) MC increases with decreasing returns (5 through 11 units of output) TC Cost 400 ($ per year) 300 Total cost is the vertical sum of FC and VC. VC 200 Variable cost increases with production and the rate varies with increasing and decreasing returns. 100 50 0 1 2 3 4 5 6 7 8 9 Fixed cost does not vary with output FC 10 11 12 13 Output Short Run Cost Curve: Summary Short run cost curves (AVC, ATC and MC) are UShaped- Law of variable proportion In the short run with fixed plant, there is a phase of INCREASING PRODUCTIVITY (falling unit costs) a phase of DECREASING PRODUCTIVITY (increasing unit cost) of the variable factors. Between these two phases there is a single point at which unit COSTS are MINIMUM. At this point on ATC, the plant is utilised optimally (optimal combinations of fixed and variable factors) Cost Minimizing Input Choice in Long Run: Producing a Given Output at Minimum Cost Capital per year K2 Q1 is an isoquant for output Q1. There are three isocost lines, of which 2 are possible choices in which to produce Q1. A K1 K3 C0 L2 L1 C1 L3 Isocost C2 shows quantity Q1 can be produced with combination K2,L2 or K3,L3. However, both of these are higher cost combinations than K1,L1. Q1 C2 Labor per year Cost in the Long Run †¢ How does the isocost line relate to the firm’s production process? MRTS = ? K = ? MPL ?L MPK Slope of isocost line = ? K MPL =w ?L = ? w r MPK r when firm minimizes cost Long Run versus Short Run Cost Curves The Inflexibility of Short Run Production Capital E per year Capital is fixed at K1. To produce Q1, min cost at (K1,L1). If increase output to Q2, min. cost is K1 and L3 in short run. Long-Run Expansion Path In Long R, can change capital and min costs falls to K2 and L2. C Expansion Path: A Combination of Labour Capital that firm chooses to K2 Minimize Cost at each Level of K1 Output. P Short-Run Expansion Path Q2 Q1 L1 L2 B L3 D F Labor per year Derivation of Expansion Path Long Run Total Cost Curves †¢ Long Run Versus Short Run Cost Curves Long-Run Average Cost (LAC) – Most important determinant of the shape of the LR AC and MC curves is relationship between scale of the firm’s operation and inputs required to minimize cost Long-Run Costs How does per unit costs behave as the firm EXPANDS all INPUTS, even plant size or scale of operation? The Long-Run Average Total Cost (LRATC) reflects the lowest possible unit cost related to different plant sizes and/or scales of operation. In long run no fixed factor, all factors are variable. LRATC=LVC or Average total and variable costs coin cide. The LRATC Curve is U-shaped Long Run Versus Short Run Cost Curves †¢ Long-run marginal cost leads long-run average cost: – If LMC LAC, LAC will fall – If LMC LAC, LAC will rise – Therefore, LMC = LAC at the minimum of LAC In special case where LAC is constant, LAC and LMC are equal Long Run Average and Marginal Cost Cost ($ per unit of output LMC LAC A Output U-Shaped LAC Curve †¢ Increasing Returns to scale †¢ Constant Returns to Scale †¢ Diminishing Returns to Scale Sources of Returns to Scale Economies of Scale Diseconomies of Scale Economies of Scale Economies of Scale: Output can be doubled for less than a doubling Cost- Pindyck et al. LRATC DECREASEs as the Scale of Operation INCREASES. Diseconomies of Scale (DRS): Doubling of Output requires more than a doubling of Cost LRATC INCREASES with the scale of operation. U-shaped LAC reflects ECONOMIES of SCALE for relatively low output levels and diseconomies of scale for higher levels Distinction between IRS Economies of Scale Increasing Returns to Scale – Output more than doubles when the QUANTITIES of all inputs are doubled Economies of Scale – Doubling of output requires LESS than a doubling of COST Ex: Milking cows by hand in large dairy firms†¦. Constant Returns to Scale but experience Economies of scale if milked by machine (Pindyck et al. ) ‘†¦.. Firm’s production process can exhibit constant returns to scale, but still have economies of scale as well. Of course, firm can enjoy both economies of scale and increasing returns to scale (Pindyck) Emergence of Economies of Scale? †¢ As output increases, firm’s AC of producing is likely to decline to a point 1. Production Economies On a larger scale, workers can better SPECIALIZE.. DEVELOPMETN OF Skills, Time Saving etc 2. Scale can provide flexibility – managers can organize production more effectively 3. DISCOUNT for BULK PURCHASE of INPUTS (Raw Materials) Firm may be able to get inputs at lower cost if can get quantity discounts. Lower prices might lead to different input mix. ECONOMIES of SCALE Change in TECHNOLOGY in the long run -Changes in FACTOR PRICES -Transport and Storage Economies (Average cost of Transport Relatively low for bulk transport and bulk storage) -Selling or Marketing Economies (Lower Average cost of Advertising at large Scale) Economies of Scale Managerial Economies Arises Primarily due to Specialisation of Management Mechanisation of Manageri al Function. Division of Managerial Task-Specialization of ManagementImprovement in Efficiency. High Degree of Mechanisation (Telephone, computer) and Decline in Cost Decision Making Process Decentralized (increase in efficiency) Continues†¦. – LOW COST OF FINANCE Larger firm can borrow at lower interest rate and have access to Financial Market Exp: PRIME LENDING RATE of Commercial Banks. – Lower Salaries can be Paid if employees prefer to be associated with organisation of Repute or there is no LABOUR UNION (Low expenditure†¦Ã¢â‚¬ ¦Relatively low cost) Diseconomies of Scale †¢ At some point, AC will begin to increase 1. FACTORY SPACE and MACHINERY may make it more difficult for workers to do their jobs efficiently 2. Managing a larger firm may become more complex and inefficient as the NUMBER OF TASKS INCREASES 3. Increase in INPUT PRICES resulting from increase in Usage by the firm or Limited availability of Inputs Diseconomies of Scale –Management Limitations (diseconomies) Decisions are Delayed in large firms (information often consciously or unconsciously distorted as it passes through various hierarchical levels or stopped for different reasons at some stage) DECISIONS OF TOP MANAGEMENT will not be optimal if information is not accurate or comes with time lag (by that time environment undergone a change) CRITICS argue in the MODERN WORLD it does not PREVAIL. Do you agree? Long Run Costs Economies of scale are measured in terms of †¢ COST-OUTPUT ELASTICITY (Ec) †¢ EC is the percentage change in the cost of production resulting from a 1-per cent increase in output ?C C EC = ?Q Q = MC AC Long Run Costs †¢ EC is equal to 1, MC = AC – Costs increase proportionately with output – Neither economies nor diseconomies of scale †¢ EC 1 when MC AC – E conomies of scale – Both MC and AC are declining †¢ EC 1 when MC AC – Diseconomies of scale – Both MC and AC are rising Long Run Average Cost Curve: Flatbottomed (Rs) Curve (a Special Case) Per Unit LRATC Curve Econ. of Scale Neither Economies nor Diseconomies of Scale Disecon . of Scale Scale of Operation (Q) Production with Two Outputs – Economies of Scope †¢ Many firms produce more than one product and those PRODUCTS are CLOSELY LINKED †¢ If it is CHEAPER for a firm to produce various products JOINTLY then producing it in different firms independently –Economies of Scope. †¢ Examples: – Chicken farmpoultry and eggs – Automobile companycars and trucks – Universityteaching and research -Commercial Banking along with Investment Banking and Provision of Insurance Economies/Diseconomies of Scope: Case of Multi-Product Firm If Total Cost of jointly producing Cars  © and Trucks (T) is smaller than the cost incurred for producing cars and trucks independently by different firms ECONOMIES OF SCOPE Exists if TC(C,T) [TC (C,0) + TC(0, T)] Reasons: Automobiles and Trucks can be produced with same metal sheet and engine assembly facilities. Joint Production: Better utilization of Production Facilities and lower costs. Economies of Scope †¢ Advantages 1. Both use capital and labor 2. The firms share management resources 3. Both use the same labor skills and types of machinery Economies of Scale and Economies of Scope Economies of scale: Should a Public sector commercial bank merge with its competitor (other PSBs) Economies of Scope: Should Commercial Bank offer Mutual Fund or Life insurance scheme? Production with Two Outputs – Economies of Scope †¢ There is no direct relationship between economies of scope and economies of scale – May experience economies of scope and diseconomies of scale – May have economies of scale and not have economies of scope Production with Two Outputs – Economies of Scope The degree of economies of scope (SC) can be measured by percentage of cost saved producing two or more products jointly: C(q1 ) + C(q 2 ) ? C(q1 ,q2 ) SC = C(q1 ,q2 ) C(q1) is the cost of producing q1 C(q2) is the cost of producing q2 C(q1,q2) is the joint cost of producing both products Production with Two Outputs – Economies of Scope †¢ With economies of scope, the joint cost is less than the sum of the individual costs †¢ Interpretation: – If SC 0 Economies of scope – If SC 0 Diseconomies of scope – The greater the value of SC, the greater the economies of scope Dynamic Changes in Costs – The Learning Curve Firms may lower their costs not only due to economies of scope, but also due to managers and workers becoming more EXPERIENCED at their JOBS †¢ As management and labor gain experience with production, the firm’s MARGINAL and AVERAGE COST may fall Dynamic Changes in Costs – The Learning Curve †¢ Learning cur ve: Measures the impact workers’ experience on the costs of production †¢ Describes the RELATIONSHIP between a firm’s CUMULATIVE output and the amount of INPUTS needed to produce each unit of output †¢ Learning curve information facilitates to take decision whether production operation is profitable or not. Based on the information plan how much cumulative output to be produced to reduce cost The Learning Curve Hours of labor per machine 10 8 6 4 2 0 10 20 Hours of Labour needed Per unit of output declines With increase in cumulative output 30 40 50 Cumulative number of machine produced Dynamic Changes in Costs – The Learning Curve †¢ Reasons 1. Workers SPEED OF WORK increases with experience 2. Managers learn to SCHEDULE PRODUCTION processes more efficiently (flow of material to organisations of manufacturing) 3. More FLEXIBILITY is allowed with experience; may include more specialized tools and plant organization 4. Suppliers become more efficient in processing required material†¦. often pass this advantage (lower material cost) to company Economies of Scale Versus Learning Cost (Rs per unit of output) Movement from A to B along AC1-Lower cost due to Economies of Scale Move from A (on AC1) to C (On AC2) leads to lower Cost due to Learning Economies of Scale A B Learning AC1 AC2 Output C Sum up†¦.. †¢ Relevance of studying cost of production †¢ Identify which cost matter †¢ How to minimize cost in the short run and long run †¢ Why is long run AC U-Shaped †¢ Distinction between Economies of Scale and Scope †¢ Role of Learning Curve in Cost