1 cost of production explicit cost: includes all tangible expenses that appear in the account books...
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Cost of Production
Explicit cost: Includes all tangible expenses that appear in the account books
- incurred through market transaction
Implicit Cost- Does not appear in account books- own resources of entrepreneur- imputed cost
Accountant’s cost considers only explicit cost whereas economist’s cost includes both
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Cost of Production
Private: All expenses including explicit and implicit costs incurred by a firm for purchasing or hiring resources
Social: Cost which society bears on account of the production process- disutility such as deforestation, pollution…
Externalities- positive and negative
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Cost of Production
• Short run costs : Costs incurred in the short run
• Long run costs- Costs arising out of change in size and kind of output
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• Fixed cost: Cost incurred on fixed factors- remains constant at different levels of production-has to be incurred even if there is no production . E.g., rent, interest
• Variable cost varies with output and is zero when there is no production E.g., material cost, transport cost
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• Opportunity cost: Cost of next best alternative foregone
• Arises because of scarcity and versatility of factors of production
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• Production costs are the costs which are incurred to make a product, transport it and make it available to the consumer- costs of hiring resources, raw materials, energy, transport etc
• Selling costs are those that are incurred for changing the demand and preference of consumers- on advertising, sales promotion, displays, free samples, salaries of salesmen etc
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Short run Costs
Short run Costs• TFC• TVC• TC=TFC+TVC• AFC= TFC/ No. of Units of output• AVC= TVC/ No. of Units of output• AC= TC/ No. of Units of output• MC= TCn - TC n-1
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Short run Costs
Quan
tity
TFC TVC TC=
TFC+TVC
MC AC=
TC/N
AFC= TFC/N
AVC= TVC/N
0 55 0 55 - undefined
undefined
undefined
1 55 30 85 30 85.00 55.0 30.0
2 55 55 110 25 55.0 27.5 27.5
3 55 75 130 20 43.3 18.3 25.0
4 55 105 160 30 40.0 13.8 26.3
5 55 155 210 50 42.0 11.0 26.3
6 55 225 280 70 46.7 9.1 37.5
7 55 215 370 90 52.9 7.9 45.0
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Short run Cost Curves
TC
TFC
TVC
Output
Tot
al C
ost
xo
yTVC
TFC
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Short run Costs
Behaviour of Total Costs:
• TFC is a horizontal straight line, parallel to X axis as it remains constant irrespective of output
• TVC slopes upwards as output increases
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Short run Cost Curves
MC
AC
AVC
AFC
Output
Cos
t
xo
y Fixed cost is spread over a larger output
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Short run Costs
Behaviour of Average Costs:• AFC: Falls as output increases-
rectangular hyperbola- arithmetic result• AVC, ATC and MC: Decrease first, then
rise• MC: Determined only by the rate of
change in variable cost - independent of fixed cost
• For the first unit, AVC= MC
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Short run Costs
• AVC decreases as firm expands and approaches optimum level of output. After plant capacity output is reached, AVC starts increasing.
• AVC’s slope indicates increasing, constant and decreasing returns to variable factors
• The lowest point of the U-shaped AVC occurs where the quantity of output has the minimum cost
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Long run Cost Curves
• Firms can change output by altering size of plant in the long run
• All costs are variable in the long run
• Long run is a relative concept-varies from industry to industry
• Long period be divided into a number of short periods
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Long run Cost Curves
SAC1 SAC 2SAC 3
Output
Cost
0 X
Y There will be a new SAC every time the scale is revised. Diagram depicts 3 such SACs.
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Long run Cost Curves
Envelope curve because it envelopes a series of short run curves
Disk shape because of phases of increasing and diminishing returns
It is also called planning curve
LAC
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I.Economic vs Accounting Cost
• Consider a garment factory producing 100 shirts, using hired resources as given below: Labour (at Rs.2900), machines(2100), raw materials (Rs.1800) electricity (Rs. 700). The producer uses his own resources as follows: Land worth Rs. 5000, family labour worth Rs.3500, and his own truck (cost Rs. 1500) to transport materials. Work out the economic cost and accounting cost of producing 100 shirts.
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Economic vs Accounting Cost
Factors hired Cost in RsLabour 2900Machines 2100Raw Materials 1800Electricity 700Accounting cost 7500Self owned factors Cost in Rs Family Labour 3500Land 5000Transport 1500
10,000
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Economic vs Accounting Cost
Economic cost of producing a 100 shirts is
Rs. 17500. Economic cost per shirt: Rs.175
Accounting costs of producing 100 shirts is only Rs. 7500.
Accounting cost per shirt: Rs.75
•
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SUM
The cost of attending a private college for one year is $ 6,000 for tuitions, $ 2000 for room, $ 1500 for meals, and $ 500 for books. The student could also have earned $ 15,000 by getting a job instead of going to college and 10% interest on expenses she incurs at the beginning of the year. Calculate the explicit, implicit and total economic costs of attending college.
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Approaches to Cost Reduction
• Philip Young and John McAnley have categorised Cost Reduction methods as follows
• 1. Budgetary Approach - Actual cost must be brought in line with the budgeted amounts- cutting costs to match the fall in revenue-Approach involves identifying items in the budget that are amenable to quick changes- travel is frozen, coffee and refreshments no longer served at meetings, etc
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Approaches to Cost Reduction
2. Input Reduction Approach: “Doing more with less”- plant shut downs, early
retirement offers, VRS3. Input Cost Reduction Approach: Under this, managers try to reduce input cost in
various ways- reduction of wage costs through offers of shares of company in exchange for lower wages; moving into offices costing lower rent or maintenance; searching for cheaper suppliers of materials
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Approaches to Cost Reduction
4. Input Substitution ApproachA company may consider building a plant in a foreign country to take advantage of lower wages
5. “Not Made Here” Approach: It may be decided that an outside vendor of service can supply at a cheaper rate than what it costs the company to produce- e.g., outsourcing
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Approaches to Cost Reduction
6. Suggestion Box Approach- from employees, especially those who are connected directly with production process