Wednesday, September 22, 2010

Cost of Production

Cost of production of the firm will change with the changes in its output. The relation between cost and output is called “cost function”. The cost function of the firm depends upon the production function and the prices of the factors used for production. How much costs the firm will incur on production depend on the level of output. Moreover, the quantity of a product that will be offered by the firm for supply in the market will depend to a great degree upon the costs of production incurred on the various possible level of output.

Short Run and Long Run Costs (Variable and Fixed Costs)

Short run is a period of time within which the firm can vary its output by varying only the amount of variable factors, such as labor and raw materials. In the short run, fixed factors such as capital, equipment, building, top management personnel etc. cannot be varied. The short run is a period of time in which only variable factors can be varied (if level of output increases, the costs of variable factors will increase and vice-versa) while fixed factors remain the same. It means in short run the costs of fixed factors such as rent expenses, insurance expenses, interest expenses, utility expenses, salary expenses etc. do not changes with the level of output. Then per unit fixed costs decreases as the level of output increases and vice-versa. On the other hand, long run is a period of time during which the quantities of all factors, variable as well as fixed, can be adjusted. Thus, in the long run output can be increased by increasing capital, equipment, building etc. It means in the long run all costs are variable. Because level of output can be increased not only by increasing labor and raw materials but also expanding capital, equipment building etc. which remain fixed in short run

Total, Average and Marginal Costs

Total costs of a firm are the sum of its total variable costs and total fixed costs. Thus,

Total costs (TC) = Total variable costs (TVC) + Total fixed costs (TFC)

The total variable cost varies with the changes in output, the total cost of production will also respond to changes in the level of output. The total cost increases as the level of output rises. The variable cost per unit is fixed but total-variable cost is variable.

Average cost (per unit cost) is the total costs divided by the number of output produced. Therefore,

Average cost (AC) = Total costs ÷ Number of output.

Average fixed cost (per unit fixed cost) is the total fixed costs divided by the number of output produced. Therfore,

Average fixed cost (AFC) = Total fixed costs ÷ Number of output.

Average variable cost (per unit variable cost) is the total variable costs divided by the number of output produced. Therefore,

Average variable cost (AVC) = Total variable costs ÷ Number of output.

Marginal cost is the addition to total cost caused by an increment in output. Marginal cost may be defined as the change in total cost resulting from the unit change in the quantity produced. Thus,

Marginal cost (MC) = Change in total costs ÷ Change in the number of output.

Table: Cost of Production

Units of output

Total fixed cost

Average fixed cost

Total variable cost

Average variable cost

Total average cost

Total variable cost

Marginal cost

0

20

-

0

-

20

-

-

1

20

20

20

20

40

40

20

2

20

10

25

12.5

45

22.5

5

3

20

6.67

28

9.33

48

16

3

4

20

5

30

7.5

50

12.5

2

5

20

4

40

8

60

12

10

6

20

3.33

52

8.67

72

12

12

7

20

2.86

100

14.29

120

17.14

36

8

20

2.5

120

15

140

17.5

20

Relationship between Average and Marginal Cost

The relationship between average and marginal cost can be explained in three ways:

· When average cost decreases, marginal cost also decreases and the marginal cost is lower than average cost (See above table).

· When average cost increases, marginal cost also increases and the marginal cost is greater than average cost (See above table).

· When average cost is same, at this point marginal cost is equal to average cost (See above table).

Why Long Run Average Cost Curve is U-Shaped

· As output increases at the beginning, the fixed cost decreases. As a result the average cost decreases.

· As capacity expands in the long-run the firm can use modern equipment which results in low cost.

· For the division of labor, the efficiency and productivity of labor increases, as a result cost decreases.

· Though output increases, the administrative cost does not increases proportionately. For this ultimately average cost decreases.

· The firm gets benefit in case of commercial expenses like purchase discount transportation cost input and output etc. which ultimately decreases average cost.