3.3.2 Costs

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    a) Formulae to calculate and understand the relationship between:
    Cost – opportunity cost of the factors of production used
    Total cost
    How much it costs to produce a given level of output – an increase in output results in an increase in total costs. Total costs = total variable costs + total fixed costs.
    Total fixed cost
    In the short run, at least one factor of production cannot change
    This means there are some fixed costs and they don’t vary with output.
    E.g. rents, advertising and capital goods are fixed goods – indirect costs
    Total variable cost
    In the long run, all factor inputs can change
    This means all costs are variable
    E.g. the production process might move to a new factory or premises – not possible in the short run – variable costs change
    Average (total) cost
    Average (total) cost (ATC) = total costs / quantity produced.
    ATC = AVC + AFC
    Average fixed cost
    Average fixed costs (AFC) = total fixed costs/ quantity
    AFC = TFC/ Q
    Average variable cost
    Average variable costs (AVC) = total variable costs/ quantity
    AVC = TVC/ Q
    Marginal cost
    This is how much it costs to produce one extra unit of output – calculated by ∆TC/ ∆Q

    Economic Cost:
    Full economic cost of production – includes a sum to represent opportunity cost of factors of production for which no money payment is made – imputed cost
    Economic cost = money cost + imputed cost
    Accountant’s measure of profit takes into account only money costs like wages, raw materials and power
    His measure of profit exceeds the economists
    When economic profit is 0 – accounting profit is positive
    Situation in which normal profit is made
    If revenue were to fall further – wouldn’t be sufficient to cover opportunity costs of factor of production
    Normal profit is the minimum accounting profit to keep factors of production in their current use
    Any profit above this is supernormal or economic profit
    Unlike accounting profit, economic profit (and, thus, normal profit as well) takes into account the opportunity cost of a particular enterprise
    Summary:
    • Accounting profits = Sales Revenue – Accounting Cost (money cost) • Economic costs = Accounting Cost (money cost) + Opportunity Cost of the factors of production • Economic profit (supernormal profit) = Sales Revenue – Economic Cost
    Example:
    • 2 firms would like to hire a machine – Firm A would generate £400 revenue per week, Firm B £300 revenue per week • if rent rises about £300 per week, Firm B drop out • Firm A are expected to hire the machine at a rent of marginally about £300 per week • £300 per week represents the opportunity cost of the machine, as it would generate this sum in its next best use (with firm B)

    b) Derivation of short-run cost curves from the assumption of diminishing marginal productivity
    Measure of the short run varies with industry – no standard
    • E.g. the short run for the pharmaceutical industry is likely to be significantly longer than the short run for the retail industry
    In the short run – some fixed costs
    In the long run – all costs are variable
    In the very long run, the state of technology can change, such as electronics.
    The law of diminishing marginal productivity – adding more units of variable input to a fixed input, increases output at first but after a certain number of inputs are added, the marginal increase of output becomes constant – then, when there is an even greater input, the marginal increase in output starts to fall
    At some point in the production process, adding more inputs leads to a fall in marginal output
    Could be due to labour becoming less efficient and less productive
    At this point, total costs start to increase.

    c) Relationship between short-run and long-run average cost curves
    The LRAC curve is shown in the diagram below
    The point of lowest LRAC is the minimum efficient scale – where the optimum level of output is since costs are lowest.

    If SRAC = LRAC, the firm operates where it can vary all factor inputs.

     

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