Chapter 7 - Cost Concept PDF

Chp 7 - Cost Concept Concepts of cost Cost and output relationship in the short run and in the long run Short run and long run cost curves and numerical problems Long run average cost Learning curve CONCEPTS OF COST A firm who wants to maximize their profit concentrates on reven...

Chp 7 - Cost Concept Concepts of cost Cost and output relationship in the short run and in the long run Short run and long run cost curves and numerical problems Long run average cost Learning curve CONCEPTS OF COST A firm who wants to maximize their profit concentrates on revenue and cost of the firm. Profit of the firm can be increased either by increasing revenue or by reducing cost. Firm generally cannot influence revenue because it is determined by the market forces but it is possible for the firm to reduce cost by producing maximum output or by increasing efficiency of the organization. For managerial decision-making, cost is very important because it helps to decide price for the commodity. It also helps to decide whether to increase the production or not. Q1. Explain the following concepts-: a) Private cost and Social cost: Costs which are directly incurred by the individual or firm producing good or service is called private cost. This cost gives private benefit to an individual or firm engaged in relevant activity. Social cost on the other hand is bared by the society as a result of production of commodity. Even though social cost occurs due to production of a commodity it is not bared by the producer. It consists of external cost b) Historical cost and Replacement cost: The original money value spent at the time of purchasing of an asset is called historical cost. The amount which has to be spent at the time of replacing of the existing asset is called the replacement cost. c )Fixed cost and Variable cost : Fixed cost refers to the firm’s expenditure on fixed factors of production. Variable cost on the other hand refers to the firm’s expenditure on variable factors of production. When no output is produced, variable cost is zero  d )Total cost, Average cost and Marginal cost: Total cost (TC) – Firms total expenditure on all fixed and variable factors for producing a commodity is called the Total cost of production. TC= TFC+TVC Average Cost (AC) or Average Total Cost (ATC) – It refers to the per unit cost of producing a commodity. AC = TC/Q Average Fixed Cost (AFC)- It is the per unit fixed cost of production. AFC= TFC/Q Average Variable Cost (AVC) - It is the per unit variable cost of production. AVC= TVC/Q Marginal Cost (MC)It is the addition made to the total cost. Or cost of producing an additional unit of output is called as the marginal cost. MC= TCn- TCn-1 MC = Change in total cost/ change in output D TC DQ e ) Sunk Cost and Incremental Cost: In order to enter in to the market certain costs are incurred by the firm. These costs are known as Sunk cost. It includes the cost by the firm for setting up the business, advertisement. Incremental cost refers to a change in total coat as a result of policy change or a change in managerial decision. f ) Implicit Cost and Explicit Cost: Implicit cost refers to the cost of all own factors which the entrepreneur employs in the business Explicit cost on the other hand is the direct cash payment made by the firm for purchasing or hiring of various factors of production. E.g. rent paid for hiring of land g) Accounting and Economic Cost: Accounting cost includes only explicit cost i.e. the firm’s expenditure on purchasing of various factors of production. For financial purpose and tax purpose, accounting cost is important. Economic cost on the other hand includes both explicit and implicit cost. This cost is important for managerial decision making.  Q2. Explain the relationship between TFC, TVC AND TC with the help of diagram. COST AND OUTPUT RELATIONSHIP IN THE SHORT RUN AND IN THE LONG RUN Output TFC TVC TC 0 50 0 50 1 50 20 70 2 50 35 85 3 50 45 95 4 50 65 115 5 50 95 145 6 50 140 190 7 50 200 250 8 50 280 330 (All Costs in Rupees) TFC is the firm’s total expenditure on fixed factors of production. For zero level of output TFC is zero. It remains constant for all the levels of output. TVC on the other hand is the firm’s total expenditure on variable factors of production. For zero level output TVC is zero. It increases with an increase in the level of output.  TFC curve is a straight-line curve parallel to X axis. This is because when output is zero, some fixed cost has to be paid and this cost remains constant for all the levels of output. TFC curve is horizontal. TVC curve starts at the point of origin because when output is zero, TVC is also zero. TVC curve initially increases at a diminishing rate with an increase in the level of output and then increases at an increasing rate. As TC is the addition of TFC and TVC, TC curve is above TFC and TVC curves. The  Cost and Output Relationship Cost Function Production function gives the functional relationship between the level of output and the various factor inputs (land, labor, capital and entrepreneur). The cost of production depends on the level of output produced, nature of technology used, prices of factors of production. The cost function is derived from the production function C = f (Q, T, Pf) C = total cost Q = Level of output produced T = Technology Pf = Prices of factors f = Functional relationship If we assume that technology, prices of factors are constant, total cost increases with an increase in the level of output i.e. C = f(Q). Any change in production function will shift cost function either up or down  Q3. Define AC, AFC, AVC and MC and also discuss the relationship between them. SHORT RUN COST- OUTPUT RELATIONSHIP Output TFC TVC TC AFC AVC AC MC 0 50 0 50 - - - - 1 50 20 70 50 20 70 20 2 50 35 85 25 17.5 42.5 15 3 50 45 95 16.66 15 31.66 10 4 50 65 115 12.5 16.25 28.75 20 5 50 95 145 10 19 29 30 6 50 140 190 8.33 23.33 31.66 45 7 50 200 250 7.14 28.57 35.71 60 8 50 280 330 6.25 35 41.25 80 1. As AFC is continuously declining. AFC curve slopes downward from left to right. 2. Initially AVC curve is declining, reaches to a minimum and then increases with an increase in the level of output. AVC curve starts increasing after a normal capacity level of output is produced. More intensive use of various factors of production leads to an increase in AVC. 3. AC curve lies above AFC and AVC curves because AC is the addition of AFC and AVC. AC curve initially declines due to fall in AFC curve. AC curve reaches to minimum point and then increases due to an increase in AVC curve. AC curve is a U- shaped curve. 4. MC curve is also a U-shaped curve. MC curve also falls in the beginning, reaches to the minimum and then increases. When MC curve starts rising, it intersects the AVC curve and AC curve at their minimum point. Q4. Bring out the relationship between AC and MC. MCAC, MC pulls the AC curve up. Long run cost and output relationship Q5. Explain the derivation of Long run Average Cost curve. For output greater than OQ3 firm will use plant SAC3 because the average cost with SAC2 will be greater as compared to average cost with SAC3.  As the LAC curve includes the family of short run average cost curves, it is called an Envelop curve. In the long run firm can also plan to increase its scale of production and therefore LAC curve is also called the Planning Curve. Q6. Discuss the Learning curve effect. The learning curve shows an inverse relationship between an average cost of production and the level of output. This means that as firm produces more and more output, its average cost of production declines. Learning curve effect is a result of an experience which the firm gains during the process of production.. As firm becomes older, it learns to use new techniques of production efficient way of using raw material and skills. Firm learn to reduce cost through experience. Therefore, learning curve is also called an Experience curve. The effect of learning curve applies to the manufacturing and service sector. Q7. If the Total cost of production is Rs. 75, with the help of following data, calculates TC, AC, AFC,AVC,MC. Outpu TFC TVC TC AC AFC AVC MC t 0 75 0 75 - - - - 1 75 35 110 110 75 35 35 2 75 50 125 62.5 37.5 25 15 3 75 70 145 48.33 25 23.33 20 4 75 100 175 43.75 18.75 25 30 5 75 160 235 47 15 32 60 Q8. With the help of following information, complete the table given below OUTPU TFC TVC TC AFC AVC AC MC T 0 80 0 80 - - - - 1 80 40 120 80 40 120 40 2 80 70 150 40 35 75 30 3 80 120 200 26.67 40 66.67 50 4 80 190 270 20 47.5 67.5 70 5 80 290 370 16 58 74 100 6 80 420 500 13.33 70 83.33 130 Q9. Distinguish between. Short run cost curve Long run cost curve Fixed cost is fixed variable Fixed cost and variable cost cost changes. both changes. Fixed cost can’t be change. Fixed cost can be change. Fixed cost can be converted Production is more about into long run. planning hence, it is called as planning curve. Fixed cost is parallel and Here the graph is envelope horizontal in graph. curve. Focus is more in the output. Focus more on the production. Short run is short period of Long run is long period of time. time.