Class costs i

Meaning of Costs Opportunity costs meaning of opportunity cost examples Measuring a firm’s opportunity costs factors not owned by the firm: explicit costs factors already owned by the firm: implicit costs irrelevance of: historic costs replacement costs

Costs in the Short run Costs and inputs costs and the productivity of factors costs and the price of factors Fixed costs and variable costs Total costs total fixed cost ( TFC ) total variable cost ( TVC ) TVC and the law of diminishing returns total cost ( TC = TFC + TVC )

Total costs for firm X TC Output (Q) 0 1 2 3 4 5 6 7 TFC (£) 12 12 12 12 12 12 12 12 TVC (£) 0 10 16 21 28 40 60 91 TC (£) 12 22 28 33 40 52 72 103 TVC TFC

Total costs for firm X TC TVC TFC Diminishing marginal returns set in here

Costs in the Short run Marginal cost marginal cost ( MC ) and the law of diminishing returns

Average and marginal costs Output ( Q ) Costs (£) MC x Diminishing marginal returns set in here

Costs in the Short run Marginal cost marginal cost ( MC ) and the law of diminishing returns the relationship between MC and TC curves

Costs in the Short run Average cost average fixed cost ( AFC ) average variable cost ( AVC ) average (total) cost ( AC ) Relationship between average and marginal cost

Relationship between AC and MC If MC < AC, AC will be falling If MC > AC, AC will be rising If MC = AC, AC is at minimum

Economies of Scale Percentage change in average cost of production following a one percent increase in output External economies of scale- factors beyond the control of the firm that cause a fall in AC following increase in output Internal economies of scale- factors within the control of the firm that cause a fall in AC following increase in output.

Average and marginal costs Output ( Q ) Costs (£) AFC AVC MC x AC z y

Total cost= a + bQ + cQ 2 + dQ 3 Average variable cost = b + cQ + dQ 2 Average total cost = a/Q + b + cQ + dQ 2 or AFC + AVC Marginal cost = Δ TC/ Δ Q or Δ TVC/ Δ Q = b + 2cQ + 3dQ 2

Determinants of short run costs The technology used to determine the capital to labour ratio. The more capital intensive is production the more important will be fixed costs relative to variable costs. The technology used to determine the labour to output ratio. With given capital this changes as output increases. The more labour intensive is production the more important will be variable costs to fixed costs The changing labour to output ratio initially favours lower costs, but eventually increases costs when capital is over utilized. To produce more output the firm may employ additional labour units to meet orders or get existing workers to work overtime. The latter will receive premium payments and the former may have to be paid higher wages to secure their services.

Managerial abilities . Costs may vary between firms depending on the abilities of their managers to organize production and motivate their employees effectively. Efficient management may achieve higher productivity and lower unit cost levels than inefficient management.

Costs in the Long run Long-run average costs shape of the LRAC curve assumptions behind the curve

A typical long-run average cost curve Output O Costs Economies of scale Constant costs Diseconomies of scale LRAC

Long-run average and marginal costs Output O Costs LRAC Initial economies of scale, then diseconomies of scale LRMC

Costs in the Long run Relationship between long-run and short-run average costs the envelope curve

Deriving long-run average cost curves: factories of fixed size Costs Output O 3 factories 2 factories 1 factory SRAC 3 SRAC 4 SRAC 5 5 factories 4 factories SRAC 1 SRAC 2

Deriving long-run average cost curves: factories of fixed size SRAC 1 SRAC 3 SRAC 2 SRAC 4 SRAC 5 LRAC Costs Output O

Costs in the Long run Long-run average costs shape of the LRAC curve assumptions behind the curve Long-run marginal costs Relationship between long-run and short-run average costs the envelope curve Long-run cost curves in practice the evidence minimum efficient plant size

Relationship between LRMC and SRMC LRMC = SRMC when LRAC= SRAC

Economies of scope Economies of scope occur when products share common inputs and diversification leads to cost savings. The operation of bus services, terms operating a single bus on a single route may not be disadvantaged in terms of operating costs. However, a bus company operating a network of routes may be able to reduce its unit costs by attracting a higher number of passengers through operating connecting services and through ticketing. Network operation may also allow lower unit costs for marketing and providing timetable information.

Measuring Economies of Scope For a firm producing three products, the scope index S can be measured as S= [ c 1 + c2 + c3 + c(1+2+3) ] =(C1 + C2 + C3) If S is positive, three products an be manufactured together

Learning Curve As management and labor gain experience with production, the firm's marginal and average cost of producing a given level of output falls for four reasons. Workers often take longer to accomplish a given task the first few times they do it. As they become more adept, their speed increases. Managers learn to schedule the production process more effectively, from the flow of materials to the organization of the manufacturing itself. Engineers, who are initially very cautious in their product designs, may gain enough experience to be able to allow for tolerances in design that save cost without increasing defects. Better and more specialized tools and plant organization may also lower cost. Suppliers of materials may learn how to process materials required by the firm more effectively and may pass on some of this advantage to the firm in the form of lower materials cost.

Class costs i

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Class costs i

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