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LESSON 7
Theory of Costs
7.1 OBJECTIVES OF THE CHAPTER
The objective of this chapter is to apprise the readers about how the decisions regarding the costs of production are taken by the producer. This is done through the explanation of the short run costs of production and long run costs of production as given in the traditional theory of costs of production.
7.2 INTRODUCTION
Economic theory has given various concepts of costs. These are discussed below:
- Long run costs: Cost of production is dependent on many factors. It is dependent on the level of output, technology and prices of inputs. The long run cost function can be written as, C = f (X, Pf, T)
Structure of the Unit 7 .1 Objectives of the Chapter 7 .2 Introduction 7.3 The Traditional Theory of Costs 7.4 Reasons for the U – shape of the Cost Curves: Economies and Diseconomies of Scale. 7.5 Criticism of the traditional theory of costs 7.6 A Quick Revision 7.7 Keywords 7.8 Assess Your Performance 7.9 Suggested Readings
Where, c stands for costs, X stands for the level of output, Pf stands for prices of the inputs and T stands for technology. Long run costs are also called as planning costs or ex-ante costs. These are called so because they present the optimal opportunities for the expansion of the output and thus, help the entrepreneur plan his level of investment.
- Short run costs: Short run costs of production are those costs which are incurred in the short run. Since, in the short run factors of production are divided into fixed and variable factors of production, therefore; the costs incurred on fixed factors are called as fixed costs and the costs incurred on variable factors are called as variable costs. The cost function can be written as, C= f (X, Pf, K), Where, K is the fixed factors. If the prices of inputs and technology also remain constant then the short run cost function can be written as, C= f (X)
- Explicit costs: Costs incurred on the purchase of different factors of production are called as explicit costs. These are not self owned rather these are bought from the market.
- Implicit costs: Certain factors of production are self owned and thus, these are not bought from the market. For example, if the entrepreneur makes use of his personal house as office for working then an imputed value of the office would be calculated. That value would be called as implicit costs.
- Accounting costs: Accounting costs includes the payments made to the different factors of production and other costs that are entered in the books of accounting.
- Opportunity costs: Opportunity costs are the costs of the next best alternative foregone.
- Economic costs: Economic costs are the costs which includes both opportunity costs and accounting costs.
7.3 THE TRADITIONAL THEORY OF COSTS
The behaviour of the costs of production can be studied under the traditional theory of costs. The traditional theory distinguishes between the short run and long run. Short run has been defined as that time period in which some factors are fixed and some are variable. Thus, in the short run we
a. The raw materials b. Costs of direct labour c. Running expenses of fixed capital, such as fuel, ordinary repairs. The total variable cost curve is shown in figure 7.3.1b. Its shape is called inverted S- shape. This shape is due to the law of variable proportions. In initially, as the variable factor i.e. labour is employed, its productivity initially increases then reaches a maximum and then starts to decline and then it becomes negative.
The total costs curve is obtained by joining adding both TFC and TVC. The total cost curve does not start from the origin as fixed costs do not become zero. After that total fixed costs take the shape of total variable costs.
2) Average Costs Average costs are per unit costs of production. Average costs are obtained by dividing the total costs with the total output produced. It can be written as, AC = TC X Where, AC stands for average costs, TC stands for total costs, And X stands for total output. Average costs are divided into average fixed costs and average variable costs.
TFC
TVC TC TVC
TFC
O x x1 X O’ X’ O X’’ Output Output Output
Y
C
Costs
Figure 7.3.1a Figure 7.3.1b Figure 7.3.1c
Average fixed costs: Average fixed costs are the per unit fixed costs. This can be written as,
AC = TFC +TVC X
Or AC = TFC +TVC X X Or, AC = AFC +AVC Where, AFC stands for average fixed costs and AVC stands for average variable costs.
The average fixed cost curve is shown in figure 7.3.1d. The shape of the curve is a rectangular hyperbola. Rectangular hyperbola means that at each stage same amount is added. This is true because average fixed cost curve is the slope of the total fixed cost curve. At every stage total fixed costs remain the same but the denominator keeps on increasing. This leads to a fall in the average fixed cost curve. Average variable costs:
AFC
Y
O X
Costs
Output
Figure 7.3.1d
the plant (e 1). Graphically the average total cost curve is derived from the slope of the straight line drawn from the origin to the point on the total cost curve corresponding to that particular level. 3) Marginal costs Marginal cost is defined as the change in the total cost which results from a unit change in output. Mathematically, it can be written as, MC = ∆ TC ∆ X Where, MC stands for marginal cost of production. Thus, it shows that the marginal cost of production is the change in the total cost caused by the production of an additional unit of output. Graphically, marginal cost curve is the slope of the total cost curve. The marginal cost curve is also u – shaped. This is shown in figure 7.3.1e. Initially the marginal cost curve is decreasing then it reaches a minimum point. After the minimum point it immediately starts increasing.
Thus, the traditional theory of costs divides the costs on the basis of the time period. In the short run the cost curves (AC, AVC, and MC) are assumed to be u - shaped. This u – shape of the cost curves is due to the application of the law of variable proportions. The u – shape of the costs curve implies that in the short run with a fixed plant there is phase of increasing productivity or declining costs for the firm then there is a phase of decreasing productivity or increasing costs. In between the two phases there is a single point which gives minimum costs to the firm. When the firm reaches the minimum point then the plant is utilized optimally. So, this point is also called as the optimum point of production.
7.3.2 Relationship between average total cost and average variable cost
Given below are the main points of the relationship between average total cost and average variable cost:
- The average variable cost is a part of average total cost as, AC = ATC +AVC
- Both average variable cost and average total costs curves are u – shaped.
- The minimum point of average total cost occurs to the right of the minimum point of average variable cost. This can be seen from figure 7.3.1e. e 1 comes to the right of the minimum point of average variable cost curve i.e. e. The reason for this is that average total cost curve includes average fixed cost and average variable cost.
- Since average cost curve includes average fixed and average variable costs, therefore, the fall in average cost curve is due to these only. Average fixed costs falls as the output is increased. So, when the AVC reaches minimum point, AC is still falling as AFC is able to counter the rise in the variable costs.
- However, beyond point e 1 the fall in average fixed costs is not able to pull the average cost curve down as the inefficiency of the variable factor rises strongly which is revealed in the sharp rise of average variable cost curve. Thus, beyond point e1 average variable cost curve is pulling the average cost curve upwards.
7.3.3 Relationship between marginal cost and average total cost
The relationship between the marginal cost and average total cost is explained below:
- The marginal cost curve cuts the average total cost curve and the average variable cost curve at their minimum points.
- As long as the marginal cost lies below the average cost curve, it pulls the latter downwards. When the marginal cost curve lies above the average cost curve then it pulls the latter upward.
7.3.4 Long run costs of the traditional theory
In the long run all the factors of production are variable. There is no fixed factor. In the long run the scale of the plant can also be changed as more of both capital and labour can be hired. In the long run the traditional theory discusses two cost curves:
7.3.4.1 Long run average cost curve:
Long run average cost curve is also called as the planning curve as it presents before the entrepreneur the opportunities to expand the scale of the plant in the future. In the long run firm is concerned about the average costs only. The long run average cost curve is derived from the short run cost curve. This is because long run is assumed to be a summation of the short run
Figure 7.3.4.1b shows the long run average cost curve with the three different plants. For producing 2000 units of output the first short run average cost curve (SAC 1) is relevant. However, if the market demand of the firm expands to 3000 units even then the firm will operate at SAC 1 because at that level of output SAC 2 will be inefficient as it will give him more costs. However, as the firm expands and reaches 4000 units of output then it can choose between SAC 1 and SAC 2. Likewise, the firm will move from SAC 2 to SAC 3. Here the important thing to note is that when the costs are decreasing in the long run then these are also decreasing in the short run. In the figure, when LAC is declining then SAC1 is also declining. When LAC reaches a minimum point then in the short run also the firm reaches a minimum point. In the figure, LAC is minimum at point m. At this point the short run average cost curve i.e. SAC 2 is also at its minimum.
When the long run average cost curve starts to increase then in the short run also the costs are increasing. Thus, long run average cost curve is also called as the envelope curve because it envelops all the short run average cost curves. It also envelops the optimal decisions for producing the different levels of output. Optimality implies that each point on the long run average cost curve represents the minimum cost for producing that particular level of output. Thus, there is no other lower level of costs of production for producing that level of output. If the producer is on any point above the long run average cost curve then it is inefficient because it
Figure 7.3.4.1b
SAC 1 SAC 2
SAC 3
will show higher costs for producing output. Likewise, any point below the cost curve is desirable because it indicates lower per unit costs. However, given the current state of technology such a point is not attainable. Further, when the LAC is falling the plants are not fully utilized and when the LAC is rising the plants are over – utilized. Only at the minimum point of LAC the plant is being fully utilized.
The long run average cost curve is also U – shaped. The U- shape of the cost curve implies that the firm has only one level of output which is produced at minimum cost of production. This U – shape of the long average cost curve is due to the operation of the economies and diseconomies of scale. Economies of scale are the advantages that accrue to a firm. When initially the firm is producing 2000 units the firm is experiencing economies of scale. Because of this per unit costs start declining. Then the firm reaches a minimum cost point where these benefits are maximum but after that the firm experience diseconomies of scale. Such diseconomies of scale are largely due to the managerial diseconomies that accrue to a firm at higher levels of output. At such higher levels of output it becomes difficult for the managers to handle such operations and thus, they take wrong decisions. This leads to increase in costs and thus, the long run average cost curve starts increasing. The U – shape of the cost curves in the traditional theory has another implication. The cost curves are so shaped that the firm can optimally produce only one level of output. There is no reserve capacity with the firms because of which the firms are not supposed to have excess stock to meet even the seasonal variations. Thus, complete inflexibility is there.
7.3.4.2 Long run marginal cost curve
The long run marginal cost curve is also U – shaped. It is derived from the short run marginal cost curve. However, it is not an envelope curve. The long run marginal cost curve is obtained from the points of intersection of the short run marginal cost curves with vertical lines to the OX axis drawn from the points of tangency of the corresponding SAC curves and LAC curves. In figure 7.3.4.2a the long run and short run average cost curves are drawn. For producing OX level of output, aX1 is the minimum cost of production. So the point where the vertical line aX cuts the short run marginal cost curve, that point is the first point of long run marginal cost curve. In the figure point c is the point where the vertical line drawn from point a is cutting the short run marginal cost curve (SMC 1). Likewise, at point d the vertical line drawn from point a 1 is cutting the short run marginal cost curve (SMC 2). At point e, the vertical line eXm is cutting the
The traditional theory of costs believes that the u shape of the cost curves is due to the economies and diseconomies of scale. Whenever, in the long run, a firm expands its level of output it derives various benefits. Such benefits lead to a reduction in the costs of production; these are called as economies of scale. These are defined as the reduction in the average cost of a product in the long run resulting from an expanded level of output of industry. Likewise, diseconomies of scale are the increases in the average costs of a product in the long run resulting from an expanded level of output of the industry. These can be classified into:
External economies and diseconomies of scale : External economies arise from the expansion of the industry, i.e. reductions in the costs of all the firms in an industry due to the expansion of overall industry. External diseconomies arise from the expansion of the industry, i.e. increase in the costs of all the firms in an industry due to the expansion of overall industry. Thus, external economies and diseconomies are not dependent on the output level of the individual firm rather these are dependent on the output level of the total industry. The external economies of scale shift the long run average cost curve downwards. In figure 7.4.1 the firm is originally at LAC1. However, due to the increased output certain benefits accrue to all the firms in the industry. As a result the long run average cost curve shifts downwards from LAC1 to LAC2.
Likewise, when there are external diseconomies of scale then the long run average cost curve shifts upwards from LAC1 to LAC3.
LAC 2
LAC
LAC
O X Output x
Y
LAC
Marshall^5 gave the following examples of the external economies of scale: i. Improved methods of machinery which are accessible to the whole industry, ii. Economies which result from the growth of correlated branches of industry which mutually assist one another and being concentrated in the same localities encourage development of hereditary skills, the growth of subsidiary trades supplying it with implements and machinery. iii. Economies which are connected with the growth of knowledge and the progress of arts, especially in matters of trade knowledge: newspapers, trades, trade and technical publications.
Thus, external economies are common to all and these are basically:
i. Cheap raw materials and capital equipment : Such economies are realized when if the whole industry of a product, say x, expands then the whole industry would demand more of raw materials, capital equipment. As a result the industries that are supplying raw materials and capital equipment will expand their output and this will lead to decrease in costs of these. Such benefits are passed on to the main industry producing x. ii. Economies due to technological up gradation that are common to all the firms in the industry : When the whole industry expands this may lead to the discovery of new technical knowledge, innovations and new methods of production. Due to this the productivity of the whole industry will increase and as a result the costs will come down for the whole industry. iii. Improved transportation and marketing services : The economies of scale are also realized when there is an improvement in the transportation and marketing facilities or in communication services. For example, the development of the mobile telephone services has passed on economies to all the industries. Likewise, the improvement in the transportation services leads to less breakage, and saves time and costs involved in transporting. Internal economies and diseconomies of scale:
(^5) Ahuja,H.L. (1980), Modern Economics, S.Chand and Company Limited, New Delhi.
Pecuniary economies are the economies that accrue to a firm due to discounts that a firm can obtain owing to its large scale. Following are the different discounts that a firm can obtain: A firm can manage to get discounts in the prices of raw materials, price of the finance taken from the outside sources. Banks give loans to the large firms at reduced rates owing to their large size. A firm can also manage to get lower prices for the advertising expenditure. This may happen as large firms spend more on advertising so this may lead to a reduction in the price of advertising. Likewise transport costs may also come down. Firms also, sometime manage to pay lower prices to the workers. This may happen due to the brand name of the company. A worker may prefer to get job in a big firm with a huge brand name but with a lower salary rather than a job in a small firm with no brand name but with high salary.
7.5 CRITICISM OF THE TRADITIONAL THEORY OF COSTS
Critics have questioned the costs curves of the traditional theory. Following are the points of criticism leveled against this theory:
1) The cost curves are not U – shaped: The critics have pointed out that the costs curves as postulated by the traditional theory of costs are not U – shaped. This shape of the cost curves in the traditional theory is based on the belief that there is no in-built flexibility in the firms. However, in reality the firms do have flexibility as they keep excess reserves for meeting the seasonal variations. 2) Managerial diseconomies can be checked: The traditional theory of costs believes that the cost start increasing after the minimum point because of the managerial diseconomies. At the higher level of output the top management becomes overburdened and thus, they take wrong decisions because of which the per unit costs start increasing. However, critics have pointed out that with time the managerial diseconomies can be checked by the improved techniques of the management science. However, even if they appear then these are overturned by the technical economies that are realized at the higher levels of output.
3) No empirical evidence in support of U – shaped cost curve: The traditional theory of costs is also criticized on the grounds that there is no empirical evidence in support of the U – shaped cost curves. The empirical research has shown that the cost curves have long stretch of output where the costs are minimum. Such cost curves are also called as the saucer shaped cost curves. Some other empirical studies have shown the downward sloping L shaped cost curve.
7.6 A QUICK REVISION
Traditional theory of costs
Short run costs (^) Long run costs
Total cost^ Total Fixed costs
Total Variable costs
Average costs
Average Fixed costs
Average Variable costs
Marginal costs
Average cost
Marginal cost
Costs incurred on the purchase of different factors of production are called as explicit costs. These are not self owned rather these are bought from the market. Long Questions
Q.1 Explain the U – shape of the cost curves in the traditional theory of costs.
Q.2 Explain the traditional theory of costs.
Q.3 Discuss the role played by the internal and external economies of scale in the traditional theory of costs.
Q.4 Explain the different concepts of short run cost curves given by traditional theory.
Q.5 Explain the derivation of the long run average cost curve and long run marginal cost curve.
7.9 Suggested Readings
Ahuja,H.L. (1980), Modern Economics, S.Chand and Company Limited, New Delhi.
Koutsoyiannis, A. (1979), Modern Microeconomics, Macmillan Press Limited.
