Session 14 Explicit & Implicit costs Direct and Indirect costs Private and Social costs Relevant (Incremental):

Present day explicit, implicit and future costs that arise due to decision taken today Separate and common costs Production function is Q = LK Cost in terms of production function C = L *w + K *r Cost functions TC = Q Fixed and Variable costs The short run costs are not a function of capital but only of the variable costs. Slope of Total cost is subject of the change in output with change in cost. The short run total variable cost STVC curve has an inverse S-shape due to diminishing marginal product. When the STVC is concave from below, it the units of labor that add at increasing levels to the TP because of the underutilized fixed input but the number of units of labor increase there comes a point when fixed and variable inputs are being utilized efficiently after which the productivity of the variable input starts to decline. What is marginal cost? It is change in TC with change in one unit of output, which initially is high then becomes a minimum and then starts to rise again. We then proceed to average costs: Total fixed and total variable costs per unit. Derivation of Average fixed costs: rectangular hyperbola, constant decrease. Both the rectangles are of equal area. Derivation of Average variable costs: AVC = TVC / Q = w X L/ Q, L/Q is inverse of APl hence TVC is w/APl; hence a mirror image of APl since w is a constant Derivation of short-run marginal costs: change in TC / change in Q, no change in TFC, change in TC in the short run is on account of change in TVC. We can say that SMC = change in TVC/ change in Q = w * change in L/ change in Q which is inverse of MP so w/ MPl, curve of MC depends on the curve of MPl When MPl is maximum MPC is minimum, APl is maximum, AVC is minimum, when AVC is maximum it = MC. So MC reaches a minimum before AVC

Derivation of ATC: sum of AVC and AFC. Initially both are falling so ATC also falls. As output is increasing AVC begins to rise at an increasing rate, AFC continues to fall at the decreasing rate. The force of rising AVC pulls ATC up. Thus ATC will reach a minimum after AVC. The shape of ATC is also u-shaped but flatter than AVC. The MC = ATC at ATCs minimum point. The MC cuts both AVC and ATC at their lowest points but ATC reaches minimum to the right of minimum point of AVC. If in the short run the cost of fixed input changes only the ATC will be affected, however if the cost of the variable input falls, all the three curves will shift downwards. Returns to Scale: increasing, constant and decreasing The costs in the long run have everything to do with the aspects of production and cost theory and how the manager can find a cost minimizing input combination when all the inputs are variable. The long run costs are directly related to the expansion path of a business, it is cost-output relation equivalent of expansion path. The first decision the manager makes is about the scale of operations. He must know the cost of producing at each relevant output. Just as the short run costs arise out of the short run production function, the long run costs arise out of the long run expansion path chosen by the manager. LAC = Long run Total Cost/Output Q LMC = LTC / Q

Hence in the example LAC = 120/100 = Rs.1.20 There are no fixed costs in the long run, there is no fixed cost when output is zero, and hence the marginal cost for producing the first 100 units is LMC = LTC / Q = 120-0/100-0 = Rs.1.20

Economies and Diseconomies of scale The economic forces that explain the shape of the long run cost curves are economies and diseconomies of scale. EoS occurs when LAC falls which in our example last from 0 to 300 units. DoS occur when LAC rises with output, which in our example set in after 300 units. Why do we enjoy EoS: Specialization and division of labor, technological factors equipment with that rate of production, e.g. two machines, one that produces at the rate of 30000 units a day and the second packaging machine that packages at the rate of 45000 units a day. So the production has to be 90000 units per day. Cost of larger machines is proportionately less than smaller ones. E.g. printing machine. Technological element. E.g. ditch digging.

Thus two broad forces: 1. Specialization and division of labor and 2. Technological factors enable a producer to produce more at lower unit cost by expanding scale of operation, so we have a negatively sloped portion of the LAC. So why does the curve slope upwards, why does it not get flat? The DoS is attributed to the limitations of inefficient management, controlling and coordinating various activities , delegation of authority and responsibility, so cost of management rises , so does unit cost of production. In businesses where economies are negligible, diseconomies soon set in. The different shapes of the LAC signify the length EoS and DoS. There can be companies that enjoy EoS even after suffering from management inefficiencies due to the economies presented by technology, large scale purchasing of raw material, advertising, and a large firm can even procure funds easily and at lower rates of interest. In realities the extremes are not found easily, a modest scale of operation allows the company to enjoy economies of scale and not face diseconomies until after a particular scale, this LAC would have a horizontal section. This is called constant returns to scale, where LAC is flat and equal to MC at all outputs. Relation between short run and long run costs: Long run is the planning horizon: A firm employs two inputs and capital becomes fixed in the short run. So long run is like a catalogue and short run are like pages. A manager can choose the units of capital, so if a firm can choose between 10, 30 and 60 units of capital, then we can see all the three short run positions. So we can have three ATCs of the three positions., so when the manager wants to produce from 0 to 4000 units the manager will choose small plant size, so lets say that he can produce 3000 units at 0.50 ATC and 1500 TC which is 0.75 for the medium plant size, when the firm wishes to produce between 4000 and 7500 units because the ATC of the medium plant size lies below the other two plant sizes. So the LAC takes an elongated u shape so it is called the envelope curve. Output elasticities: Increasing returns to scale: output more than doubles when inputs are doubles. Economies of scale: Doubling of output requires less than doubling of costs So economies of scale can be measured in terms of cost-output elasticity: As long as the ratio is less than 1, economies of scale exist. Degrees of economy of scope: as long as the combination of inputs used by one firm produces more output then it costs less than two independent firms producing the goods separately. Short run expansion C/ Q *Q/C = MC/AC