Cost of Production

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  • Topic: Costs, Economics of production, Cost
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  • Published : August 18, 2011
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Costs of Production

July 2011

Topics to be Discussed
Measuring Cost: Which Costs Matter? How do Cost Curves Behave? – Cost in the Short Run – Cost in the Long Run How to Minimize Cost? How to draw Implications for Business Strategy?

Topics to be Discussed
Production with Two Outputs: Economies of Scope Dynamic Changes in Costs: The Learning Curve Estimating and Predicting Cost

Measuring Cost: Which Costs Matter? Accountants tend to take a retrospective view of firms’ costs, whereas economists tend to take a forward-looking view Accounting Cost – Actual expenses plus depreciation charges for capital equipment Economic Cost – Cost to a firm of utilizing economic resources in production, including opportunity cost

Costs as Opportunity Costs
Accountants measure the explicit costs but often ignore the implicit costs. Economists include all opportunity costs when measuring costs. Accounting Profit = TR - Explicit Costs Economic Profit = TR - Explicit Costs Implicit Costs

Explicit and Implicit costs
The firm’s costs include Explicit Costs and Implicit Costs: – Explicit Costs: costs that involve a direct money outlay for acquiring factors of production. – Actual expenditure incurred by firm for hire, rent or purchase of the inputs so as to undertake production. (Exp: Wages to hire labour, rental price of capital, equipment and buildings and purchase price of raw materials and semi finished products).

– Implicit Costs: Costs that do not involve a direct money outlay – (Ex. Opportunity costs of the owner’s own inputs used Implicit wages, implicit rent, cost of capital).

Opportunity Cost
Economic costs distinguish between costs the firm can control and those it cannot Opportunity cost – Cost associated with opportunities that are foregone when a firm’s resources are not put to their highest-value use

Opportunity cost of an action is the value of the next best alternative forgone. For an Input: What the input could have earned from best alternative use (outside the firm).

Although opportunity costs are hidden and should be taken into account, sunk costs should not Sunk Cost – EXPENDITURE THAT HAS BEEN MADE AND CANNOT BE RECOVERED – Firm buys a piece of equipment that cannot be converted to another use

Cost that is committed but can not be avoided
– Should not influence a firm’s future economic decisions

Sunk Cost
From a firm’s point of view it is the cost that arises when an investment in an asset can not be recovered by subsequent resale. Firm can neither sell nor lease it to any other person and even cannot be used for other alternative purposes. Investment is a SUNK COST when its OPPORTUNITY COST is zero.

Fixed Cost versus Sunk Cost
Fixed Cost – Cost paid by a firm that is in business regardless of the level of output Fixed costs can be avoided if the firm goes out of business (say key executives will not be needed) Sunk Cost – Cost that has been incurred and cannot be recovered Ex: Cost of factory with specialized equipment which is of no use in another industry Exception: Something can be recovered if it is sold for scrap.

Family of Total Costs...
Total Fixed Costs (TFC) Total Variable Costs (TVC) Total Costs (TC) TC = TFC + TVC

Short Run Costs
Fixed Costs:

– Those costs that do not vary with the amount of output produced or level of output. – Total obligations of the firm per given period (time) for all fixed inputs (Land, Building, Capital Equipment). – Exp: Payment for renting the plant and equipment if firm owns it, insurance, property taxes, salaries (for top management fixed by contract and to be paid during the period of contract irrespective of going for production or not) – -Annual allowances made for depreciation (wear and tear) and expenditure on maintenance

Variable Cost
Those costs that do vary with the amount of output produced. – Obligations of the firm per period for all variable inputs – (Exp. Payment for Raw materials and fuels,...
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