BBA I Semester Managerial Economics Cost Analysis Study Material Notes
Table of Contents
BBA I Semester Managerial Economics Cost Analysis Study Material Notes: Introduction Cost Concepts and Classifications Accounting and Economic Costs Fixed Costs and Variable Costs Direct costs and indirect costa Private and Social COsts Incremental Costs and sunk Costs Actual costs and Opportunity costs Importance of Opportunity cost Out of Pocket costs and Book costs Urgent costs and Postponable costs Cost Output Relation Short Run cost Curves Short Run total Costs and Output The COst Functions :
CTET Paper Level 2 Science Set II Multiple Choice Model Paper in Hindi
COST ANALYSIS
INTRODUCTION
The firm’s costs determine its supply. Supply along with demand determines price. To understand the process of price determination and the forces behind supply, we must understand the nature of costs. In this chapter, we study some important concepts of costs, and traditional and modern theories of cost.
COST CONCEPTS AND CLASSIFICATIONS
Costs are very important in business decision-making. Cost of production provides the floor to pricing. It helps managers to take correct decisions, such as what price to quote, whether to place a particular order for inputs or not, whether to abandon or add a product to the existing product line and so on.
Ordinarily, costs refer to the money expenses incurred by a firm in the production process. But in economics, cost is used in a broader sense. Here, costs include imputed value of the entrepreneur’s own resources and services, as well as the salary of the ownermanager.
There are various concepts of cost that a firm considers relevant under various circumstances. To make a better business decision, it is essential to know the fundamental differences and uses of the main concepts of cost.
Accounting and Economic Costs
The classification of costs into fixed and variable costs, out-of-pocket and book costs, separable and common costs, controllable and uncontrollable costs, urgent and postponable costs is the classification of the accountant. They are meant for legal, financial and auditing purposes. The remaining classification of total average and marginal costs, actual and opportunity costs, historical and replacement costs, past and future costs and short-run and long-run costs are economic costs. This classification of the economist is designed to provide decision making guidelines for the entrepreneur to achieve the firm’s economic goals.
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Fixed Costs and variable costs
The total costs of production of a firm are divided into total variable costs and total fixed costs. The total variable costs are those expenses of production which change with the change in the firm’s output. Larger output requires larger inputs of labour, raw materials, power, fuel, etc. which increase the expenses of production. When output is reduced, variable costs also diminish. They cease when production stops altogether. Marshall called these variable costs as prime costs of production.
The total fixed costs, called supplementary costs by Marshall, are those expenses of production which do not change with the change in output. They are rent and interest payments, depreciation charges, wages and salaries of the permanent staff, etc. Fixed costs have to be incurred by the firm, even if it stops production temporarily. Since these costs are over and above the usual expenses of production, they are known as overhead costs.
Actual Costs and Opportunity Costs
Actual costs refer to the costs which a firm incurs for acquiring inputs or producing a good and service such as the cost of raw materials, wages, rent, interest, etc. The total money expenses recorded in the books of accounts are the actual costs.
Opportunity cost is the cost of sacrifice of the best alternative foregone in the production of a good or service. Since resources are scarce, they cannot be used to produce all things simultaneously. Therefore, if they are used to produce one thing, they have to be withdrawn from other uses. Thus the cost of the one is the alternative forgone. It is the opportunity missed or alternative forgone in having one thing rather than the other. The cost of using land for wheat growing is the value of alternative crop that could have been grown on it. The opportunity cost of labour is what it could get in some alternative employment. The cost of capital to the capitalist is the amount of interest he could earn elsewhere. The normal earnings of management are what an entrepreneur could earn as a manager in some other joint stock company. In this way, opportunity cost is the cost of the opportunity missed or alternative forgone.
Importance of Opportunity Cost
The concept of opportunity cost is very important in the following areas of managerial decision making.
(1) Decision-Making and Efficient Resource Allocation. The concept of opportunity cost is very important for rational decision-making by the producer. Suppose, a producer has to decide whether he should produce black and white T.V. or colour T.V. from his given resources. He can come to rational decision only by measuring opportunity cost of production of both types of T.V. and by comparing these products with existing market prices. As a result, efficient allocation of resources will also be possible. A resource will always be used in that business where it will have the highest opportunity cost. For example, if a graduate is receiving Rs. 3,000 as a shop assistant but can earn Rs. 5,000 as a clerk, then he will join the job of a clerk leaving the shop because his opportunity cost is high.
(in) Determination of Relative Prices of Goods. If the same group of resources can produce either a colour T.V. or four black and white T.V.s, the price of a colour T.V. will be kept equal to at least a four-fold price of a black and white T.V. Hence, the concept of opportunity cost is useful in the determination of relative prices of various goods.
Determination of Normal Remuneration of a Factor. Opportunity cost determines ice for the best alternative use of a factor of production. Suppose a manager can earn Rs. 20,000 per month as a lecturer in a management school, the firm will have to pay him at least Rs.20,000 for continuing his service as a manager.
Hence, it is obvious that the concept of opportunity cost has special importance in the management
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Direct Costs and Indirect Costs
Direct costs are the costs that have direct relationship with a unit of operation, i.e., they can be easily and directly identified or attributed to a particular product, operation or plant. For example, the salary of a branch manager, when the branch is a costing unit, is a direct cost. Direct costs directly enter into the cost of produciton but retain their separate identity.
On the other hand, indirect costs are those costs whose source can not be easily and definitely traced to a plant, a product, a process or a department, such as electricity, stationery and other office expenses, depreciation on building, decoration expenses, etc.
All the direct costs are variable because they are linked to a particular product or department. Therefore, they vary with changes in them. On the contrary, indirect costs may or may not be variable.
Private and Social Costs
Private costs are the costs incurred by a firm in producing a commodity or service. These include both explicit and implicit costs. However, the production activities of a firm may lead to economic benefit or harm for others. For example, production of commodities like steel, rubber and chemicals, pollutes the environment which leads to social costs. On the other hand, production of such services as education, sanitation services, park facilities, etc. leads to social benefits. Take for instance, education which not only provides higher incomes and other satisfactions to the recipients but also more enlightened citizens to the society. If we add together the private costs of production and economic damage upon others such as environmental pollution, etc., we arrive at social costs.
Incremental Costs and Sunk Costs
Incremental costs denote the total additional costs associated with the marginal batch of output. These costs are the additions to costs resulting from a change in the nature and level of business activity, e.g., change in product line or ouput level, adding or replacing a machine, changes in distribution channels, etc. In the long-run, firms expand their production, employ more men, materials, machinery and equipment. All these expenses are incremental costs.
Sunk costs are the costs that are not affected or altered by a change in the level or nature of business activity. It cannot be altered, increased or decreased by varying the level of activity or the rate of output. All past or actual costs are regarded as sunk costs. Thus. sunk costs are irrelevant for decision making as they do not vary with the changes expected for future by the management, whereas incremental costs are relevant to the management for business making
Explicit Costs and Implicit Costs
Explicit costs are those payments that must be made to the factors hired from outside rol of the firm. They are the monetary payments made by the entrepreneur for purchasing or hiring the services of various productive factors which do not belong to him. Such payments as rent, wages, interest, salaries, payment for raw materials, fuel, power, insurance premium, etc. are examples of explicit costs.
Implicit costs refer to the payments made to the self-owned resources used in production. They are the earnings of owner’s resources employed in their best alternative uses. For example, a businessman utilises his services in his own business leaving his job as a manager in a company. Thus, he foregoes his salary as a manager. This loss of salary becomes an implicit cost of his own business. Implicit costs are also known as imputed costs. They are important for calculation of profit and loss account. They play a crucial role in the analysis of business decisions.
Historical and Replacement Costs
The historical cost is the actual cost of an asset incurred at the time the asset was acquired. It means the cost of a plant at a price originally paid for it. In contrast, replacement cost means the price that would have to be paid currently for acquiring the same plant. So historical costs are the past costs and replacement costs are the present costs. Price changes over time cause a difference between historical costs and replacement costs. For example, suppose that the price of a machine in 1995 was Rs. 1,00,000 and its present price is Rs. 2,50,000, the actual cost of Rs. 1,00,000 is the historical cost while Rs. 2,50,000 is the replacement cost.
The concept of replacement cost is very useful for the management. It projects a true picture while the historical cost gives poor projection to the management. Historical cost of assets is used for accounting purposes, in the assessment of net worth of the firm, while the replacement cost is used for business decision regarding the renovation of the firm.
Past Costs and Future Costs
Past costs are the costs which have been actually incurred in the past. They are beyond the control of the management because they are already incurred. These costs can be evaluated with retrospective effect.
On the contrary, future costs refer to the costs that are reasonably expected to be incurred in some future periods. They involve forecasting for control of expenses, appraisal of capital expenditure decisions on new projects as well as expansion programmes and profit-loss projections through proper costing under assumed cost conditions. The management is more interested in future costs because it can exercise some control over them. If the management considers the future cost too high, it can either plan to reduce them or find out sources to meet them. These costs are also called avoidable costs or controllable costs.
Business Costs and Full Costs
Business costs are the costs which include all the payments and contractual obligations made by the firm together with the book cost of depreciation on plant and Equipment. They are relevant for the calculation of profits and losses in business, and for legal and tax purposes.
In contrast, full costs consist of opportunity costs and normal profit. Opportunity costs are the expected earnings from the next best use of the firm’s resources. Normal pronto is the minimum profit required for the existence of a firm.
Common Production Costs and Joint Costs
Sometimes, two or more than two products emerge from a common production process and from a single raw material. For example, the same piece of leather may be used for slippers or shoes. Such products present some peculiar and important problems for the management, They are identifiable as separate products only at the end of the process. So the costs incurred upto this point are common costs. Thus, common costs are the costs which can not be traced to separate products in any direct manner.
When an increase in the production of one product results in an increase in the output of another product, such products are joint products and their costs are joint costs. For example, when gas is produced from coal, coke and other products also emerge automatically. Likewise, wheat and straw, cotton and cotton seeds may be its other examples.
Shutdown Costs and Abandonment Costs
Shutdown costs are the costs that are incurred in the case of a closure of plant operations. If the operations are continued, these costs can be saved. These costs include all types of fixed costs, the costs of sheltering plant and equipment, lay-off expenses, employment and training of workers when the operation is restarted.
On the other hand, abandonment costs are the costs which are incurred because of retiring altogether a plant from use. These costs are related to the problem of disposal of assets. For example, the costs are related to the discontinuance of tram services in Delhi.
These concepts of costs are very important for the management when they have to make decisions regarding the continuance of existing plant, suspension of its operations or its closure.
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Out-of-Pocket Costs and Book Costs
The costs which include cash payments or cash transfers that may be recurring or non-recurring are called out-of-pocket costs. All the explicit costs such as rent, wages, interest, transport charges, etc. are out-of-pocket costs. They are also called explicit costs.
Book costs are the actual business costs which enter into book accounts but are not paid in cash. They are considered while finalising the profit and loss accounts. For example, depreciation which does not require current cash payments. They are also called imputed costs. Book costs may be converted into out-of-pocket costs. If a factor of production is owned, that is book cost. But, if it is hired, that is out-of-pocket cost.
Urgent Costs and Postponable Costs
Urgent costs are those costs that are necessary for the continuation of the firm’s activities. The cost of raw materials, labour, fuel, etc. may be its examples which have to be incurred if production is to take place.
The costs which can be postponed for some time, i.e., whose postponement does not affect the operational efficiency of the firm are called postponable costs. For example,
ce costs which can be postponed for the time-being. This distinction of cost is very useful during war and inflation.
Escapable Costs and Unavoidable Costs
Escapable costs are the costs which can be reduced by contraction in business activities. Here, net effect on costs is important. However, it is difficult to estimate indirect effects such as the closure of an unprofitable business unit which will reduce costs but will increase the other related expenses like transportation charges, etc.
On the other hand, unavoidable costs are the costs which do not vary with changes in the level of production, but they are unavoidable such as fixed costs.
Incremental Costs and Marginal Costs
There is close relation between marginal cost and incremental cost. But they have difference also. In reality, incremental cost is used in a broad sense in relation to marginal cost.
Marginal cost is the cost of producing an additional unit of output, while incremental cost is defined as the change in cost resulting from a change in business activities. In other words, incremental cost is the total additional cost related to marginal quantity of output.
The concept of incremental cost is very important in the business world because, in practice, it is not possible to use every unit of input separately.
THE COST FUNCTION
The cost function expresses a functional relationship between total cost and factors that determine it. Usually, the factors that determine the total cost of production (C) of a firm are the output(Q), the level of technology (7), the prices of factors (P) and the fixed factors (F). Symbolically, the cost function becomes
C=f(Q.T,P,F) Such a comprehensive cost function requires multi-dimensional diagrams which are difficult to draw.
In order to simplify the cost analysis, certain assumptions are made. It is assumed that a firm produces a single homogeneous good (g) with the help of certain factors of production. Some of these factors are employed in fixed quantities whatever the level of output of the firm in the short run. So they are assumed to be given. The remaining factors are variable whose supply is assumed to be known and available at fixed market prices. Further, the technology which is used for the production of the good is assumed to be known and fixed. Lastly, it is assumed that the firm adjusts the employment of variable factors in such a manner that a given output of the good q is obtained at the minimum total cost, C. Thus the total cost function is expressed as C=f@)
which means that the total cost (C) is a function () of output (Q), assuming all other factors as constant. The cost function is shown diagrammatically by a total cost (TC) curve. The TC curve is drawn by taking output on the horizontal axis and total cost on the vertical axis, as shown in Figure 1. It is a continuous Output curve whose shape shows that with increasing output total cost also increases. The total cost function and the curve relate total cost to output under given conditions. But if any of the given conditions such as the technique of production change, the cost function is changed. For instance, if there is an improved technique of production, the cost of production for any given output will be less than before which will shift the new cost curve TC, below the old curve TC, as shown in Figure 1. On the other hand, if the prices of factors rise, the cost of production will increase which will shift the cost curve upwards from TC to TC,, as shown in Figure 1.
The cost function is observed both in the short run and the long run, which we explain below.
COST-OUTPUT RELATION
The cost-output relationship is discussed under the short-run and long-run cost analysis which are explained as under.
(A) Short-Run Cost Curves
The short run is a period in which the firm cannot change its plant, equipment and the scale of organisation. To meet the increased demand, it can raise output by hiring more labour and raw materials or asking the existing labour force to work overtime.
Short-Run Total Costs and Output
The scale of organisation being fixed, the short-run total costs are divided into total fixed costs and total variable costs:
TC=TFC + TVC Total Costs or TC. Total costs are the total expenses incurred by a firm in producing a given quantity of a commodity. They include payments for rent, interest, wages, taxes and expenses on raw materials, electricity, water, advertising, etc.
Total Fixed Costs or TFC are those costs of production that do not change with output. They are independent of the level of output. In fact, they have to be incurred even when the firm stops production temporarily. They include payments for renting land and buildings, interest or borrowed money, insurance charges, property tax, depreciation, maintenance expenditures, wages and salaries of the permanent staff, etc. They are also called overhead costs.
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Total Variable Costs or TVC are those costs of production that change directly with output. They a rise when output increases, and fall when output declines. They include expenses on raw materials, power, water, taxes, hiring of labour, advertising etc., They are also known as direct costs.
TVC The relation between total costs, variable costs, fixed costs and output is presented in Table 1, where column (1) indicates different levels of output from 0 to 8 10 units. Column (2) indicates that total fixed costs remain at Rs. 300 at all levels of output. Column (3) shows total 200K variable costs which are zero when output is nothing and they continue to increase with the rise in output. In the beginning they rise quickly, then they slow down as Output the firm enjoys economies of large scale production with further increases in output and later on due to diseconomies of production, the variable costs start rising rapidly. Column (4) relates to total costs which are the sum of columns (2). and (3) i.e., TC = TFC + TVC. Total costs vary with total variable costs when the firm starts production.
Table 1: Cost-Output Relationship
The curves relating to these three total costs are shown diagrammatically in Figure 2. The TC curve is a continuous curve that shows that with increasing output total costs also increase. This curve cuts the vertical axis at a point above the origin and rises continuously from left to right. This is because even when no output is produced, the firm has to incur fixed costs. The TFC curve is shown as parallel to the output axis because total fixed costs are the same (Rs. 300) whatever the level of output. The TVC curve has an inverted-S shape and starts from the origin O because when output is zero, the TVCs are also zero. They increase as output increases. So long as the firm is using less variable factors in proportion to the fixed factors, the total variable costs rise at a diminishing rate. But after a point, with the use of more variable factors in proportion to the fixed factors, they rise steeply because of the application of the law of variable proportions. Since the TFC curve is a horizontal straight line, the TC curve follows the TVC curve at an equal vertical distance.
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(A) Cost-Output Relationship in the Short-Run
In the short run analysis of the firm, average costs are more important than total costs. The units of output that a firm produces do not cost the same amount to the firm. But they must be sold at the same price. Therefore, the firm must know the per unit cost or the average cost. The short-run average costs of a firm are the average fixed costs, the average variable costs, and the average total costs.
Average Fixed Costs (or AFC) equal total fixed costs at each level of output divided by the number of units produced:
The average fixed costs diminish continuously as output increases. This is natural because when constant total fixed costs are divided by a continuously increasing unit of output, the result is continuously diminishing average fixed costs. Thus the AFC curve is a downward sloping curve which approaches the quantity axis without touching it, as shown in Figure 3. It is a rectangular hyperbola.
Short-Run Average Variable Costs (or SAVC) equal total variable costs at each level of output divided by the number of units produced:
SAC or SATC TVC
SMC SAVC SAVC=
Costs
TFC
The average variable costs first decline with the rise in output as larger quantities of variable factors are applied to fixed plant and equipment. But eventually they begin to rise due to the law of diminishing returns. Thus the SAVC curve is U-shaped, as shown in Figure 3.
AFC Short-Run Average Total Costs (or SATC or SAC) are the average costs of producing any
Output given output. They are arrived at by dividing the total costs at each level of output by the number of units produced:
@ U-Shape of SAC Curve. Average total costs reflect the influence of both the average fixed costs and average variable costs. At first average total costs are high at low levels of output because both average fixed costs and average variable costs are large. But as output increases, the average total costs fall sharply because of the steady decline of both average fixed costs and average variable costs till they reach the minimum point. This results from the internal economies, from better utilisation of existing plant, labour, etc. The minimum point B in the figure represents optimal capacity. As production is increased after this point, the average total costs rise quickly because the fall in average fixed costs is negligible in relation to the rising average variable costs. The rising portion of the SAC curve results from producing above capacity and the appearance of internal diseconomies of management, labour, etc. Thus the SAC curve is U-shaped, as shown in Figure 3.
Short-Run Marginal Cost (SMC). Marginal cost is the addition made to total cost by producing an additional unit of output : Marginal cost can be calculated either from TVC or TC. The result will be the same in both the cases (see table 1). The SMC curve is also U-shaped, as shown in fig. 3. It first falls and then rises.
Relationships among SAVC SATC, AFC and SMC can be explained as follows:
(a) SAVC, SATC and SMC first fall, then remain constant and ultimately rise as output increases.
(b) SMC curve intersects both SAVC curve and SATC curve at their minimum points A and B respectively.
(c) The minimum point CofSMC is at an output lower than the output levels A and B at which SAVC and SATC are minimum.
(d) The minimum point B of SATC is at a larger output than the minimum point A of SAVC.
(e) When both AFC and SAVC fall, SATC will also fall. (f) There is a direct relationship between SATC and SMC curves. Both are U-shaped.
(i) When SATC falls, SMC also falls. But the fall in SMC is more and in SATC less. That is why the minimum point of SMC is before the minimum point B of SATC.
(ii) SMC requals SATC at its minimum point B.(iii) When SATC rises, SMC is above it. But the rise in SMC is greater than SATC.
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(B) Cost-output Relationship in the Long-run
In the long run, there are no fixed factors of production and hence no fixed costs. The firm can change its size or scale of plant and employ more or less inputs. Thus in the long run all factors are variable and hence all costs are variable.
The long run average total cost or LAC curve of the firm shows the minimum average cost of producing various levels of output from all possible short-run average cost curves (SAC). Thus the LAC curve is derived from the SAC curves. The LAC curve can be viewed as a series of alternative short-run situations into any one of which the firm can move. Each SAC curve represents a plant of a particular size which is suitable for a particular range of output. The firm will, therefore, make use of the various plants up to that level where the short-run average costs fall with increase in output. It will not produce beyond the minimum short-run average cost of producing various outputs from all the plants used together.
Let there be three plants represented by their short-run average cost curves SAC, SAC, and SAC, in Figure 4. Each curve represents the scale of the firm. SAC, depicts a lower scale while the movement from SAC, to SAC, shows the firm to be of a larger size. Given this scale of the firm, it will produce up to the least cost per unit of output. For producing ON output, the firm can use SAC, or SAC, plant. The firm will, however, use the scale of plant represented by SAC, since the average cost of producing ON output is NB which is less than NA, sac, the cost of producing this output on the SAC, plant. If the firm is to produce OL output, it can produce at either of the two plants. But it would be advantageous for the firm to use the plant SAC, for the OL level of output. But it would be more profitable for the firm to produce the larger output OM at the lowest average cost ME from this plant. However, for output OH, the firm would use the SAC, plant where the average cost HG is lower
Cost Analysis – / 99 order to produce any level of output the firm will use that plant which has them cost.
The Term expands its scale by the three stages represented by SAC, SAC, and a curves, the thick wave-like portions of these curves form the long-run average cost curve
portions of these SAC curves are of no consideration during the long run because the firm would change the scale of plant rather than operate on them.
But the long-run average cost curve LAC is usually shown as a smooth curve fitted to the SAC curves so that it is tangent to each of them at some point, as shown in Figure 5, where SAC, SAC, cost curves. It is tangent to all the SAC curves but only to one at its minimum point. The LAC is tangent to the lowest point E of the curve SAC, in Figure 5 at OQ optimum output. The plant SAC, which produces this OQ optimum output at the minimum cost QE is the optimum plant, and the firm producing this optimum output at the minimum cost with this optimum plant is the optimum firm. If the firm produces less than the
Output optimum output oQ, it is not working its plant to full capacity and if it produces beyond OQ, it is overworking its plants. In both the cases, the plants SAC, and SAC, have higher average costs of production than the plant SAC
The LAC curve is known as the “envelope” curve because it envelopes all the SAC curves. According to Prof. Chamberlin, “It is composed of plant curves; it is the plant curve. But it is better to call it a “planning” curve because the firm plans to expand its scale of production over the long run.”
The long-run marginal cost (LMC) curve of the firm intersects SAC, and LAC curves at the minimum point E. The LMC curve is also derived from the SAC curves.
LAC Curve Flatter than SAC Curve
Though the long-run average cost (LAC) curve is U-shaped, yet it is flatter than the short-run average cost (SAC) curve. It means that the LAC curve first falls slowly and then rises gradually after a minimum point is reached.
1 Initially, the LAC gradually slopes downwards due to the availability of certain economies of scale like the economical use of indivisible factors, increased specialisation and the use of technologically more efficient machines or factors. The returns to scale increase because of the indivisibility of factors of production. When a business unit expands the returns to scale increase because the indivisible factors are employed to their maximum capacity. Further, as the firm expands, it enjoys internal economies of production. It may be to install better machines, sell its products more easily, borrow money cheaply, procure the services of more efficient manager and workers, etc. All these economies help in increasing the returns to scale more than proportionately. After the minimum point of the long-run average cost is reached, the LAC curve may flatten out over a certain range of output with the expansion of the scale of product tuation, the economies and diseconomies balance each other and the LAC curve has a disc base.
2. With further expansion of scale, the diseconomies like the difficulties of coordination management, labour and transport arise which more than counterbalance the economies so that the LAC curve begins to rise. To these internal diseconomies are added external diseconomies of scale. These arise from higher factor prices or from diminishing productivities of factors. As the industry continues to expand the demand for skilled labour, land, capital etc. rises. Transport and marketing difficulties also emerge. Prices of raw materials go up. All these factors lead to diminishing returns to scale and tend to raise costs.
Conclusion. The LAC curve first falls and then rises more slowly than the SAC curve because in the long run all costs become variable and few are fixed. The plant and equipment can be altered and adjusted to the output. The existing factors can be worked fully and more efficiently so that both the average fixed costs and average variable costs are lower in the long run than in the short run. That is why, the LAC curve is flatter than the SAC curve.
Similarly, the LMC curve is flatter than the LAC SMC curve because all costs are variable and there are few fixed costs. In the short-run, the marginal cost is related to both the fixed and variable costs. As a result, the SMC curve falls and rises mo.c swiftly than the LMC curve. The LMC curve bears the usual relation to the LAC curve. It first falls and is below the LAC curve. Then rises and cuts the Output LAC curve at its lowest point E and is above the latter throughout its length, as shown in Figure 6.
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ECONOMIES OF SCALE AND THE LAC CURVE
The shape of the LAC curve depends fundamentally upon the internal economies and diseconomies of scale, while the shift in the LAC curve depends upon external economies and diseconomies of scale.
The LAC curve first declines slowly and then rises gradually after a minimum point is reached. Initially, the LAC curve slopes downwards due to the availability of
Internal certain internal economies of scale to the firm like the economical use of indivisible factors, increased specialisation, use of technologically more efficient machines, better managerial and marketing organisation, and benefits of pecuniary economies. All these economies lead to increasing returns to scale. It means that as Output output increases, the LAC curve declines own in Figure 7 where the LAC curve falls gradually upto point M.
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economies of scale exist only up to this point which is the optimum point of the rve. If the firm expands its output further than this optimum level, diseconomies of scale arise. The diseconomies of scale result from lack of coordination, inefficiencies in management, problems in marketing, and increases in factor prices as the firm expands its scale. As a result, there are decreasing returns to scale which turn the LAC curve upwards, as shown in the figure where the LAC curve starts rising from point M. Thus internal economies and diseconomies of scale are built into the shape of the LAC curve because they accrue to the firm from its own actions as it expands its output level. They relate only to the long run.
On the other hand, external economies and diseconomies of scale affect the position of the LAC curve. External economies of scale are external to a firm and accrue to it from actions of other firms when the output of the whole industry expands. They reflect interdependence among firms in an industry
meal Diseconomies try. They are realized by a firm when other firms in the industry make inventions and evolve specialization in production price thereby reducing its per unit cost. They also arise to firms in an industry from reductions in factor prices. As a result, per unit cost falls and the LAC curve shifts Output downwards as shown by the shifting of the
On the contrary, external diseconomies shift the LAC curve upwards. External diseconomies arise solely through a rise in the market prices of factors used in an industry. When an industry expands, the increase in the demand for factors like labour, capital, equipment, raw materials, power, etc. rises and when the industry is unable to meet this demand due to shortages, per unit cost of firms rises. As a result, the LAC curve shifts upwards, as shown by the shifting of the LAC curve to LAC, in Fig. 8.
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EXERCISES
1 Explain the short-run cost-output relationship.
2. Explain the cost-output relationship in the long-run.
3. Why is the long-run cost curve flatter than the short-run curve ?
4. What is the basis of U-shaped short-run average cost curve ?
5. How do economies and diseconomies of scale affect the LAC curve ?
6. Explain opportunity cost. What is its importance in management?
7. Write a note on the cost function.
