Long Run Total Cost (LTC)
SERIES -3PRINCIPLES OF BUSINESS DECISIONMG UNIVERSITY, KERALAGOPAL SALIMCOST OF PRODUCTIONThe term cost of production means the expenses incurred during the course of production of a commodity or service. It is the total money expenses incurred by the producer in the process of transforming the input into output. DIFFERENT CONCEPTS OF COSTS1. Opportunity CostThe resources of any firm operating in the market are limited and investment options are many. The firm therefore has to decide or select only those investment opportunities which provide the firm with the best return or best income on investment. The opportunity cost of a company is thus this income or return which the firm could have earned on the next best investment alternative. So it is the next best alternative sacrificed during the process of production. For example, let us assume that an individual has two job offers in hand. One job offer is promising him a salary of Rs. 30, 000 per month while the other job offer will ensure salary of Rs. 25, 000 per month. If the job profile and other factors related to the job offers are more or less same then it can be easily expected that the individual will select the job offer which will provide him with higher salary that is salary of Rs. 30, 000 per month. Thus, in this case, the opportunity cost is the return involved in the next best alternative i.e; Salary of Rs. 25, 000 in the next best job offer.2. Money Cost and Real CostMoney Cost?of production is the actual monetary expenditure made by company in the production process. Money cost thus includes all the business expenses which involve outlay of money to support business operations. Real Cost?of production includes all such expenses or costs of business which may or may not involve actual monetary expenditure. It is the real effort exerted during the course of production process.3. Accounting Cost and Economic Cost (Explicit Costs and Implicit Costs)Accounting Cost?includes all such business expenses that are recorded in the book of accounts of a business firm. . Such expenses include expenses like cost of raw materials, wages and salaries of the employees, depreciation of the fixed assets, taxes etc. Such accounting expenses or costs are also termed as?explicit costs in economics. Economic Cost or implicit costs, on the other hand includes all the accounting expenses as well as the Opportunity cost of a business firm and this includes the cost of owner occupied factors of production.4. Private Cost and Social CostThe actual expenses of individuals or firms which are borne or paid out by the individual or a firm can be termed as?Private Cost. Thus for a business firm this may include expenses like cost of raw material, salaries, rent etc. On the other hand, social cost?includes private cost and also such costs which are not borne by the firm but by the society at large. For example the cost of damage or disutility caused by the operations of a firm in an economy may not be borne by the firm in question but it impacts the society at large and thus such cost is added to the private cost to find the social cost of producing the product. 5.Fixed Costs and Variable CostsFixed Cost?is that cost which does not change (that is either goes up or goes down) irrespective of whether the firm is operating or not. Even when the plant is not operating the firm still has to bear such expenses which are indirect in nature. For example rent of the factory premises, wages of administrative employees etc. In other words fixed cost is not related direct to production or manufacturing expenses. Variable Cost?on the other hand is directly proportional to the production operations. As the size of production grows, the variable costs also increase. When the firm is not operating on account of strike or lockout etc, then the variable cost of the firm is zero.6. Sunk Costs. These are costs that have been incurred and cannot be recouped. If a firm leaves the industry, it cannot reclaim sunk costs. For example, if a firm spends money on advertising to enter an industry, it can never claim these costs back even if it leaves the industry. 7. Avoidable Costs.?Costs that can be avoided during the course of operations of a firm is termed as avoidable costs. If a firm stops producing cars, it can avoid the purchase of raw materials and electricity. . Sometimes there types of costs are known as an escapable cost.8. Out-of-Pocket and Book Costs:Out-of-pocket costs means costs that involve current cash payments to outsiders while book costs such as depreciation do not require current cash payments. The distinction primarily shows how cost affects the cash position. Book costs can be converted into out-of-pocket costs by selling the assets and having them on hire. Rent would then replace depreciation and interest. While undertaking expansion, book costs do not come into the picture until the assets are purchased. COST FUNCTIONCOST FUNCTIONCost function explains the functional relationship between the output and the cost of production. When output increases, the cost of production also increases. The cost function can be expiated with the help of a mathematical function as given below:C = f (Q)Where C is the cost of productionQ is the output.We can say that C is an increasing function of output.CATEGORIZATION OF COST FUNCTIONThe cost function can be explained by categorizing it into short cost function and long run cost function.1. Short Run Cost FunctionIn the short run, certain factors of production are fixed and certain other factors are variable The money spent on fixed factors are called as Total Fixed Cost (TFC) and the money spent on variable factors is called as Total Variable Cost (TVC). So we may say that the Total Cost is the sum of Total Fixed Cost (TFC) and Total Variable Cost (TVC). Thus:TC = TFC +TVC2.Long run cost functionThe long run cost function explains the relationship between the output and cost in the long run. In the long run all factors are variable and hence all costs are variable. SHORT RUN COST CONCEPTSThe short run cost concepts can be explained with the help of the following table:Output (Q)Total Fixed Costs (TFC)Total Variable Costs (TVC)Total Cost(TC)Average Fixed Cost (AFC)Average Variable Cost (AVC)Average Total Cost or Average Cost (AC)Marginal Cost (MC)1101020101020021018285914831024343.33811.33641028382.5079.504510405028101261060701.671011.67201. TOTAL FIXED COST (TFC)TFC is the cost incurred on fixed inputs or factors of production. It is the investment in overheads made by a firm. Whatever may be the output in the short run, the TFC remains the same. Hence we may say that the TFC is a positive constant as given in the column 2 of the above table.Diagrammatically, the TFC can be shown with the help of the following diagram:YTotal Fixed CostTFCFX OutputOIn the above diagram, the output is measured along the X axis and the total fixed cost on Y axis. The TFC is a constant at various levels of output. Hence, it is a line parallel to the output axis, which shows the same level of costs at different levels of output.2.Total Variable Cost (TVC)TVCYTVCXOutputOIn the above graph, the output is measured along X axis and the total variable costs (TVC) is measured along the Y axis. When output is zero, the variable cost is also zero and hence, the curve originates from O axis. When output increases, initially the TVC increases at a smaller rate and later it increases at faster rate. This is shown by the TVC curve.3. TOTAL COST (TC)TC is the sum total of the cost incurred for the production of a given volume of output by a firm. The total cost is the sum of TFC+ TVC. YTCTFCXO TVCCOSTOUTPUTIn the above diagram, the output is measured along the X axis and the Total Cost is measured along the Y axis. TC is the total cost curve which is the sum of TFC and TVC. It starts from TFC as it is equal to TFC when the output is zero. It has got the same shape of the TVC as it initially increases at a slower rate and afterwards, increases at a higher rate. The difference between TVC and TC is the TFC.AVERAGE COST CURVESAVERAGE FIXED COST (AFC)Average Fixed Cost = Total Fixed Cost / OuputSo: AFC = TFC/QYAFCAFCXOOutputIn the above diagram, the output is measured along the X axis and the AFC is measured along the Y axis. When output increases , the AFC decreases and hence the curve is negatively sloped.2.AVERAGE VARIABLE COST (AVC)Average Variable Cost = Total Variable Costs/Output So: AVC = TVC/QYAVC AVCOutputXOIn the above diagram, the output is measured along the X axis and the AVC is measured along the Y axis. When output increases, the AVC declines initially and after which it increases. Hence the AVC curve is U shaped.3.AVERAGE COST (AC)Average Cost or Average Total Cost = Total Cost/ OutputSo: AC or ATC = TC/QYAC, AVC, AFCMCACAVCOOUTPUTXIn the above diagram, the output is shown on the X axis and the AC, AVC and MC is shown on the Y axis. The AC decreases initially and after which it increases. This is shown by the AC curve which is above the AVC curve in the diagram.4. MARGINAL COST (MC)The marginal cost (MC) is the addition made to the total cost by the production of an additional unit. Mathematically it can be shown as below:MC = dTC/dQ Where ‘d’ is the changeTC is the total costQ is the outputThe MC curve initially decreases and then increases which is shown by the dotted cost curve in the above diagram. While it increases, it passed through the minimum point of both AVC and AC.LONG RUN COSTIn the long run, all the factors of production used by an organization vary. The existing size of the plant or building can be increased in case of long run. There are no fixed inputs or costs in the long run. Long run is a period in which all the costs change as all the factors of production are variable. Hence all the costs are variable in the long run.Long Run Total Cost (LTC)Long run Total Cost (LTC) refers to the minimum cost at which given level of output can be produced. According to Leibhafasky, “the long run total cost of production is the least possible cost of producing any given level of output when all inputs are variable.” Long Run Average CostThe LAC is the per unit cost of production in the long run. It is the derived by dividing the long run total cost by the level of output produced. In the following diagram, we have drawn the long-run average cost curve as having an approximately U-shape. It is generally believed by economists that the long-run average cost curve is normally U shaped, that is, the long-run average cost curve first declines as output is increased and then beyond a certain point it rises. This is because of economies of scale and diseconomies of scale.The curve is U shaped due to increasing returns to scale, constant returns to scale and diminishing returns to scale. This implies that initially the output increases at an increasing rate which brings down the average cost of production. Then the output is subjected to constant returns to scale which implies that the rate of change in input and the rate of change in output, both remains the same. In the final stage, the output increases at slower rate as compared to the inputs, this in turn increases the cost per unit.. In the above diagram, SAC1 to SAC7 are short run average costs curve which shows various scales of production. Initially when additional production capacity is created by adding more plants, the cost decreases and once it reaches the output of OQ, the cost decreases to the minimum. This output OQ is called as the optimum output in the long run. After OQ level of output, further additions of plants or scale increases the cost of production due to diseconomies of scale. The long run cost curve is obtained by the tangential point of so many short run costs curves and hence it is called as an envelope curve or planning curve. In the above diagram, LAC envelopes so many short run cost curves.…………….. ................
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