i) Ue eens UNIT 9 _ COST AND RETURN __— Structure 9.0 Introduction 9.1 Objectives nine a 9.2. Relavant Costs for Decision-Making yut Relationship 9.3. Traditional Theory of Cost: Cost Funetion and Cost Ourp 93.1 Short-Run Cost-Output Relations 932 Long-Run Cost-Output Relations 933. Economies and Diseconomies of Scale 9.4 Modem Theory of Cost 9.5 CostControl and Cost reduction 9.6 Cost Behaviour and Business Decision _ 9.7 Answers to Check Your Progress Questions 9.8 Summary 9.9 Key Words 9.10 Self Assessment Questions and Exercises 9.11 Further Readings PRN DANEHinie tee was ee 9.0 INTRODUCTION ‘The theory of cost provides conditions for minimizing the cost: of production. In addition, analysis of cost of production is very important in almost all kinds of| business decisions, especially those related to, the weak points of production management; determining the output level for cost minimization; determining the price of the product and dealers’ margin; and estimating and projecting the cost of business operation. Cost functions help in determining the relationship between outputs and costs, In this unit, we will study the relevant costs for decision-making and the traditional and modem theories of cost. 9.1 OBJECTIVES After going through this unit, you will beable to: © Discuss the relevant costs for decision-making ‘© Explain the traditional theory and modem theories of cost. * Describe the cost function and cost output relationship # Discuss the concept of cost control, cost reduction, cost business decisions ‘atl (ost and Rey NOTES1 Snsiructional feral 9.2 RELAVANT COSTS FOR DECISION-MAKING ions can be Bice comers bat are relevant to business operations and dec Abe (cost concenn sf theitnature and purpose under two overlapping categories: used in econ mt S used for accounting purposes, and (ii) analytical cost concepts concepts of ee analysis of business activities. We will discuss some important of cost le two categories, Itis important to note here that this classification Concepts is only a matter of analytical convenience. Accounting Cost Concepts 1. Opportunity Cost and Actual Cost: Actual cost is all paid out costs of the business. firms to take the advantage of the best opportunity available to them. The ‘Opportunity cost is the opportunity lost for lack of resources. An opportunity to make income is lost because of scarcity of resources like land, labour, capital, etc. We know that resources available to any person, firm or society are scarce but have altemative uses with different returns. Income maximizing resource owners Put their scarce resources to their most productive use and thus, they forego the income expected from the second best use of the resources. Thus, the opportunity cost may be defined as the returns expected from the second best use of the Tesources foregone due to the scarcity of resources. The opportunity cost is also called alternative cost. Had the resource available to a person, a firm ora society been unlimited, there would be no opportunity cost. 2. Business Costs and Full Costs: Business costs include all the expenses that are incurred to carry outa business. The concept of business costs is similar to the actual or real costs. Business costs “include all the payments and contractual obligations made by the firm together with the book cost of depreciation on plant and equipment.” Business costs are used for calculating business profits and losses and for filing retums for income-tax and also for other legal purposes. The concept of full cost, includes business costs, opportunity cost and normal profit. The opportunity cost includes the foregone earning expected from the second best use of the resources, or the market rate of interest on the internal money capital and also the value ofan entrepreneur’s own services that are not charged for in the current business. Normal profit is anecessary minimum earning in addition to the opportunity cost, which a firm must receive to remain in its present occupation. 3. Actual or Explicit Costs and Implicit or Imputed Costs: The Actual or Explicit costs are those which are actually incurred by the firm in payment for labour, material, plant, building, machinery, equipment, travelling and transport, advertisement, etc. The total money expenses, recorded in the books of accounts are, for all practical purposes, the actual costs. Actual cost comes under accounting cost concept. atake Cost Inc there are certain other costs that sa cost Be, “ontrast to explicit costs, there ing system. the form ofeash outlays, nor do they appear the eat Sk are known as implicit or imputed costs Opportunity wile his no ofimplicit cost. For example, suppose an entrepreneur lary basis. TES firm ona sal imhisown business and worksas amanagerinsome other IN TT TT acs of fhe sets up his own business, he foregoes his salary 85 MONT an implicit Salary isthe opportunity cost of income from his own BUSA oct are the cost ofhis own business. Thus, implicit wages, tent, andi sivaty ‘wages, rent and interest that an owner's labour, buildingand caP! can eam from their second best use. Implicit costs are not taken into account while ofthe business, but they form an important considerat Not to retain a factor in its present use. The explicit an‘ make the economic cost. ; cash 4. Out-of-Pocket and Book Costs: The items of expenditure that involve cas Payments or cash transfers, both recurring and non-recurring, are Known 3 out-of-pocket costs. All the explicit costs (¢.g. wages, Tent, ine ee materials and maintenance, transport expenditure, electricity and telephone expenses, etc fallin this category. On the contrary there are certain actual business costs that do not involve cash payments, but a provision is therefore made is. the books of account and they are taken into account while finalizing the profit and loss accounts. Such expenses are known as book costs. In a way, these are payments made by a firm to itself. Depreciation allowances and unpaid interest on the owner’s own funds are the example of book costs. alculating the loss or gains jon in deciding whether or implicit costs together Analytical Cost Concepts The analytical cost concepts refers to the different cost concepts that are used in analysing the cost-output relationship with increase in inputs and output and also the cost concepts that figure in analysing the effect of expansion of production on the societyas a whole. 1. Fixed and Variable Costs. Fixed costs are those that remain fixed in amount fora certain quantity of output. Fixed cost does not vary with variation in the output between zero and a certain level of output. In other words, costs that do not vary or remain constant for a certain level of output are treated as fixed costs, The fixed costs include (i) depreciation of machinery, building and other fixed assets, (i) costs of managerial and administrative staf, (i) maintenance of land, etc. The concept of fixed cost is associated withthe short-run, Variable costs are those which vary with the variation in the total Variable costs include cost of raw material, running cost of fixed capital. fuel, repairs, routine maintenance expenditure, direct labour with the level of output, and the costs of all other inputs that va 2. Total, Average and Marginal Costs. Total cost (TC) outlays of money expenditure, both explicit and implicit, ontew" se NOTES Ssttmirutona Material ee Ost (TC tistical nature—it is not actual cost. Itis obtained St(7C) by the total output (O), ie, Mi 40-7 , farginal cos of pros eNO is defined as the addition to the total cost on account ducing one addi marginal unit ee aioaal Unit of the product. Or, marginal costis the cost of the number of units pro eee Costis calculated as TC,— TC, , where mis the ofthe cotfimetion. + WSS Cost function, Cis obtained as the first derivative @ Moses Total, avera, i S * ‘age and m: cr 5 alysit of firm’s production seein cost concepts are used inthe economic analysis and in pricing decisions, Th am v's prod ig decisions. These cost concepts are discusset further detail in the following: section. i 3. Short mae ‘Run and Long-Run Costs. Short-run and long-run cost concepts are ‘Variable and fixed costs, respectively, and often figure in economic analysis cost-output relationship, ‘Short-run refers to the time period during which scale of production remains unchang ed. The costs incurred in the short-run are called short-run costs. Itincludes both the variable and the fixed costs. From analytical point of view, short-run Costs are those that vary with the variation in output in short-run, the size of the firm remaining the same. Therefore, short-run costs are treated as variable costs. Long-run costs, on the other hand, are those that are incurred to increase the scale of production in the long-run. The costs that are incurred on the fixed factors like plant, building, machinery, etc., are known as long-run costs. It is important to note that the running cost and depreciation of the capital assets are included in the short-run or variable costs. Furthermore, Jong-run costs are by implication the costs that are incurred in the long-run. In the long run, however, even the fixed costs become variable costs as the size of the firm or scale of production increases. Broadly speaking, ‘the short-run costs are those associated with variables in the utilization of fixed plant or other facilities whereas long-run costs are associated with the changes in the size and kind of plant.” 4. Incremental Costs and Sunk Costs. Conceptually, incremental costs are closely related to the concept of marginal cost but with a relatively wider connotation. While marginal cost refers to the cost of the marginal unit (generally one unit) of output, incremental cost refers to the total additional cost associated with the decisions to expand the output or to add a new variety of product, ete.§. Historical and Replacement Costs. Historical cost refers to the coat inoue wp aston the acquisition of productive assets, 8 land, building, machinery Whereas replacement cos refers othe expenditute male for replacing an ON Sat These concepts owe their significance tothe unstable nature of input PCE. Stable prices overtime, other things given, keep historical and fadap arabe on par with each other. Instability in asset prices makes the two costs differ Io each other. As regards their application, historical cost of assets is used for accounting Purposes, in the assessment ofthe net worth ofthe firm whereas replacement cost figures in business decisions regarding the renovation of the plant, Private costs are those which are actually incurred or provided for by an individual ora firm on the purchase of goods and services from the market, Fora firm, all the actual costs, both explicit and implicit, are private costs, Private costs are intemalized costs that are incorporated in the firm's total cost of production, Social costs on the other hand, refer to the total cost borne by the society due to production of a commodity. Social costs include both private eost and the external cost. Social cost includes (a) the cost of resources for which the firm is not required to pay a price, i.e., atmosphere, rivers, lakes, etc., and also for the use of public utility services like roadways, drai and (b) the cost in the form of ‘disutility’ ronment pollution, ete. The costs of category (b) are generally assumed to equal the total private and Public expenditure incurred to safeguard the individual and public interest against the various kinds of health hazards and social tension created by the production system. The private and public expenditure, however, serve only as an indicator of ‘public disutility’—they do not give the exact measts the social costs. ‘Cheek Your Prog) 1. Define explicit cost 2. Under which ca iegory does the running cost and depreciation of the capital RELATION: The theory of cost deals with how cost of production ch output. In other words, the cost theory deals with cost-out principle of the cost-output relationship is that the fotal cost) in output, This simple statement of an observed practical importance, What is important froma Ost and Rey NOTES.yen NOTES “enstructional Merial as the rate of increase in total cost with increase in ourput and the direction of chan ess s 3Ye"28e Cost (AC) and the marginal cost (MC). The orremain constant. yg std M@C—whether AC and MC decrease or increase eae ' depends on the nature of the cost function. A cost function is as ent of the technological relationship between the cost and output. © general form of the cost function is written as TC=f(Q),with ATciAQ>o OD) Ee ie actual form of cost function depends on whether the time framework en for cost analysis is short-run or: long-run. Itis important to recall here that ‘Some costs remain constant in the. short-run while all costs are variable in the long- tun. Thus, depending on whether cost analysis pertains to short-run or to long- Tun, there are two kinds of cost functions: (#) short-run cost functions, and (@) long-run cost functions, Accordingly, the cost output relations are analyzed in short-run and long-run framework. 9.3.1 Short-Run Cost-Output Relations In this section, we will analyse the cost-output relations in the short-run. The long- Tun Cost output relations discussed in the following section. Before we discuss the short-run Cost-output relations, let us first look at the cost concepts and the Components used to analyze the short-run cost-output relations. The basic analytical cost concepts used in the analysis of cost behaviour are Total, Average and Marginal costs. The total cost (TC) is defined as the actual Cost that are incurred to produce a given quantity of output. The short-run TC is composed of two major elements: (i) tofal fixed cost (TFC), and (ii) total variable cost (TVC). That is, in the short-run, TC = TFC + TVC 9.2) As mentioned earlier, TFC (i.e., the cost of plant, building, etc.) remains fixed in the shortrun, whereas TVC (the labour cost) varies with the variation in the output. Fora given quantity of output (0), the average cost (AC), average fixed cost (AFC) and average variable cot (VC) can be defined as follws. TC _TFC+TVC_TFC, TVC gc~ TeaTECs Oo 7AFC+ AVC TFC ut Thus, soe Ol, ne a is AC= AFC + AVC Marginal cost (MC) can be defined as the change in the total eost due change in the total output by one unit, ie.,Cost andr “etury ATG _ TC, -TGs oe) MC= "49" 0,-0,1=! eas the fist derivative Incase TCis expressed in functional form, MCis measure NOTES arc ofcost function, ie. short- + ATYC and, in. the sI Dr ATF ynder the marginality * function and derivation Itmay be added here that since ATC= run, ATFC= 0, therefore, ATC = ATVC. Furthermor concept, where AO= 1, MC=ATVC. Now we tum to cos! of various cost curves. Short-Run Cost Functions and Cost Curves andare exhibited through . : tion Thecost-outputrelatons arerevealedby the cost functionandars tT Nosy cost curves. The shape of the cost curves depends on function. Cost amb are derived from actual cost data ofthe firms. The Given of estimated cost function depends on the cost trend revealed by cost data. Given the cost data, cost functions may takea variety of forms, ¢., linear, quadratic or cubic, yielding different kinds of cost curves. The cost curves produced by linear; quadratic and cubic cost functions are illustrated below. 1. Linear Cost Function. When total cost increases at a constant rate with inerease in production, it produces a linear cast function. A linear cost function takes the following form. TC=at+bQ ++(9.5) where 7C= total cost, O= quantity produced, a= TFC, and b= Change in TVC due to change in Q. Given the cost function [Eq. (9.5)] ACand MC can be obtaied as follows. and Note thatsince ‘6’ isa constant coefficient, MCremains constant, in case ofa linear cost function. ° Note that, in case ofa linear cost function, while MC: continues to decline with the increase in output. This is logic of the linear cost function, 2. Quadratic Cost Function. When TC increases at it increase in output (Q), the TC data produces a quadra TC=a+bQ+Q"struct rgstional where a and b are constants and TC | output, respectively, and Q are total cost and total outp Given the cost function (9.6), AC an MC can be obtained as folows. ae Clnaeng gee cot uimmn pm =T oi (9-7) 0 Q gtbte ( oT _ MC= “5 =b+20 (9:8) ee ne coe Curves that emerge from the cost function in this ease are that vi st remains constant, TVC is increasing at an increasing rate. The rising TVC sets the trend in the total cost (TC). Note that MC and AVC are rising at a constant rate whereas AC declines till a certain point and then begins t increase. 3. Cubie Cost Function When TC increases first at decreasing rate and then of increasing rate with increase in production, the TC data produces a cubic cost function. A cubic cost function is of the form TC=a+bO-cP+O (9-9) where a, b and care the parametric constants. TFC remains fixed for the whole range of output, and hence, takes the form ofahorizontal line—TFC. The TVC curve shows two different trends with increase in output. The total variable cost first increases at a decreasing rate and then at an increasing rate with the increase in the output. The rate of increase can be obtained from the slope of 7VC curve. The two patterns of change in the TVC stems directly from the law of increasing and diminishing returns to the variable inputs. So longas the law of increasing retums is in operation, TVC increases at decreasing rate, And, when the law of diminishing returns comes into operation output increases at decreasing rate causing TVC to increase at increasing rate. Average Fixed Cost (AFO):As already mentioned, the costs that remain fixed foracertain level of output make the total fixed cost in the short-run. We know that Tec AFC= “oO (9.10) Average Variable Cost (AVO). As defined above, TVC AVE="O Tc Aerage Cost (AC) The average cost (AC) is defined as AC =EW Of Diminishing Returns and the Cost Curves Wenow retum to the law of diminishing returns and explain it through the cost ieee eal ihc leet eae nea ofa variable Sect ePoucd other ener ‘constant, the returns from the marginal units of thevariable input ™may initially increase but the marginal retums decrease eventually. ach also be interpreted in terms of decreasing and increasing costs. an then be stated as, if more and more units ofa variable input are given amountofa fixed input, the marginal cst initially decreases, but Sventually increases, Both interpretations of the law yield the same: information— the aus of marginal productivity ofthe variable input and the otherinterms of jhe marginal cost. The former is expressed through a produetion function and the latter through a cost function, intent inital stage of production, both AFC and AVC are declining becanse Grintemal economies. Since AC= AFC + AVC, ACisalso declining. This shows the operation ofthe law ofincreasing retumsto the vasble inputin the initial stage of production. But beyond a certain level of output while AFC continues to fall, AVC starts increasing because ofa faster increase inthe TV. Consequently, the tale of fall in AC decreases, Beyond this leyel of output, AC starts increasing ‘hich shows that the law of diminishing retums comes intooperation, A downward trend in the MC shows ‘increasing marginal productivity of the variable input due mainly tointemal economies resulting from increase in production, Similarly, an upward trend in the MC shows increase in TVC. on the one hand, and decreasing marginal productivity ofthe variable input,on the other, he same |. The law ¢; applied to, Some Important Relationships between Different Measures of Cost Some importantrelationships between coss used in analyzing the short-run cost- behaviour may now be summed up as follows: (@) Over the range of output AFC and AVC fall, ACalso falls, () When 4FC falls but AVC increases, change in AC depends on therate of change in AFC and AVC, (@ if decrease in AFC> increase in AVC, then AC fall, @ ifdecrease in AFC= increase in AVC, AC remains constant and (iii) if decrease in AFC < increase in AVC, then AC increases, (©) AC and MC are related in following ways. Fe @ When MC falls, AC follows, overa certain range oft MCis falling, the rate of fall in MCis greater thant while MCis attributed to a single marginal unit, ACi the entire output. Therefore, AC decreases ata (ii) Similarly, when MC increases, AC also in rate for the reason given in (i). Theres, NOTESa Me ttish ereaonsip does notes Compare the behaviour of fice over the range of output from 6 units to 10 units (See {8:0'5)- Over this range of output, MC begins to increase while AC - wunues to decrease. The reason for this can be seen in Table 9.1: yor eae increasing, itinreases ata relatively lower rate that is onl i : els \ z Teduce the rate of decrease in 4C—not sufficient to Gi) MC curve imersects AC curve at its ‘minimum. The reason is, while AC continues to decrease, MC begins to rise at the same level of Output, Therefore, they are bound to intersect. Also, when AC isat its ‘minimum, itis neither increasing nor decreasing: itis constant. When ACis constant, 4C= MC. That is the point of intersection. Output Optimization in the Shor-Run Inthis section, we show the application of the same technique to cost-minimising output. Letus suppose that a short-run cost function is given as TC=200+50+2@ (9.11) Asnoted earlier, the level of output is optimized at the level of production at which MC=AC. In other words, at optimum level of output, 4C= MC. Given the cost function in Eq, (9.11), 200 +50 +20° AC= Q 200 =O 15420 (9.12) éTC and MC= 0.7 5+40 (9.13) By equating 4Cand MC equations, e.,Eqs.(9.12)and (9.13),respeetively, and solving them for Q, we get the optimum level of output. Since at equilibrium, AC = MC Bees +29 = 5+40=20 @ = 100 Q=10 Thus, given the cost function (9.20), the optimum output is 10. ( Berstructional Materiat°32 Long-Run Cost-Output Relations ri In the preceding section, we have discussed the short-run ee ep Tpeweest changes when productions inereased by ineeasing te variable 1h (labour), fixed input (capital) remaining constant. In this section, we ie long-run theory of cost Inthe context ofthe produetion theory long rn FES jaPeriod in which firms ean use more ofboth the inputs—labour and eaPia! increase their production. The long-run theory of cost deals with gon Cost-output relationship, In other words, long-run theory of cost states the n: ofrelationship between output and cost with inerease in scale of production. Tounderstand the long-run-cost-output relations andto derive long-run Cost curves, it will be helpful to imagine that a long-run is composed of a series o: short-run production decisions. As a corollary of this, long-run cost curve is Composed ofa series of short-run cost curves, With this perception of long-run- Cost-outrelationship, we may now show the derivation of the long-run cost curves and study theirrelationship with output, Long-run Total Cost Curve (LTC) order to draw the long-run total cost curve, letus begin witha short-run situation. Suppose that. firm having only one plant has its short-run total cost curveas given by STC,, in panel (a) of Fig, 9.1. Let us now suppose that the firm decides to add two more plants over time, one after the other. As a. result, two more short-run total cost curves are added to STC,, in the manner shown by STC, and STC, in Fig. 9.1 (a). The LTC can now be drawn through the minimum points of STC,, STC, and STC, as shown by the LTC curve corresponding to each STC. Long-run Average Cost Curve (LAC) Like LTC, long-run average cost curve (LAC) is derived by combining the short= tun average cost curves (SAC,). Note that there is one SAC associated with each STC. The curve SAC, in panel (b) of Fig, 9.1 corresponds to STC, in panel (a), Similatly, SAC, and SAC, in panel (b) correspond to STC, and STC, in panel (a), respectively. Thus, the firm has a series of SAC curves, each having a bottom Point showing the minimum SAC. Forinstanes,C,O, isminimum AC when the firm has only one plant. The AC decreases tu C,Q, when the second plan added and then rises to C,O, after the addition of the third plant, TI can be drawn through the SAC, SAC, and SAC, as sho LAC curve is also known as the ‘Envelope Curve’ or’ Serves as a guid tothe entrepreneur in his plans t expand C31 nd Reon NOTES|e NOTES Sef-Instructional Poa net Total Cost a Q; Q; Output (o) SAC, a en 2 c} a a Os output Fig. 9.1 Long-run Total and Average Cost Curves The SAC curves can be derived from the data given in the STC schedule, from STC function or straightaway from the LTC curve. Similarly, LAC curve can be derived from LTC-schedule, LTC function or from LTC-curve. ‘The relationship between LTC and output, and between LAC and output can now be easily derived. It is obvious from the LTC that the long-run cost output relationship is similar to the short-run cost-output relation, With the subsequent increases in the output, LTC first increases at a decreasing rate, and then atan increasing rate. Asa result, LAC initially decreases until the optimum utilization of the second plant and then it begins to increase. These cost-output relations follow the ‘laws ofreturns to scale’, When the scale of the firm expands, LAC, ie. unitcost of production, intially decreases, but ultimately increases as shown in Fig. 9.1 (b). The decrease in unit cost is attributed to the internal and external economies of scale and the eventual increase in cost, to the interna external diseconomies of scale. The economies and diseconomies of scale are prt discussed in the following section.Cost and Re Long-run Marginal Cost Curve (MO) 4 rived from the short-run margin! illustrated in Fig. 9.2in ae (b). To derive the LE NOTES ie. points A, pe Inthe long-run production planning, these points determi nS at the different levels of production. Each of these ‘outputs has an? eee ifwe draw a perpendicular fom point, it intersects SMC, tT fies paar ie SMC at MO, at output O,. The same process can be repeated or pee to find out SMCat outputs Q, and Q,. Note that points B and Ee a mahitee at BQ, and CO,, respectively. A curve drawn through points 1! - ? show by the LLC represents the behaviour ofthe marginal costa the f0P8: = This curve is known asthe long-run marginal cost curve, LMC- Itshows the trends in the marginal cos in response tothe changes in the scale of production. Some important inferences may be drawn from Fig. 9.1. The LMC must be ‘SAC is tangent to the equal to SMC for the output at which the corresponding LAC. At the point of tangency, LAC = SAC. Another important point to be noted is that LMC intersects LAC when the latter is at its minimum, i.e, point B. Tt indicates that there is one and only one short-run plant size whose minimum SAC coincides with the minimum LAC. This point is B where SAC, = SMC, = LAC = LMC The /ong-run marginal cost curve (LMO) is de cost curves (SMCs). The derivation of LMCis SACS, SMC. and LAC are the same as in Fig. 9.) O7 consider the points of tangency between SAC5and the LA ase, 42 Cost ° 2, a = Output 2.2 Derivation of LMC Optimum Plant Size and Long-Run Cost Curves Conceptually, the optimum size of a firm i ? utilization ofresources. Practically, the. optimum a ensures the LAC. Given te state of technology overtime theoreti aunique size of the firm and level of output associated: 7 In Fig. 9.2, the optimum size of the firm consists mejenn yores SAC, and SAC, Th ie . The Petit Pereiapte Plants together produce OO, units of a product at that until IGE Cost (LAC) of lars ae nat until output reaches the ooo 20x The downirend inthe LAC indicates Similarly, expansion ofthe sear eso! OO» the firms of less than optimal size. SMC and, therefore, in LAC. A beyond production capacity 00, causes arise in minimize its average cost ove LoS tiat Biven the technology, a firm aiming to where SAC= sa Gerice. time must choose a plant that gives minimum LAC utilization oftheresou a, gel: This sizeof plant assures te most efficient will make the fj S-Any change in output level—increase or decreas¢— a im enter the area ofinoptimalty 33" Economies and Diseconomies of Scale While optimizati ; Pifmization of output in the long run is an important concern of business firms, cost m ae depends not only on nt an equally import decision area. Cost of production many external factors saat the productivity of inputs — but also on concemed inthivaeet a factors that arise out of the firm. Since we are nated ohare ce theory of cost, in this section we givea detailed ey dere suena economies and diseconomies of scale and how the trend of long-run a in cost of production. To begin with, let us have look at verage cost curve (LAC). ae ee inFig.9.1@), LAC decreases withthe expansion ofproduction x D (en it begins to rise. Decrease in LAC is caused by the economies of scale and increase in LAC is caused by diseconomies of scale. Economies of scale result in cost saving and diseconomies lead to rise in cost. Economies and diseconomies of scale determine also the returns to scale. Increasing returns to scale operate till economies of scale are greater than the diseconomies of scale, and returns to scale decrease when diseconomies are greater than the economies of scale. When economies and diseconomies are in balance, retums to scale are constant. In this section, we briefly discuss the various kinds of economies and diseconomies of scale and their effect on cost of production. Economies of Scale The economies of scale are classified as (a) Internal or Real Economies, and (b) External or Pecuniary Economies. A. Internal Economies also called ‘real economies’, are those that arise within the plants. This means that internal economies firm. Intemal economies maybe classified Intemal economies, ‘ firm with addition of new production are available exclusively to the expanding88a Retayy, (Hi) Managerial economies () Beonomies in transport and storage. «on arige from two SOUTCES: Apa ea CA a aroma ; © Economies in Production Economies in p jon of labour based on NOTES (a) technological advantages, and (b) advantages of divis Specialization and skill of labour nies in input purchases arise from rial inputs and large- puts Econom ale purchase of rw materials and other material WPT Scale selling of the firm's own products. As fo economies in the The large scale the large-size firms normally make bulk purchases of their inputs. sah To Purchase entitles the firm for certain discounts in input prices bpattraak coer that are not available on small purchases. As such, the growing firms gain on the cost of their material inputs. (iii) Managerial Economies: Mi rial economies arise from (a) specialization in managerial activities, ic, the use of specialized managerial personnel, and (6) systemization of mana, nnctions. Fora large-size firm, it becomes possible todivide its management into specialized departments under specialized personnel, such as production r 's manager, HR manager, financial manager, ete. The management of different departments by speciallized managers increases the efficiency of management at all the levels of management because of the decentralization of decision-making. It increases production, given the cost. Large- scale firms have the opportunity to use advanced techniques of communication, telephones and telex machines, computers, and their own means of transport. All these lead fo quick decision-making, help in saving valuable time of the management and, thereby, improve the managerial efficiency, For these reasons, managerial cost inereases less than proportionately with the increase in production scale upto acertain level, ofcourse. (®) Economies in Transport and Storage Economies in transportation and Storage costs arise from fi ilization of transport and storage facilities. sts are incurred both on production and sales sides. Similarly, are incurred on both raw materials and finished products. The large- ze firms may acquire their own means of transport and they can, thereby, reduce the unit cost of transportation, atleast the extent of profit margin ofthe transport companies. Besides, own transport facility prevents delays in transporting goods, Some large-scale firms have their own railway tracks from the nearest rail point to the factory, and thus they reduce the cost of transporting goods: out. Forexample, Bombay Port Trust has its own railway tracks, oil¢o have their own fleet of tankers. Similarly, large-scale firms can create: godowns in various centres ofproduict distribution and can save on cost. of B. ternal or Pecuniary Economies of Scale Extemal economies are those that arise ouside the fim and aeere firms, Extemal economies appear in the form of money saeconomies, P ounlarys '8. Pecuni m of discounts and wen concessions mies acento the large-size firms in the * Seale Acquisition oferta on lark scale purchase of raw material, banks; (if) massi -xternal finance, pa , sive advertisemen ees Particularly from the commerck Port and warehouses, ete. The sss: (iv) large scale hiring of means of ry but large scale ene nese Benefits are available to all the firms of an 'itms benefit more than small firms. le Diseconomies of Seal ‘The economics of'scale have the: acertain level arson {eiown limits, seale economies exis only upto that limit erence es The expansion of scale of production beyond disadvantages thatarisedae a yd ceonamiesofscale,Diseconomies of scale are level and lead to rise in th Se aaa eo ea cnt’ Cost of production. Like economies, diseconomies may be internal and extey x mal a thal, Let us descr i diseconomies in some detail, tien eae arpa 1. Inter isece i a eed ee Internal diseconomies are those that are exclusive ofscale have a limit ney aise within the firm, Like everything else, economies init too. This limit is reached when the advantages of division of Managerial staffhave been fully exploited; excess capacity of plant, \ es, transport and communication systems, etc.,is fully used; and economy in advertisement cost tapers off, Although some economies may still exist, diseconomies begin to outweigh the economies and the costs begin to rise. Managerial Inefficiency. Diseconomies begin to appear first at the management level. Managerial inefficiencies arise, among other things, from the expansion of seale itself. With fast expansion of the production scale, personal contacts and communications between (i) owners and managers, (ii) managers and labour, and (iii) between the managers of different departments or sections get rapidly reduced. The lack of fast or quick communication causes delays in decision-making affecting production adversely. labour and warehou: Secondly, close control and supervision is replaced by remote control management. With the increase in managerial personnel, decision-making becomes complex and delays in decision-making become inevitable. Thirdly, implementation of whatever decisions are taken is delayed due to coordination problem in large scale organisations. Finally, with the expansion of the scale of production, management is professionalized beyond point. As a result, the owner's objective function of profit maximization is gradually replaced by managers’ utility function, like job security and high salary, standard or reasonable profit target, satisfying functions. ‘All these lead to laxity in management and, hence to arise in the cost of production, Labour Inefficiency: Increasing number of labour leads to a loss of control over labour management. This affects labour productivity adversely. Besides, ine eInsructional 5 aeriala _ ae se loss of Cost and Re inthe number of workers encourages labour union activities that caus ae Output per unit of time and hence, rise inthe eost of production. advantages that i , : i dis 2. External Diseconomies. External diseconomies are the a cousteaints, NOTES que Outside the firm, especially in the input markets, duetonatus® ©? Specially in agriculture and extractive industries. With the expansion® Particularly when all the firms of the industry are expanding, the ea finance concessions that are available on bulk purchases of inputsand concession2! ET come to an end, More than that, increasing demand for inputs puts Press the input markets and input prices begin to rise causing. rise in the cost ofprod These are pecuniary diseconomies. On the production side, the law of diminishing retums to scale com force due to excessive use of fixed factors, more so inagriculture and extractive industries. For example, excessive use of cultivable land turns it into barren land; Pumping out water on a large scale fr irrigation causes the water table to £0 down resulting in rise in cost of irrigation; extraction of minerals ona large scale exhausts the mineral deposits on upper levels and mining further deep causes rise in cost of production; extensive fishing reduces the availability of fish and the catch, even when fishing boats and nets are increased. These kinds of diseconomies make the L4C move upward, \e into ictive 9.4 MODERN THEORY OF COST Up till now have leamt about the traditional theory of costs, in this section we will Jeam the modem theory of cost. Unlike the traditional theory of cost, the modern theory does not agree to the U-shape of the cost curve, As per the modem theory, the short run cost curve has a saucer-type shape and the long-run average cost curve is either L-shaped or inverse J-shaped. This is because of the existence of built-in-reserve capacity which imparts flexibility and enables the plant toproduce | . larger output without adding to the costs. Short-Run Cost Curves The SAVC, SMC and the AFC has a saucer shape. Further the AVC is shaped because the reserve capacity is maintained by the firma downward sloping even as the output expands. The SAC curve even in the modem version. Long-Run Cost Curves ‘ The long-run Average cost curve is not U-shaped in, L-shaped of inverse J-Shaped. This can be the assumption that after the optimal level of overtake the economies of scale. As per the: costs includes basically production and mantional Managerial costs Scales of output, Ss of the firms depend: ve ote product Leathe 98 of operat ts. Cost cot ntrol, essentially, 0 F eS i is maj : (There etay inthe current operation tory involves the avoidance _, The primary a Possible cost. Profit mn, ousiness f - Profitmanis Si%e8s firms isto Jepeantibe systems hays OM becomes depends on theirabitiy , essentially deals with e® 8 While selling mn the avoidance or eliminate lore products. Cost control, , ive : mination Ways of operat The advantages of, olved in producing products thereby reducing its overall costs © Without cost control, itis v. ‘ery much possible that the firm’s profits start to decrease even with an incr ease in the volume of sales There are mainly two types of standards of cost control and reduction; * Extemal: This includes the company adjudging its performance in comparison to its competitions. This is done through measuring costratios, © Internal: These are standards used by the companies to identify places where costs can be reduced. Some of the tools under these standards are: control: This is nothing but a plan of action for a given Budgetary control: This is nothing “ n foi 2 aio ae in numerical terms. The: organizational activities are not pie forecasting but carried forward based on the anticipated revenues and expenses. a j dard costing: This refers to the assigning and use of certain set @. See costs based on which actual costs are computed. The ie ance in such comparisons are then corrected to minimize iff wastage.A = $$ DECISION 9.6 COST BEHAVIOUR AND BUSINESS DEC nopattern in whieh Cost behaviour primarily refers: tothe phenomenon ec Sost behaiout costs change in relation fo volumeand activity is done on the basis of: © Costs which change with the activity or volume © Costs which remain constant throughout * Costs which fall somewhere in the middle ener As you can understand, these types of costs are cal costs, BN ip variable costs. We have already seen how these affect output an p tueiness earlierin the unit, now let's see why studying costs are important in 98S decisions. The correct forecasting or estimation of cost a a managers ensure that theirplanning is accurate, Based on thisplanning. Ons activities are undertaken which ultimately reflects on the busines performance, Several researchers stress on the importance o ng. cost behaviour as itis crucial to making financial decisions in the present, as well as planning and decisions making in the future, Further, the significance of cost behaviour to business decis can be understood by the fact that any half-baked knowledge will result in the company incurring serious losses. Proper study of cost behaviours helpful in ensuring the operating margins are kept under control and that the wastages are identified and eliminated. Check Your Progress ts the is is crucial as ita 3. What is quadratic cost functio 4, What does the operation of the lay of increasing returns to variable inputs in the initial stage of production means in terms of costs? 5. Name the curve whose shape remains a U-type in the modern theory of | cost. 9.7 ANSWERS TO CHECK YOUR PROG! QUESTIONS “ forlabour, material, plant, building, machinery, transport, etc. 2. Therunning cost and depreciation of the eapit short-run or variable costs. o CO Md ety NOTESNOTES 3. When the total cost incr i ‘ i Output, the TC data Tease at increasing rate with constant increase i”) ne Produces a quadratic cost function. oftintemal es! Production, both AFC and AVC are declining because eae Sconomies. Since AC=AFC+AVC, AC is also declining. This the initia oot of the law: of increasing returns to the variable input in initial stage of production, gins tHe Ei0dér thor of coat the SAC Sucve base cake EaRore 9.8 SUMMARY * The cost conceps that are relevant to business operations and decisions an )¢ grouped on the basis of their nature and purpose under two Overlapping categories: (i) cost concepts used for accounting, and (ii) Analytical cost concepts used in economic analysis of business activities. * Accounting cost concepts include opportunity cost and actual cost; business Costs and full costs; explicit and implicit cost; and out-of-pocket and book Costs. ° Analytical Cost concepts are: fixed and variable costs; total, average and marginal costs; short-run and long-run costs; incremental costs and sunk Costs and historical and replacement costs. * The theory of cost deals with how cots of production changes with change in output. The basic principle of the cost-output relationship is that the total Cost increases with increase in output. * The short-run total cost is composed of two major elements (i)total fixed cost and, (ii) total variable cost. That is, in the short-run, TC=TFC*+TVC * Long-run cost curve is composed of a series of short-run curves. + Decrease in LAC is caused by diseconomies of scale. Economies of scale result in cost saving and diseconomies of scale determine also the retums to scale. Dieconomies of scale are disadvantages that arises due fo the expansion of production scale beyond its optimum level and lead to rise in the cost of production, © Unlike the traditional theory of cost, the modern theory does not agree to the U-shape of the cost curve. As per the modem theory, the short run cost curve has a saucer-type shape and the long-run average cost curve is either — L-shaped or inverse J-shaped. This is because of the reserve capacity which imparts oe © The primary aim of business possible cost. Profit maximiz ‘The cost accounting: a