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Untie the ribbons
Lecture 5:
Covers
Cost concepts and cost curves: total, average, marginal
cost concepts and curves
Out line :
Cost concepts
Total cost, fixed cost variable cost
Average fixed, variable & total costs
AVC and APP
MC
Relationship between MC & ACC
Method of determining the optimum level
a) Using TVP & TC
b) Input
Shot run Cost function : C = f (Y) + K
Long run cost function : C = f (Y)
Derive TC = Px1.X1 + Px2.X2 + ... + Pxn Xn
Total cost: fixed and variable
Fixed costs: sum of the monetary values of fixed inputs do
not vary with the level of output TFC = F1. PF1+F2. PF2
rent for land, land revenue, interest on fixed investments,
depreciation
Cash fixed cost: land taxes, rent, insurance premium, etc
Non-cash fixed costs include depreciation of building,
machineries and equipments, interest on capital
investment, charges for family labour and charges for
management
• Cost curves are mirror images of the production curves
• when the TP is increasing at increasing rate. TC is increasing at a decreasing rate and vice versa
• Similarly the inverse relationship can be observed in the case of AP and MP curves, and MC and
AC curves as shown in the figure;
Cost Function as an Inverse Production Function
Variable cost: TVC: X1. Px1 + X2. Px2
Average Fixed cost (AFC): AFC = TFC/Y
AVC = TVC/Y
AC = TC/Y or TFC/Y + TVC/Y = AFC+ AVC
X1 E Y3 LRTC
Co SRTC
C A Y2
F D st
B
Y1
H
G F D’ A’ B’E’
C’
0 X2 X2 0 Y1 Y2
Y3 Y
Fig 11.8 (a) Fig.11.8 (b)
Relationship between Short-Run and Long-Run Cost
Curves
Thus, the two methods of determining the optimum levels are comparable.
X X MC TR
0 VMPX Y
0
PROFIT
TVP
TR
TC
TC
TC
PROFIT
0
0
Py
ATC
Fig.10.8 (a) Determining the Optimum Fig. 10.8 (b) Determining
AVC the
Amounts of Input Using Total Value Optimum Amount of Output
Product, Total Cost, Profit and Value Using Cost and Revenue
of Marginal Product Curves. Px Curves
Minimum Loss Principle
1) when selling price covers the average total cost and
2) when selling price is less than average total cost but more than average variable cost.
3) In short run, only variable costs are important in decision-making.
4) The firm will shut down production, if price falls below average variable cost
MC
Break Even Point
Cost ATC
and P0 B
Price
E D AVC
P1 F
P2 C
P3
Shut Down Point
P4 AFC
O Y3Y2Y1 Y0
Fig. Break-Even and Shut Down Points
Short and Long run Average and Marginal Cost with
Envelope Long Run Average Cost
Illustration of Minimum Loss Principle
Example:
Suppose a farmer has incurred a cost of Rs.5000 to raise one ha of rice till
harvesting stage. Because of severe pest attack, he expects a grain yield of only 10
quintals and a straw yield of 3 tonnes. The expected price is Rs.300/q of paddy and
Rs.200/tonne of straw. The cost of harvesting and threshing would be Rs.2000/ha.
Now the farmer has to decide whether to harvest or not to harvest the crop. The
minimum loss principle guides the farmer in taking an appropriate decision.
Sl.No. Cost/return Decision I (Not Decision II
harvesting) (harvesting)
1 Total FC 5000 5000
2 Total VC 0 2000
3 Total cost 5000 7000
4 Total Revenue 0 3600
5 Profit/loss -5000(loss) -3400(loss)
If the crop is not harvested the loss would be Rs.5000, if it is harvested the loss
would be reduced to Rs.3400.
Hence the rational decision is harvesting the crop to minimize the loss
Minimum of average variable cost is the shut down point
Factor - Product Price Changes and Production Decisions
intersection of MC2 with MR
optimum output level would
reduced from Y0 to Y1
decrease from Y0 to Y1
Importance of cost study
1. to calculate profit or loss
2. determine the relative profitability
3. identify the causes for variations in the unit cost of production
4. to determine the efficiency and intensity of input-use
5. to determine the optimum requirements of variable inputs for each enterprises
Refer Practical manual Ex.No 4 for various cost and income definition for annual crop
Opportunity Cost: ; opportunity cost, the next best alternative foregone
Eg.: a farmer applies fertilizer (50 kgs) to paddy will add Rs.500 and application of
fertilizer (50 kgs) to sugarcane would add Rs.600. Now, if he fertilizes sugarcane, the
opportunity cost of fertilizer is Rs.500;
Economic Efficiency: Economic efficiency refers to the combinations of inputs that
maximize an individual’s objectives.
defined in terms of two conditions, namely, necessary and sufficient
Necessary condition:
1. no possibility of producing the same amount of product with fewer inputs
2. no possibility of producing more product with the same amount of inputs
3. when the elasticity of production is equal to or greater than zero and is equal to or
less than one (0 ≤ εp ≤ 1).
B. Sufficient Condition
1. sufficient condition for efficiency encompasses individual or social goals and values
2. In abstract theory, the sufficient condition is often called a choice indicator
necessary condition Sufficient condition
1. 1. The marginal product of any 1.There must be a diminishing
factor with respect to any marginal product of a factor with
product must equal the ratio of respect to a product.
their prices.
The rate of technical substitution 2.The rate of technical substitution
between any two inputs must equal between inputs must be diminishing
the ratio of their prices (Iso quant is convex towards origin).
3. The rate of product 3.The rate of transformation
transformation for every pair of between products must be increasing
products must equal the ratio of their (product transformation curve is
prices: concave towards origin).
Income measures in relation to different cost
concepts
1. Farm Business Income = Gross Return - Cost A1.
2. Owned Farm Business Income = Gross Return - Cost
A2.
3. Family Labour Income = Gross Return - Cost B2.
4. Net Income = Gross Return - Cost C2.
5. Farm Investment Income = Net Income + Imputed
rental value of owned land + Interest on fixed capital.
