Costs of Production revision

Costs of production©
Unit 03
1RASHAIN PERERA CIMA Adv. Dip. MA,
UOR (Mgt)

Prepared by;
RASHAIN PERERA
077 059 37 52
rashainperera@gmail.com
RASHAIN PERERA CIMA Adv. Dip. MA,
UOR (Mgt)
2

INTRODUCTION
Section 01
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Business objectives
 Profit maximization is the fundamental
objective of a business
 Profit is the excess of income over
expenses
 Income is mainly through selling goods and
services
 There are various components of costs
such as variable costs, fixed costs and
overhead costs.
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Other business objectives
 Maximizing earning per share
 Satisfying customers
 Quality products
 Continuous improvement
 Satisfactory service
 Business social responsibility (CSR)
 Growth and development
 Research and development
 AND other financial and non financial
objectives 5RASHAIN PERERA CIMA Adv. Dip. MA,
UOR (Mgt)

The production process
 Conversion of raw materials to finished
goods could be simply known as the
production process.
 Conversion process, transformation
process are some of the similar terms that
are used by various parties for production
process
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 Production process involves inputs and its
outcome could be termed as output
 Therefore it is clear that there’s a direct
relationship between inputs and outputs
 This relationship could be shown in terms
of the production function
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Production Function
 The production function shows the
relationship between the inputs and the
outputs of a particular production process.
 The production function can be presented
as below
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Q = f{L/M, K}

 In some processes some inputs might be
fixed.
 For example if capital is fixed the
production function could be re stated as
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Q = f { L/M, K }

Short Run
 Short run is a time period in which both variable
factors and fixed factors exists.
 In the short run some factors remain fixed while
some of the factors can be changed in line with
the requirement.
 For example suppose that you need to park 4 cars
in your garden but you don’t have enough space to
do so. In the short run you garden space remains
fixed while in the long run you can change it either
by buying the land next to your house or by
building an underground car park
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Long Run
 In the long run all factors are variable and
no fixed factors can be seen
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Variable factors Vs
Fixed factors

Variable Factors
 Variable factors are the inputs/ factors
which change if the activity level or output
changes
 For example if we consider a tuition class,
the tutorial cost would be variable
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Fixed Factors
 These are the factors or inputs that stay
the same or constant regardless of the
output produced or activity level
 Considering the same example mentioned in
the previous slide, the fixed factor is the
building that is being used to deliver the
lecture
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SHORT RUN
Section 02
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Short run production function
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Q = f { L/M, K }

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TP
MP
AP

Law of diminishing marginal
returns
 This says that proportion of one factor in a
combination of factors is increased, after
a certain point first the marginal then the
average product of that factor will
diminish
 In other words total output will increase at
a decreasing rate when more and more
variable factors are assigned to a fixed
input
 Refer notes for graphical presentation
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Short run revenue functions
 Revenue is the income gained by selling
goods and services
 Key formulas;
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TR = P X Qty
AR= TR/Qty
MR= change in TR/change in Qty

Short run cost functions
 There are 7 types of short run costs
 Fixed costs
 Variable costs
 Total costs
 Average fixed cost
 Average variable cost
 Average total cost
 Marginal cost
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Fixed costs
 This is the cost that stays a same
regardless of the output level
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TFC
Cost
Qty

Variable costs
 The costs that changes with the activity
level or output level
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Cost
Qty
TVC

Total costs
 This is the totality of variable and fixed
costs
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TC = VC + FC

Average fixed costs
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AFC = TFC / Qty
Cost
Qty
TFC
AFC

Average variable costs
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AVC = TVC / Qty
Cost
Qty
AVC

Average total costs
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ATC = AFC + AVC
Cost
Qty
AVC
ATC
AFC

Marginal costs
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MC = Chg TC/Chg Q
Cost
Qty
AVC
ATCMC

Cost functions VS production
functions
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Short run profit functions
 Profit the excess of revenue over
expenditure
 Where TR is a function of price and
quantity sold
 TC is a function of variable, fixed costs
and overheads
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Profit = TR - TC

Types of profits
 Accountants profit
 Economists profit
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= TR – explicit costs
= TR – implicit – explicit costs

 Explicit costs
 Explicit costs are the costs that can be
accountant in monetary terms. For example
electricity paid 10 000
 Implicit costs
 These are the opportunity costs or unseen
decision costs.
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Types of economic profits
 Normal profit
 The minimum required by a firm to be in
operation
 Here the economic profit = 0
 Abnormal profit/supernormal profit
 This is an excess
 Here economic profit > 0
 Subnormal profit
 Is an actual loss
 Here economic profit < 0
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LONG RUN
Section 03
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Long run production function
 Is a time period where only variable
factors exists
 Long run production function can be
explained with the help of economies of
scale
 Economies of scale refers to an
advantageous situation derived by a firm
with increase in capacity, size and
production
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 Envelop curve
 It is said that LRAC is made of several
SRAC curves. LRAC is derived by joining the
optimums of those SRAC curves as shown
below.
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LRAC
SRAC 1 SRAC 2

 Economies of scale and LRAC curve
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Optimum
level
EOS
DEOS

 Returns to scale and LRAC curve
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Increasing
returns to
scale
constant returns
to scale
Decreasing
returns to
scale

 Increasing returns to scale
 Firms experience this if their average cost
per unit in production falls as the firms
expand in size/ activity level
 Reasons
 Bulk buying
 Spreading overheads
 Risk bearing economies
 Financial economies
 Marketing economies of scale
 Specialization
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 Decreasing returns to scale
 Reasons
 Depreciation of resources
 Stress
 Lack of control
 Poor communications in the large firm
 Weaknesses in the management and
coordination.
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MARKET STRUCTURES
Section 04
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Characterization of markets
 Number of firms? Size of firms?
 Type of product?
 Barriers to entry and exit?
 Information availability?
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Perfect competition
 Characteristics
 Large number of small firms
 Homogenous or identical product
 No/low barriers to entry and exit
 Perfect information available for both
consumers and producers
 No advertising can be seen
 A price taker
 Faces a perfectly elastic demand curve
 No/low competition
 Ex; paddy farmers, wheat farmers etc
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 Industry VS firms demand curve (price
taker)
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Industry Firm
P
S
D
P=D=AR=MR

 Price = demand = AR = MR
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Price Demand TR AR MR
10 1 10 10 10
10 2 20 10 10
10 3 30 10 10
10 4 40 10 10
P=D=AR=MR
10

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D=AR=MR=P
MC
AC
 Short run equilibrium- abnormal profit

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D=AR=MR=P
MC
AC
 Short run equilibrium-sub normal profit

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D=AR=MR=P
MC
AC
 Long run equilibrium- normal profit

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D=AR=MR=P
MC
AC
 Shut down point- case 1
since AVC can be covered the firm will
continue its operations
AVC

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D=AR=MR=P
MC
AC
 Shut down point- case 2
since AVC can not be covered the firm will
shut down or discontinue
AVC

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D=AR=MR=P
MC
AC
 Supply curve of a perfect competitive firm-
case 1
AVC

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MC
AC
AVC
 Supply curve of a perfect competitive firm-
case 2

Monopoly
 Characteristics
 Only one firm
 Sells a unique product
 High entry and exit barriers
 Less or no information available for customers
 No need to advertise
 Faces a normal downward sloping demand curve
 A price maker
 No competition
 Ex; CGR
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 MR=0.5AR
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 Short/long run equilibrium-abnormal profit
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D=AR
MR
MC
AC

Monopolistic competition
 Characteristics
 Large number of small and large firms
 Homogenous or heterogeneous product
 Barriers to entry and exit are comparatively
high
 Imperfect information
 Faces a normal downward sloping demand curve
 Advertising can be seen
 Can be a price taker or a maker
 Brand competition can be seen
 Ex; soft drinks, soap, tooth paste
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 Short run equilibrium-abnormal profit
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D=AR
MR
MC
AC

 Long run equilibrium-normal profit
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D=AR
MR
MC
AC

Oligopoly
 Characteristics
 Few large firms
 Differentiated inter dependent product
 High barriers to entry and exit
 Mutually interdependent
 Advertising can be seen
 Faces a kinked demand curve
 High competition
 Ex; television broadcasting, newspaper
publishers
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 Kinked demand curve
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 Competition methods
 Price competition
 Decreasing the price to increase sales
 discounts
 Non price competition
 Advertising
 Internet shopping
 Extension of opening hours
 Home delivery
 Cash on delivery COD
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 Price leadership
 When one firm has a dominant position in
the industry, that firm will be able to
control the prices of other firms in the
industry up to a certain extent. The
dominant firm is named as price leader.
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 The bad of oligopolies
 Inefficient in allocation of resources
 In equal distribution of income
 The good of oligopolies
 Widen the product range
 Benefits the customer with innovative
products
 Can take advantage of economies of scales
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Types of barriers to entry
and exit
 Barriers to entry
 Economies of size
 Capital intensive
 Intellectual property
 High switching cost of barriers
 Established brand loyalty
 Legal requirements
 Government standards
 Barriers to exit
 Investment in specialized equipment
 Specialized skills
 High fixed costs
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END
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