4. COSTS AND ECONOMIC OUTCOME. How economists define costs to be a useful concept for decision making.

Transcription

1 4. COSTS AND ECONOMIC OUTCOME How economists define costs to be a useful concept for decision making. The business population is made up of: a plant an establishment that performs one or more functions in fabricating and distributing goods (a factory, a farm, a mine, a store, web site, a warehouse) a firm (an enterprise, a company) an organization that employs resources to produce goods for profit and operates one or more plants an industry (a sector) a group of firms that produce the same or similar, products. For economists using a broader concept of cost, it is the value of sacrificed opportunities. Opportunity cost as the best of the alternatives that are not chosen, differ because there are different opportunity costs for different decisions under different circumstances. But costs are not necessarily synonymous with monetary outlays. In practice, cost is a useful concept only when applied in specific contexts. For the reason that opportunity cost does not necessarily involve direct outlays of cash by the firm, economists distinguish between explicit costs and implicit costs. Explicit costs (revealed and expressed) involve direct monetary expenses (payments) a firm must make to an outsider to obtain a resource. Implicit costs (present but not obvious) do not involve outlays of cash since it is a monetary income a firm sacrifices when it uses a resource it owns rather than supplying the resource in the market. Closely related to the above distinction between costs is the distinction between economic costs and accounting costs. Accounting costs show historical expenses that should be objective and verifiable as they are designed to serve various agents and public as well as state institutions. Economic costs based on opportunity costs serve decision making so they are the sum of explicit and implicit costs. Economic profit Normal profit Economic loss if TR>TC=C e +C i if TR=TC if TR<TC or P>ATC or P=ATC or P<ATC then e >0 then e=0 then L e >0 e TR C i Ce a TR C i a TR Ce C i Ce Le a 22

2 Suppose you are earning $22,000 a year as a sales representative for a T-shirt manufacturer. At some point you decide to open a retail store of your own to sell T- shirts. You invest $20,000 of savings that have been earning you $1,000 per year. And you decide that your new firm will occupy a small store that you own and have been renting out for $5000 per year. You hire one clerk to help you in the store, paying her $18,000 annually. A year after you open the store, you total up your accounts and find the following: Total sales revenue.. $120,000 Costs of t-shirts.$ 40,000 Clerk s salary. 18,000 Utilities 5,000 Total explicit costs 63,000 Accounting profit.. $ 57,000 Forgone interest $1,000 Forgone rent... 5,000 Forgone wages. 22,000 Forgone entrepreneurial income...5,000 Total implicit costs 33,000 Economic profit.. $24,000 The error of the implicit cost lies in the failure to take the essential costs which are associated with the consequences of decisions. Scarce resources should be used in accordance with the most profitable (valuable) application. Example: Company wants to lay off an employee who gives him the advantage = 2500 PLN, and his salary = 1900 PLN. Should the employee be laid off? Working in a room that you can rent for 800 PLN. 23

3 TP L = X TP max The production function S R TP L 0 L min L max Labour MP L AP L MP L TP L AP L TP L L MP L AP L 0 L min L max Labour The law of diminishing marginal product (marginal returns) as a firm uses more of a variable factor of production with a given quantity of the fixed factor of production, the marginal product of the variable product eventually diminishes The law of diminishing marginal returns assumes that technology is fixed and all units of labour are of equal quality. if the use of one factor of production is increased while all other factors are kept constant, states that as successive units of a variable resource (labour) are added to a fixed resource (capital, land), beyond some point the extra, or marginal, product that can be attributed to each additional unit of the variable resource will decline. 24

4 How to choose a combination of inputs to minimize the cost of producing a given quantity of output it is the main issue of the cost theory. Production process can be described in two approaches from time point of view, i.e. short run (rigidity of some inputs that cannot be adjusted to the changing market situation) and long run (firm is free to adjust all its inputs). Short-run total cost (TC) informs of minimized total cost of producing X units of output when at least one input is fixed at a particular level. It is usually assumed that the amount of capital used by the firm is fixed at K. The short run total cost is a sum of two components: total fixed cost (TFC) that covers rental costs, depreciation cost, insurance payments, interest on loan, property taxes, other payments to which the firm is committed in the short run (sometimes called by business as overhead costs) and total variable cost (TVC), i.e. a sum of expenditures on variable inputs, principally labour, raw materials, energy and so forth, at the short run minimizing input combination TC(X) =TFC+TVC(X). When assessing the cost of a decision, the decision maker should consider only those costs that decision actually affect. Some costs must be incurred no matter what decision is made. Sunk costs are costs that have already been incurred and cannot be avoided. While evaluating alternative decisions sunk costs should be ignored. Fixed cost error, i.e. sunk cost, consists in taking into account the costs and benefits which are not the consequence of the decision to be taken, i.e. it is a decision taking into account irrelevant costs and benefits. Example: Structure of production and overhead costs Total fixed cost is equal to the cost of the fixed capital services (TFC = r K ). According to a firm s ability to adjust all its inputs in the long run the firm incurs only variable costs, it is even able to expand or reduce its size. Dividing both sides of TC(X) equation by an amount of output (X) short run average costs can be defined respectively:. TC TFC ATC x x AFC TVC AVC, where: x ATC- average total cost, AFC average fixed cost and AVC- average variable cost. In consequence: ATC(X) = AFC(X) + AVC(X). While making decisions a cost of special importance is the marginal cost (MC), which is defined as the change in total costs as the volume of output changes. Since in short - run only the variable costs change, so the marginal cost is a change in total variable cost when the output changes TC TVC MC or. x x 25

5 Total variable cost curve is derived from the production function. m.u. TC F B C E TVC A TFC D H 0 X 1 X 2 X 3 X 4 X m.u MC ATC 20 0 AVC AFC X

6 Factor K Q3 TC TC Q Q 2 Q Factor L 27

7 L a b o u r Production function for semiconductors Capital K