Information Technology: Economic Aspects Tutorial
    
Module 2- The Production Process
Section III - The Classical Cost Function - The Short Run
Part A.

 Economic Costs versus Accounting Costs. It is important to distinguish at this time the difference between economic costs and accounting costs. Accounting costs are what people are most familiar with because that is what everyone works with on a day-to-day basis. They represent both the internal and external record of the expenses incurred by the firm in its daily operations. Accounting costs include both cash outlays as well as accrued expenses that are spread over time to smooth out expense lumps and, hopefully, relate them more closely to the actual ‘usage’ of the items generating the initial expenditure. However, these costs do not truly reflect to the economist the actual cost of the resources to the firm.

The concept of cost used by economists is that of opportunity cost. The opportunity cost of an input is the price the input could receive in its next most remunerative use. That is, it is the price the input could receive if it was not employed at the firm under review in the next best employment available to it. In a perfectly competitive market, the next best employment price an input could receive is exactly the price it is receiving in its present use. Since the general assumption that will be used in this tutorial is that factors of production are obtained from competitive markets, it will be assumed that the price that is paid for an input is, in fact, its opportunity cost.

One additional comment needs to be made at this time. It is assumed that the capital used to finance the firm receives its opportunity cost in order for it to be at this firm rather than to be used somewhere else. That is, since funds are raised in a competitive capital market, capital receives just the return it needs to receive, given the riskiness of the firm, in order to be invested in the firm rather than in some other firm of similar risk. Due to this assumption, a firm that just covers all of its economic costs earns no economic profits. Economic profits are not a residual as are accounting profits. This is because the return on capital is an opportunity cost that must be earned and hence is included with the other economic costs used in the firm to produce output.

In this tutorial, factors of production have been separated, in the short-run case, into fixed factors of production and variable factors of production. Thus, if there are assumed to be only two factors of production, one fixed and one variable, there will be only two factor prices, one for the fixed factor of production, P(F), and one for the variable factor of production, P(V). It is, further, assumed that each factor of production is acquired in a competitive market so that these prices represent the opportunity cost of employing the resources.

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Part B. Costs

There are five cost variables that are important for the discussion of the output of the firm. Four of these variables are graphed in Chart II-3.
    1. Total Cost. The total cost (TC) to the firm is the sum of all the fixed costs (FC) of production and the variable costs (VC) of production. This leads to the following total cost equation:


      2. TC = FC + VC = [P(F) x Q(F)] + [P(V) x Q(V)].

    2. Average Fixed Cost. The average fixed cost (AFC) of the firm is the cost of the fixed factor of production divided by the total quantity of output produced.


      3. AFC = FC/Q(O) = [P(F) x Q(F)]/ Q(O)

      Since the fixed costs of the firm stay constant throughout all levels of output in the short-run, the graph of this variable takes on the form of a rectangular hyperbola.

    3. Average Variable Cost. The average variable cost (AVC) of the firm is


      4. cost of the variable factor of production divided by the total quantity of

      output produced.

      AVC = VC/Q(O) = [P(V) x Q(V)]/Q(O)

      Here, the price of the variable factor of production stays constant (because the factor is acquired in a competitive market), but the quantity of the variable factor used per unit of output will vary over the range of output produced. As presented in section II above, there is a section of output in which the average amount of the variable factor per unit of output goes down; this is followed by a section of output in which the average amount of the variable factor per unit of output goes up. In charting this relationship, the graph of the average variable cost equation looks somewhat like a U-shape.

    4. Average Total Cost. The average total cost (ATC) of the firm is the


      5. sum of the average fixed cost and the average variable cost for each level of output.

      ATC = AFC + AVC = {[P(F) x Q(F)]/Q(O)} + {[P(V) x Q(V)]/Q(O)}

      In Chart II-3, it can be observed that the average total cost curve is nothing more than the vertical sum of the average fixed cost curve and the average variable cost curve. Note two things, however. First, the trough of the average variable cost curve is below and to the left of the trough of the average fixed cost curve. (More of this in the next section.) Second, the average variable cost curve and the average fixed cost curve get closer and closer together as potential output increases. This is because the difference between the curves is the average fixed cost curve and this curve approaches the X-axis asymptotically as potential output increases.

    5. Marginal Cost. The marginal cost (MC) of output is the incremental


      6. change in total cost associated with an incremental increase in total output. Each marginal cost figure is connected with a change from one specific level of output to another specific level of output.

      MC = D(TC)/D(Q(O))

      The usual graph of the marginal cost curve depicts the marginal cost curve declining at lower levels of output, but then rising continuously after it reaches a minimum. There is one very crucial relationship between the marginal cost curve and the average variable cost curve and the average total cost curve that helps in the charting of these items. The marginal cost curve will always be increasing when it crosses the other two curves, and, the marginal cost curve will always cross the other two curves at their lowest points.

    6. In Chart II-3, the standard forms of the following four variables


are graphed: the average total cost curve, the average variable cost curve, the average fixed cost curve, and the marginal cost curve. In this chart, the generalized production conditions of the normal manufacturing or service firm are shown. The crucial element in this depiction is that the average total cost curve always begins to rise at some point at a level of output or service that does not exhaust the extent of the market for that particular output or service.






 
       
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