Cost Accounting of Factor Inputs

Introduction
In the supply process, households first offer the factors of production they control to the factor market.
The factors are then transformed by firms into goods that consumers want. Production is the name given to that transformation of factors into goods.

The Role of the Firm

A key concept in production is the firm. The firm is an economic institution that transforms factors of production (inputs) into consumer goods (output, quantity supplied).

The Role of the Firm

A firm:
Organizes factors of production. Produces goods and/or services. Sells goods it produces to individuals.

The Role of the Firm

When the firm only organizes production it is called a virtual firm.
Virtual firms subcontract out all work. While most firms are not virtual, more and more of the organizational structure of business is being separated from production.

The Firm and the Market

Whether an activity is organized through the market depends on transaction costs.

Transaction costs costs of undertaking trades through the market.

The Firm and the Market

The various forms that businesses organize themselves include
sole proprietorships, partnerships, corporations, for-profit firm, nonprofit firms, and cooperatives.

Firms That Maximize Profit

Profit is the difference between total revenue and total cost.

Profit = total revenue total cost

= TR TC
= P*Q (TC/Q)*Q

Firms Maximize Profit

For an economist, total cost is explicit payments to factors of production plus the opportunity cost of the factors provided by the owners. Total Costs = accounting costs + opportunity costs. Accounting costs = expenses that appear on the books.

Firms Maximize Profit

Total revenue is the amount a firm receives for selling its good or service plus any increase in the value of the assets owned by firms.

Firms Maximize Profit

Economists and accountants measure profit differently.

Firms Maximize Profit

For accountants, total revenue is total sales times price. Profit is explicit revenue less explicit cost.

Firms Maximize Profit

For economists, revenue includes any increase or decrease in the value of any assets the firm owns. They count implicit costs which include the opportunity costs of owner-provided factors of production.

Firms Maximize Profit

For economists:
Economic profit =
(explicit and implicit revenue) (explicit and implicit cost)

A Production Function

32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0

Diminishing marginal returns

Diminishing absolute 7 returns 6 TP 5 Output per worker 4 3

Diminishing marginal returns

Diminishing absolute returns

Increasing marginal returns

Output

2
1

AP

3 4 5 6 7 Number of workers

10

(a) Total product

3 4 5 6 7 Number of workers (b) Marginal and average product

9 MP

10

For factors hired or employed by a firm:

The costs are (the value of) the highestvalued alternative use of the money spent in hiring them.
They are called explicit costs as they involve a transfer of money.

For factors owned by a firm:

The costs of using these factors are (the value of) the highest-valued alternative uses of the factors. They are called implicit costs () or imputed costs , as they do not involve a transfer of money.

Classification of costs of different factor inputs Sunk cost (historical cost)

The cost of a past act.
As past options are not available at present, sunk cost cannot be avoided now. Sunk cost is not a (present or future) cost. Bygone is bygone. It should have no effect on any present or future decisions.

Fixed cost
The cost of employing fixed factors.

It does not change with output.

It has no effect on MC & no effect on the determination of the wealth-maximizing output level. It is a present cost paid for the use of fixed factors and hence it affects the net receipt.

Variable cost
The cost of employing variable factors. It changes with output. It affects marginal cost & hence it affects the wealthmaximizing output. It is a present cost paid for the use of variable factors & hence it affects the net receipt.

Q8.6: A restaurant is making a short run decision for its production next month. Identify if the following costs are sunk costs (SC), fixed costs (FC) or variable costs (VC). (a) Rent of the restaurant under a 2-year contract ( ) (b) Wage payments ( ) (c) Expenditure on meat and vegetables ( ) (d) Water charges ( ) (e) Electricity charges ( ) (f) Acquisition cost of machines ( ) (g) Continuing possession cost of machines ( ) (h) Operating cost of machines ( )

Cost Function

Cost function () describes the relationship between output and cost.

Output

= ???

Short-run Cost Curves

Measure of costs

Output changes Cost changes Change in cost can be expressed in three ways: Total cost (TC)
Average cost (AC)

Marginal cost (MC)

Total cost
is the whole amount of payments to all factors used in producing a given amount of output (Q), composed of:

Total fixed cost (TFC): is the whole amount of

payments to fixed factors. Total variable cost (TVC): is the whole amount of payments to variable factors.

Total Cost Curves

$400 350 300 250 200 150 100 50 0

TC
VC

Total cost

TC = (VC + FC)
L O M 2 4 6 8 10 20 Quantity of earrings 30 FC

Formula:
Assume two factors only: Capital (fixed factor) and labour (variable factor) L units of labour are employed at a wage rate of w.

Total Cost:
total fixed cost:

TC = TFC +TVC
a constant independent of output TVC = w x L

total variable cost:

Average cost/average total cost (ATC)

is the cost per unit of output, composed of : average fixed cost (AFC): the fixed cost per unit of output. average variable cost (AVC): the variable cost per unit of output.

Formula:
Average Total Cost:
ATC TC TFC TVC AFC AVC Q Q AFC TFC Q

average fixed cost:

average variable cost:
AVC TVC Q

w L L Q L w w Q AP L

w L Q

Features:
AFC curve drops continuously. (AFC = TFC/Q) AVC curve is Ushaped. ( AVC = w/AP and AP is inverted-U shaped.) ATC curve and AVC curve will come closer and closer as the amount of output increases (ATC = AFC + AVC and AFC drops continuously).

The turning point of ATC curve (b) occurs at a larger output than the turning point of AVC curve (a). Why?

At (a), the fall in AFC is > the rise in AVC initially

but at (b), the fall in AFC is < the rise in AVC eventually

(a) (b)

Marginal Cost is the change in total cost for producing an additional unit of output, composed of : The marginal cost curve goes through the minimum point of the average total cost curve and average variable cost curve. Each of these curves is U-shaped.
marginal fixed cost (MFC): is the change in fixed cost for producing an additional unit of output marginal variable cost (MVC): is the change in variable cost for producing an additional unit of output.

The U Shape of the Average and Marginal Cost Curves

The law of diminishing marginal productivity sets in as more and more of a variable input is added to a fixed input.
Marginal and average productivities fall and marginal costs rise. And when average productivity of the variable input falls, average variable cost rise. The average total cost curve is the vertical summation of the average fixed cost curve and the average variable cost curve, so it is always higher than both of them.

Formula:
Marginal cost:
TC TFC TVC MC MFC MVC Q Q

marginal fixed cost:

MFC

TFC 0 Q

marginal variable cost:

w L MVC TVC Q w w L Q Q Q MP L L w L

As TFC is a constant, MFC = 0. So MC = MVC. MC = MVC = w/MP. As MP curve is inverted-U shaped, MC or MVC curve is U-shaped. MC curve passes through the minimum points of AVC curve and ATC curve.

MC or MVC curve is U-shaped

Derivation of total cost curves:

MC curve (= MVC curve) = Slope of TC curve & TVC curve. Notice the points where MC = mini.; MC = AVC and MC = ATC.

Q8.7: The following table is composed of product items and cost items of a firm. Suppose the unit cost of capital and labour are $10 and $20 respectively. Fill in the missing columns..
Units Units of of capital labour TP AP MP TFC TVC TC ATC

4 4 4 4 4 4

1 2 3 4 5 6

2 5 10 14 14 12

Q8.8 (a) When output increases, if AP of a variable factor rises, what will happen to AVC and ATC?

(b) When output increases, if AP of a variable factor falls, what will happen to AVC and ATC?

Long-run Cost Curves

The firm enjoys economies of scale at the beginning

LRAC & LRMC

As the scale of production further, the firm suffers diseconomies of scale

LRAC & LRMC

Optimum scale
The production scale (combination of factors) with the lowest LRAC. U-shaped LRAC curve LRAC curve with a horizontal region

Optimum scale

Derivation of total cost curves:

LRMC = slope of LRTC

Slope =LRMC =LRAC

Notice the points where LRMC = mini. and LRMC = LRAC.

The Relationship Between Productivity and Costs

The shapes of the cost curves are mirrorimage reflections of the shapes of the corresponding productivity curves.

The Relationship Between Productivity and Costs

When one is increasing, the other is decreasing. When one is at a maximum, the other is at a minimum.

The Relationship Between Productivity and Costs

$18 16 14 12 10 8 6 4 2
Productivity of workers at this output

MC AVC

9 8 7 6 5 4 3 2 1

Costs per unit

A AP of workers MP of workers

4 8 12 16 20 24 Output

4 8 12 16 20 24 Output

Relationship Between Marginal and Average Costs

The marginal cost and average cost curves are related.
When marginal cost exceeds average cost, average cost must be rising. When marginal cost is less than average cost, average cost must be falling.

Relationship Between Marginal and Average Costs

This relationship explains why marginal cost curves always intersect average cost curves at the minimum of the average cost curve.

Relationship Between Marginal and Average Costs

The position of the marginal cost relative to average total cost tells us whether average total cost is rising or falling.

Relationship Between Marginal and Average Costs

To summarize:
If MC > ATC, then ATC is rising. If MC = ATC, then ATC is at its low point. If MC < ATC, then ATC is falling.

Relationship Between Marginal and Average Costs

Marginal and average total cost reflect a general relationship that also holds for marginal cost and average variable cost.
If MC > AVC, then AVC is rising. If MC = AVC, then AVC is at its low point. If MC < AVC, then AVC is falling.

Relationship Between Marginal and Average Costs

Average total cost will fall when marginal cost is above average variable cost, so long as average variable cost does not rise by more than average fixed cost falls.

Relationship Between Marginal and Average Costs

$90 ATC MC 80 Area A Area C 70 60 AVC Area B ATC 50 AVC 40 30 B 20 A MC 10 Q0 Q1 0 1 2 3 4 5 6 7 8 9 Quantity of output

Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases.

Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases.

Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output increases.

 The goal of firms is to maximize profit, which equals total revenue minus total cost. When analyzing a firms behavior, it is important to include all the opportunity costs of production. Some opportunity costs are explicit while other opportunity costs are implicit.

 A firms costs reflect its production process.

A typical firms production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product. A firms total costs are divided between fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output produced; variable costs do change as the firm alters quantity of output produced.

 Average total cost is total cost divided by the quantity of output. Marginal cost is the amount by which total cost would rise if output were increased by one unit. The marginal cost always rises with the quantity of output. Average cost first falls as output increases and then rises.

 The average-total-cost curve is U-shaped. The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC. A firms costs often depend on the time horizon being considered. In particular, many costs are fixed in the short run but variable in the long run.