How The Cost of Production Applies in The Practical Arena?

A Report

By

P.T. Attygalle

Business Economics

My advice to the readers who follow this guide. 

This is a report that I created and published with my knowledge and experience in Business Economics of 2nd year 1st schemester. Maybe it’s not a fully completed guide and it may have some errors too. 

So, if you are following this try not to use any copy-pasting technique. Also, I have disabled that feature and if you copy something and paste it on your assignments, the result will reduce or cancel the full marks. Because there are so many tools that we can check the plagiarism. So take this content, study, and make a new one with your own words. All prices are in the Sri Lankan Rupees. You can convert them into your currency from google currency converter.

Table of Contents

1. Production Process
2. Building a PC for Educational Package
3. Cost structure Fixed cost & Variable cost
4. Reasons for incurring this kind of cost
5. Short-run production process
6. Identifying the fixed cost and variable cost relating to the production level
7. How to calculate TC / TVC and TFC?
8. Total cost for our production levels and behavior of the cost curves
9. The behavior of the cost curves of short-run
10. What are the solutions to overcome the issues of this behavior of the cost curves?
11. Profit Maximization in short-run – TR / TC approach
12. Average cost (AC), Average variable cost (AVC), and average fixed cost (FC) for our production levels and behavior
13. How to calculate average costs?
14. The behavior of AC/AVC and AFC
15. How to overcome the issues of this behavior of the cost curves?
16. Profit maximization output in the short run
17. The behavior of the marginal cost (MC) and average total cost (AC/ATC) in the short run
18. Relationship between Average Cost and Marginal Cost
19. Average product (AP) and average cost (AC)
20. What is the optimum production level?
21. Long-run production of V Tech Computers
22. The long-run cost structure of the V tech computers
23. Is there any relationship between short-run and long-run ATC’s/AC’s?
24. The Law of Returns to Scale
25. Which point would you wish to choose to do the production?
26. Long-run equilibrium – Profit maximization in the long run
27. Profit maximizing output total and marginal approaches
28. Profit maximizing output – Total approach
29. Profit maximizing output – Marginal approach

Production Process

Building a PC for Educational Package

1^st step – Take the PC case and install the motherboard

2^nd step– Install the CPU and cooler apply thermal paste

3^rd step– Install PSU

4^th step– Install DVD writer

5^th Step– Install the hard drive

6^th step– Install the graphic card

7^th step– Install CMOS battery

8^th step– Install the ram

9^th step – Close the case and plug in all of the other accessories (power cable, mouse, keyboard, speakers, webcam)

10^th step – Connect the monitor

Cost structure Fixed cost & Variable cost

Fixed Cost

Variable Cost

Reasons for incurring this kind of cost

As a company, we need to spend for our production process. When it came to short-run production, we have to face two kinds of cost structures. Those are Fixed cost (TFC) and variable cost (TVC).

What is TFC – Total fixed cost is the cost of the fixed assets that do not vary with production. Examples of fixed costs include rental lease payments, salaries, insurance, property taxes, interest expenses, depreciation, and potentially some utilities.

What is TVC – Total variable cost is the cost paid to the variable input. Inputs include labor, capital, materials, power, and land, and buildings. Variable inputs are inputs whose use vary with output.

Also during the short-run production process, this variable cost will be increased with the production because of the variable inputs.

Short-run production process

Our short-run production is depending on fixed and variable inputs which we mentioned above cost structure. We’ll try our best the increase our short-run production and reduce the cost of one product. It means the company will try its best for production efficiency.

Our product equation

Q = f (L, K, R, T)

(L = Labor, K = Capital, R = Row Material, T = Technology)

Identifying the fixed cost and variable cost relating to the production level

This is the total fixed cost and total variable cost for some of our production levels.

How to calculate TC / TVC and TFC?

TC=TVC+TFC or AVC x Q

TVC=TC-TFC or AVC x Q

TFC=TC-TVC or AFC x Q

 

Total cost for our production levels and behavior of the cost curves

 

 

 

What is the law of variable proportions

the law exhibits the relationship between the units of a variable factor and the amount of output in the short term. This is assuming that all other factors are constant.

The law states that keeping other factors constant, when you increase the variable factor, then the total product initially increases at an increasing rate, then increases at a diminishing rate, and eventually starts declining.

The behavior of TC curve

This TC curve is consisting of the value of the TVC curve and the TFC curve (TC = TFC + TVC). This curve is also an inverted S upward sloping curve. The slope of this TC curve depends on this TVC curve also the difference between of this TC and the TFC curves will depend on the TFC curve. TC curve is placed above the TVC curve at a vertical distance equal to the TFC.

What are the solutions to overcome the issues of this behavior of the cost curves?

When we consider the above graph, we can see our cost curves (TVC, TC) gets inverted S upward sloping shape. So it’s 0-3 area TVC is increasing a lower rate after that it’s increasing a higher rate. In here we need to clarify one best point for our production process. So we need to illustrate the profit curve for deciding the profit maximization output. In the short run, we will choose the maximum production level which we can achieve with this TFC and the technology to overcoming the issues of this cost curve.

Profit Maximization in short-run – TR / TC approach

Below the level of output 0-5 area company incur losses because TC is higher than TR. Then when it came to 6 company earn profits. In the 11^th level of output, they can earn the maximum level of profit.

 

 

 

In here, the point where TC and TR will intersect is known as the break-even point (Q= 2.5).

However, this approach is not free from defects. Firstly, a visual inspection suggests the maximum distance between TR and TC. But it is not easy to determine the exact volume of output where the vertical distance between TR and TC curves is the greatest.

Secondly, we do not know the price per unit of output sold. To obtain price, we will have to divide total revenue by the total output.

Average cost (AC), Average variable cost (AVC), and average fixed cost (FC) for our production levels and behavior

 

 

 

Let’s move on to calculate and illustrate the average cost, average variable and average fixed cost of the Educational Package

 

 

 

 

 

How to calculate average costs?

AFC=TFC÷Q or ATC-AVC

AVC=TVC÷Q or ATC-AFC

AC=TC÷Q or AVC+AFC

The behavior of AC/AVC and AFC

In here we can see the cost of one unit of our Educational Package.

Average Fixed Cost (AFC) – Fixed cost per unit of output.

Our TFC is RS 62,000 during the short-run production process and also we can’t increase it within a limited time period. Therefore, that TFC will remain to our whole production period in the short run. So, our AFC is illustrated from this amount divided by the level of production. As a result of this, our AFC curve gets a downward sloping shape (above chart). Since TFC is constant, any increase in output decreases the AFC. While the AFC can become really small, it is never zero.

Average variable cost (AVC) – variable cost per unit of output

Average variable cost is the total variable cost divided by the number of units produced. So in here, we can see our TVC curve will get a U shape during the short run. Usually, the AVC falls as the output increases from zero to 4. After that, AVC rises steeply due to the operation of diminishing returns.

Law of diminishing returns.

When we increase our production level using variable factors while fixed inputs remain the same, our average production cost is decreased until 4 units of outputs. After that our AVC again increased. This will cause the U shape of the AVC curve. When increasing variable inputs while technology and fixed inputs are the same the result will be increasing variable cost after it reaches a maximum point of output.

Assumptions

·         Technology is assumed to be given and unchanged.

·         There must be a fixed factor (at least one).

·         All units of variable factors of production are assumed to be homogeneous.

Average cost (AC) – total cost per unit of output

The average total cost is the sum of the average variable cost and the average fixed costs. According to the above graph, this average cost curve will also get a U shape. This ATC curve will depend on the behavior of AVC and the AFC. In the beginning, both AVC and AFC curves fall (graph). Hence, the ATC curve falls as well. Next, the AVC curve starts rising in the 4^thlevel of production, but the AFC curve is still falling. Hence, the ATC curve continues to fall. This is because, production level 4 to 5, fall in the AFC curve is greater than the rise in the AVC curve. As the output rises further, the AVC curve rises sharply. This offsets the fall in the AFC curve. Hence, the ATC curve falls initially and then rises.

How to overcome the issues of this behavior of the cost curves?

In here we can understand we were unable to find a suitable point for the company to operate.

Profit maximization output in the short run

To overcome the issues of these cost curves company needs to find the best point for operating their business in the average cost curves. That means we need to find our profit maximization output.

The Profit Maximization Rule states that if a firm chooses to maximize its profits, it must choose that level of output where Marginal Cost (MC) is equal to Marginal Revenue (MR) and the Marginal Cost curve is rising. In other words, it must produce at a level where MC = MR.

According to our calculations, there are two points in the above graph which MC equals MR (production levels 1 and 6). But in production level 1, we can produce more it’ll be helpful to cover TFC. So production level 6 is the best point for the company to operate according to the marginal approach.

The behavior of the marginal cost (MC) and average total cost (AC/ATC) in the short run

Already we were able to identify the behavior of the AC curve. Let’s talk about the MC.

What is marginal cost (MC)

Marginal cost is the addition made to the cost of production by producing an additional unit of the output.

MC=∆TC/∆Q

Relationship between Average Cost and Marginal Cost

·         When we consider the average cost and the marginal cost of our company, we can understand 0 level of output to 4^thunit of output, our AC curve is decreasing. During this period our MC curve is decreasing at a higher rate than the AC curve (above chart).

·         From then, our AC curve started to increase. During the period of increasing of AC curve, we can see our MC curve is also increasing at a higher rate than the AC curve.

If the average cost is a minimum, then marginal cost = average cost

Average product (AP) and average cost (AC)

·         According to the following charts our average cost curve is decreasing to the 0 – 4^th level of output. In the 4^thunit of output, our average cost reaches the minimum amount. From then it’s started to increase again. The meaning of that is our production cost for one unit is decreasing until we increase our production level to 4 then again it’s decreasing.

·         Also our average product is increasing to the 0-4^th level of output. And it becomes to the maximum amount of in the 4^th unit. When we increase the production level more than the 4^th unit, again our average product is started to decrease.

·         So in here we can see when the average cost decreases, the average product is increasing. When it becomes to the minimum point, an average product reaches the maximum point (in the 4^th unit). From then, the average cost started to increase again. So, therefore, our average product again started to decrease.

·         The average cost (AC) curve looks like the average product (AP) curve turned upside down with the minimum point of the AC curve corre­sponding to the maximum point of the AP curve.

What is the optimum production level?

In here we can see best production level for the company is 4^th unit of output level. Because of that, at that point, the average cost of the company is at its minimum level. Also, the average product curve reaches its maximum level in the 4^th unit of output. So according to these charts, we can assume that unit 4 is the optimum level for the production.

Long-run production of V Tech Computers

After once we reach the targets of the short-run production of our company, we were able to upgrade our technology, and also we were able to change and insert more fixed factors to the business. As a result of this in the long run we don’t have any fixed inputs. Because all the factors are variable. Also, the company expects to reduce production costs by improving technology.

·         As we expected, we hope to start our new store in the Colombo area.

·         Also the company will move on to a new place which is owned to the company.

·         With the new technical software improvements, we don’t need to buy them.

·         Our market researchers identified there are some persons in the country, who are willing to buy laptops and other computer accessories in the global market like eBay / Ali Express. So company decides to start an online store on eBay.

Long-run cost structure of the V tech computers

Is there any relationship between short-run and long-run ATC’s/AC’s?

The simplest answer to this question is yes. Let’s see what is the relationship between short-run and long-run ATC / AC.

In the long run, all costs of a firm are variable. The factors of production can be used in varying proportions to deal with increased output. The firm having a time period long enough can build a larger-scale or type of plant to produce the anticipated output. The shape of the long-run average cost curve is also U-shaped but is flatter than the short-run curve as is illustrated in the above diagram.

The relationship Between Short-Run and Long-Run Average Total Costs shows how a firm’s LRAC curve is derived.

This long-run – LRAC (LAC) curve is illustrated using short-run ATC curves. The shape of the LRAC curve depends on these AC curve. The LRAC curve is found by taking the lowest average total cost curve at each level of output. As of this example when we came to the minimum value of each AC curve (AC1-AC9) we can see the long-run average cost (LRAC) curve.

The reason for this ‘U’ shape of the LRAC curve is the law of returns to scale.

The Law of Returns to Scale

The law of returns to scale explains the proportional change in output with respect to the proportional change in inputs. In other words, the law of returns to scale states when there is a proportionate change in the amounts of inputs, the behavior of output also changes. 

Types of the law of return to scale

·         Increasing Returns to Scale- LRAC will decrease. (0-4^th unit of output in the above chart)

·         Constant Return to Scale- LRAC will be constant (4-5^th level of output)

·         Decreasing Returns to Scale- LRAC will increase (5-9^th level of output)

Which point would you wish to choose to do the production?

Long run equilibrium – Profit maximization in long run

Profit maximization depends on producing a given quantity of output at the lowest possible cost, and the long-run equilibrium in perfect competition requires zero economic profit. Therefore, firms ultimately produce the output level associated with minimum long-run average total cost.

The marginal cost must pass through the minimum point of the average total cost. Therefore, in the long-run equilibrium, price equals three costs.

·         minimum long-run average total cost- LRATC

·         the minimum point on one short-run average-total-cost curve- SRATC

·         marginal cost- MC

(The illustration shows the long-run equilibrium in perfect competition.)

This price also corresponds to the minimum long-run average total cost to ensure zero economic profit in the long run. Thus, new firms have no incentive to enter the market, and existing firms have no incentive to leave the market. Price or marginal revenue equals marginal cost at Q0, ensuring that profit is maximized. The long-run equilibrium requires that both average total cost is minimized and price equals average total cost (zero economic profit is earned).

Profit maximizing output total and marginal approaches

Profit maximizing output – Total approach

In the total approach, if we need to calculate the profit maximization output, we need to draw the total revenue and find the revenue of the company of each production level. Then we can illustrate the profit curve.

So in here, we can see 0-2.5 production area companies incur losses. Because TR is lower than TC. When it becomes to 3^rd unit, the company started to earn profits because TC is lower than TR. But there will be one point for profit maximization. According to these calculations, in the 5^thunit of the production company can reach the maximum amount of the profit. So we can identify it as the profit maximization output.

Profit maximizing output – Marginal approach

The Profit Maximization Rule states that if a firm chooses to maximize its profits, it must choose that level of output where Marginal Cost (MC) is equal to Marginal Revenue (MR) and the Marginal Cost curve is rising. In other words, it must produce at a level where MC = MR.

According to our calculations, there are two points in the above graph in which MC equals MR (production levels 1 and 6). But in production level 1 we can produce more it’ll be helpful to cover TFC. So production level 6 is the best point for the company to operate according to the marginal approach.