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9Costs of Production and the Financing of a Firm SATYADAS_CH_09.qxd 9/13/2007 2:27 PM Page 202 Costs of Production and 9 the Financing of a Firm CONCEPTS ● Explicit Costs ● Implicit Costs ● Accounting Costs ● Economic Costs ● Short-run Cost Concepts ● Long-run Cost Concepts ● Fixed or Total Fixed Cost ● Overhead Costs ● Variable Cost or Total Variable Cost ● Total Cost ● Marginal Cost ● Average Fixed Cost ● Average Variable Cost ● Average Cost or Average Total Cost ● Plant Size ● Economies of Scale ● Division of Labour ● Diseconomies of Scale ● Social Cost ● Private Cost ● Externality ● Positive Externality ● Negative Externality ● Plough Back of Profits ● Retained Earnings ● Loans from Financial Institutions ● Mortgage ● Equity and Debt Instruments 202 SATYADAS_CH_09.qxd 9/13/2007 2:27 PM Page 203 Costs of Production and the Financing of a Firm 203 owards the end of the last chapter we saw that as output increases, the total cost rises. But there is much more to it than just that. In this chapter we Tstudy in detail various types of costs and their relation to output. To begin with, there are explicit costs and implicit costs. Explicit costs are those, which are directly paid to other parties by an entrepreneur or a company running a business. They include, for example, the costs of labour, raw material, machinery purchased and so on. Implicit costs are those for which there is no direct payment but indirectly there is a cost involved. Suppose you own a two-storey building. You live on the first floor and operate a small publishing company on the ground floor. Obviously, you do not have any rental cost of business operation. But there is an implicit cost. If you had otherwise rented out the ground floor to some other party, you would have obtained some rental income. By using it for your own business, you are effectively losing that income—and that is an implicit cost. Similarly, if you use your own savings in the business, the interest income foregone is an implicit cost. Explicit costs are more commonly called accounting costs. Accounting costs plus implicit costs of the kind described above reflect the true cost of running a business and are called economic costs. In economic analysis, costs always refer to economic costs. In this chapter, we will be concerned with various cost concepts based on the time horizon of an entrepreneur, namely, the short run and the long run. There is no par- ticular calendar time like a month, quarter or year that distinguishes between the short run and the long run. Rather, as will be seen, the distinction is drawn from a production planning perspective. SHORT-RUN COST CONCEPTS If you think of a firm at a given point of time, like a snapshot, everything is fixed. The firm is producing a given amount by using a given amount of inputs and the inputs are paid their prices. All costs are given or fixed. But if we imagine the func- tioning of a firm over a relatively short length of time (like a movie), we can distin- guish between costs that are fixed and those that are not. Suppose you run a clothing store. In a span of, say, one or two months, it is likely that the rental cost of the rooms you use are fixed in the sense that how much you pay as rent does not depend on how much you sell or produce. You may have signed a lease with the landlord for six months with a specified rent and your landlord (unless he is very kind) is going to charge you that rent—irrespective of how well you are doing in your business or even if you decide to produce nothing. That is why, generally, the rental cost is con- sidered fixed in the short run. But typically labour costs are not fixed because work- ers can be hired and fired on a short notice by a firm. Costs of raw materials (for example, cloth bought in the wholesale market) are not fixed as you can buy more or less of them depending on the state of your business. As another example, suppose Dr Juneja owns a diagnostic centre. It is located in a one-storey flat, inherited from his father. He employs about 30 people including SATYADAS_CH_09.qxd 9/13/2007 2:27 PM Page 204 204 Microeconomics for Business nurses, technicians, management employees and manual workers. By taking loans from a bank he has bought several high-tech machines that do CAT scan, MRI, ultrasound tests and so on. Every month he repays the bank Rs 2 lakh in instalment towards his loan plus interest. This is an example of fixed cost because it is inde- pendent of how many patients come to Dr Juneja’s centre for service. There is also an implicit rental cost of the flat, equal to the rent foregone by using the flat for the diagnostic centre. This is also a fixed cost. However, depending on how this ven- ture is going, Dr Juneja can hire more or less of nurses or manual workers within a short notice. Hence, payment to nurses and other workers are not fixed. Over a longer time horizon, however, an entrepreneur can think of explicitly or implicitly renting a different amount of space, a different plant size, different number of machines and so on. In other words, in the long run there are no fixed costs. Returning to the short run, we then say that a firm has two types of costs, fixed cost and variable cost. Fixed costs are those costs that do not change with output. In common business terminology, these are called overhead costs. Variable costs refer to those that vary with the output. Typically, rental costs of land and capital are fixed and labour and raw material costs are variable. More formally, these are respectively called total fixed cost (TFC) and total variable cost (TVC). The sum of the two costs is simply called the total cost (TC). That is, TC = TFC + TVC. (9.1) These costs—TFC, TVC and TC—when graphed against the output, give us the TFC, TVC and TC curves respectively. See Figure 9.1 (but ignore for now the tangents, the point a and the dotted lines from this point). The TFC curve is a horizontal straight line (having zero slope) because TFC is independent of the output level. The TVC curve is upward sloping because producing more would cost more. Figure 9.1 TFC, TVC and TC Curves Rs TC TVC a TFC 0 y0 Output SATYADAS_CH_09.qxd 9/13/2007 2:27 PM Page 205 Costs of Production and the Financing of a Firm 205 Since TC is the sum of TFC and TVC and costs are measured along the vertical axis, the TC curve is the vertical sum of the TFC and TVC curves. That is, at any output level, if we measure the TFC and TVC on the vertical axis and add them up, we get the corresponding point on the TC curve. Like the marginal product and average product, we define marginal cost and average cost. Marginal cost (MC) is the addition to the total variable cost per one extra unit produced. It is also equal to the addition to the total cost per one extra unit produced since the difference between the TVC and TC is fixed. In the graph, MC is the slope of the TVC and the TC curves. You see in Figure 9.1 that as the out- put increases, the slope of TVC initially falls and then rises. This means that the MC curve (measuring MC against output) will be downward sloping first and then upward sloping. Put differently, it is U-shaped as shown in Figure 9.2(a). Also, since MC is the addition to the TVC, the area under the MC curve equals the TVC.1 Similarly, we can define Average Fixed Cost (AFC) ≡ TFC/Output Average Variable Cost (AVC) ≡ TVC/Output Average Total Cost (ATC) ≡ TC/Output, where the symbol ‘≡’ means ‘equal to by definition’. The AFC, AVC and ATC curves are drawn in Figure 9.2(b). The AFC is uniformly downward sloping by its definition—as output increases, its denominator increases while the numerator remains unchanged.2 The shapes of the AVC and ATC curves depend on the shape of the TVC or the TC curve. Referring back to Figure 9.1 again, see that at output y0, for instance, TVC = y0a and thus AVC = y0a/0y0, which is the slope of the ray 0a. If we let the output gradually increase from zero, this slope increases up to a point and then decreases. This implies that the AVC curve will be U-shaped. The argu- ment behind the ATC curve being U-shaped is similar. Figure 9.2 MC, AVC and ATC Curves Rs Rs Rs MC ATC MC ATC AVC B A AVC TVC AFC 0 0 0 y0 OutputOutputOy1 utput (a) (b) (c) 1It cannot be equal to TC as it cannot account for the fixed cost. 2Indeed, the AFC curve is shaped like, what is called in geometry, a rectangular parabola, analogous to the unitarily elastic demand curve. SATYADAS_CH_09.qxd 9/13/2007 2:27 PM Page 206 206 Microeconomics for Business Finally, turn to Figure 9.2(c) (and ignore for now the output marked y1). The mathematical relationship between the ‘average’ (A) and the ‘marginal’ (M) holds. Remember from the last chapter that M < A if A is falling and M > A if A is rising. Since AVC falls initially, MC < AVC; when AVC rises, MC > AVC. The implication is that the MC curve must cut the AVC curve at the latter’s minimum point.
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