Modern Theory of cost: short run and long run PDF

Preview

Summary

Modern Theory of cost: short run and long run...

Description

Subject

ECONOMICS

Paper No and Title

3- Fundamentals of Microeconomic Theory

Module No and Title

17- Modern Theory of cost: short run and long run

Module Tag

ECO_P3_M17

ECONOMICS

Paper 3- Fundamentals of Microeconomic Theory Module 17- Modern Theory of cost: short run and long run

Table of Contents 1. Learning Outcomes 2. Introduction 3. Short Run theory of costs 3.1 Average Fixed Cost 3.2 Average Variable Cost 3.3 Marginal Cost 3.4 Relationship between different cost concepts 4. Long-run theory of costs 4.1 Economies and Diseconomies of scale 4.2 Long- run costs and its components 4.3 Measures of Economies of scale 5. Summary

ECONOMICS

Paper 3- Fundamentals of Microeconomic Theory Module 17- Modern Theory of cost: short run and long run

1. Learning Outcomes After studying this module, you shall be able to • • • • •

Know about modern theory of costs Learn the difference between the traditional and modern theory of costs Identify reserve capacity Evaluate Economies and diseconomies of scope Analyze different types of shapes of Long run costs

2. Introduction

MODERN THEORY OF COSTS: The Modern theory suggests the existence of ‘built- in- reserve capacity ‘which imparts flexibility and enables the plant to produce larger output without adding to the costs. Built –in- reserve capacity are planned by firms. Modern theory of costs does not agree with the U-shape of the cost curves. The short-run cost curve has a saucer- type shape whereas the long-run Average cost curve is either L-Shaped or inverse J-shaped. According to the Modern theory of costs, the firm can produce a range of output and not a single level of output as under the traditional theory of cost. Firms build industrial plants with some flexibility in their productive capacity so that instead of a single output level, there is a whole range of output that can be produced optimally at low cost. The ‘Built-in Reserve capacity’ provides ‘maximum flexibility’ in the production process. The Planned reserve capacity explains the ‘Saucer – shaped’ short run average variable costs.

The Modern theory of cost stresses on the role of economies of scale, which significantly enables the firm to continue production at the lowest point of average cost for a considerable period of time. The firm checks diseconomies of scale by planning in advance and enjoys the gains of production in comparison to the traditional theory where the average cost rises after the firm reaches the optimal level of output. Developments in managerial economies explain the L – Shaped and inverse J –Shaped LAC Curves.

ECONOMICS

Paper 3- Fundamentals of Microeconomic Theory Module 17- Modern Theory of cost: short run and long run

3.

Short-Run Costs Curves under Modern Theory

The short-run Average costs consist of the Average fixed costs and Average variable costs. Because of the U- shaped AVC curve under the traditional theory, the Plant is designed to optimally produce a single level of output (at the minimum point of AVC CURVE). In case there is any departure from the optimizing output, there arises an excess capacity or unplanned capacity. If the firm produces a lower level of output OX1 then costs would be high compared to OXm level of output. The short- run Average variable costs (SAVC) has a Saucer-type shape where there is a flat- stretch corresponding to the ‘RESERVE CAPACITY ‘ or the ‘PLANNED CAPACITY ‘ – which the Plant builds to provide flexibility in the firm’s production process.

THE SHAPES OF SHORT-RUN AVERAGE VARIABLE COST CURVES UNDER TRADITIONAL AND MODERN THEORY OF COSTS:

Figure 1

ECONOMICS

Paper 3- Fundamentals of Microeconomic Theory Module 17- Modern Theory of cost: short run and long run

Figure 2

3.1 AVERAGE FIXED COST CURVE:

The Average Fixed cost curve under conditions of Reserve capacity is downward sloping- falling continuously as output expands. AVERAGE COST CURVE is the sum of AFC and AVC. Initially both AFC and AVC are falling up to OX1 level of output causing the Average Cost to fall. Between X1 and X2 level of output, AFC continues to fall but AVC remains constant, causing AC to decline. At X2 level of output, the Reserve capacity is fully utilized and so beyond this point AC starts rising.

3.2 AVERAGE VARIABLE COST: The Average Variable cost is equal to the total variable cost divided by the total output. AVC = TVC ÷ Q = (P × V) ÷ Q, where P is the price per unit of input and Vis the quantity of variable input The Average Variable cost curve is not ‘U’ Shaped as under the traditional theory but ‘trough shaped/ saucer-shaped’ under the Modern theory of cost due to the ‘RESERVE CAPACITY’ maintained by the firm. 3.3 MARGINAL COST CURVE: The MC curve intersects the SAVC curve at its minimum point. Since the SAVC curve reaches its minimum point not at a single point but over the whole flat stretch e 1e2 , therefore the short-run Marginal cost curve (SMC) coincides with the SAVC over the entire range of output corresponding to the flat stretch of the SAVC Curve. For any output less than OX1 , the SMC curve will lie below the Saucer-shaped SAVC curve and for any output higher than OX2 , the SMC curve will be above the SAVC curve. Thus, over the flat stretch pertaining to the Reserve Capacity the short-run marginal cost curve coincides with the SAVC Curve.

ECONOMICS

Paper 3- Fundamentals of Microeconomic Theory Module 17- Modern Theory of cost: short run and long run

Figure no - 3 RELATIONSHIP BETWEEN SHORT-RUN AVERAGE VARIABLE COST AND MARGINAL COST CURVES The falling portions of the SAVC Curve show the reduction in costs due to better utilization of the fixed factors and the consequent rise in productivity of the variable factors. The rising portion of the SAVC Curve depicts the rise in costs on account of diminishing returns from the variable factor and also overutilization of the fixed factors. The SAVC Curve has a flat stretch over a range of output wherein the SAVC is equal to the short run marginal cost, both being constant per unit of output. The short-run Average cost curve continues to fall even over the range of output X1 and X2 corresponding to the flat stretch of the SAVC Curve where in SAVC is assumed to be constant. As Average cost consists of Average fixed cost and Average variable cost and Average fixed cost continues to fall as the level of output increases. Even after the Planned Reserve capacity is exhausted, the Short-run Average cost curve continues to decline despite rise in SAVC because AFC continues to fall throughout. Eventually, the rise in short run Average cost becomes greater than the fall in Average fixed cost and the short-run Average cost starts to rise. The SAC Curve is intersected at its lowest point by the short-run marginal cost curve as in case of the traditional theory of costs. Beyond OX3 level of output, the SAVC Curve asymptotically approaches the short-run Average cost SAC since the gap between the two curves gradually diminishes on account of falling AFC but the two can never coincide because AFC cannot be zero.

ECONOMICS

Paper 3- Fundamentals of Microeconomic Theory Module 17- Modern Theory of cost: short run and long run

4.1 ECONOMIES AND DIS-ECONOMIES OF SCALE: The economies and dis-economies of scale explain why under the traditional theory of costs, the LAC curve is U-shaped and under modern theory, the LAC is L –shaped. Alfred Marshall classified Economies of scale into internal economies and external economies. Internal economies are internal to a firm and are not shared by its competitors in the industry while external economies are those benefits of large –scale production which accrue from outside due to the growth of the whole industry.

4.2 LONG-RUN COSTS UNDER MODERN THEORY; The shape of the long-run cost curve is dependent on the returns to scale. The traditional theory assumes a ‘U’ shaped Long-run cost curve under the presumption that after the optimal level of output, the diseconomies of scale overtake the economies of scale. The modern theory contends that the long run average costs essentially comprised production and managerial costs of which the average production costs continue to fall even at large scales while the managerial costs per unit of output may rise only gradually and at large scales of output. The long-run Average cost curve is ‘L-Shaped’ or inverse J – Shaped under the modern theory of cost. The long run Average cost curve LAC can be derived from the short-run Average cost curves. Under the modern theory of costs, the falling portions of SAC curves are considered to obtain/ derive the LAC Curve. A firm is assumed to operate till its load factor and not full capacity is achieved. Load factor generally lies between two-thirds and three-fourths of the total capacity and corresponds to the falling portion of the short-run Average cost curve. Thus, the long-run Average cost curve does not envelop the SACs but intersects them at the level of output defined by the load-factor of each plant. The existence of economies of scale checks the increase in cost and decreasing returns under the modern theory of costs.

In fig 4, we find that as the average costs of production falls continuously with the increase in the level of output, the LAC curve assumes an inverse J-shaped which signifies that there are no diseconomies of scale even at very large scales of output. If, the average costs of production continues to fall only till a certain optimal level ox1 and beyond that it becomes constant, then the LAC curve is roughly L-shaped and this signifies that the economies and diseconomies of production balance out each other beyond the optimal level of output ox1 . In case of an inverse Jshaped LAC curve, the LRMC will lie below the LAC curve at all output levels since the average costs of production can fall continuously if and only if the LRMC pulls them downwards by remaining below it. If there is a minimum optimal scale of plant. OX1 at which all possible scale economies are reaped, beyond that level of output the LAC remains constant. In this case, the LRMC lies below the LAC curve until the minimum optimal scale is reached and coincides with the LAC beyond that level of output. According to the modern theory of costs, the long run average costs essentially comprised of production and managerial costs, where the fall in production costs more than offsets the rise in managerial costs, thus the LAC curve either falls continuously or remains constant at very large scales of output.

ECONOMICS

Paper 3- Fundamentals of Microeconomic Theory Module 17- Modern Theory of cost: short run and long run

Different shapes of long-run average cost curves under modern theory of costs:

L – SHAPED LONG-RUN AVERAGE COST CURVE Figure no – 4

INVERSE-J SHAPED LAC CURVE Figure no: 5

ECONOMICS

Paper 3- Fundamentals of Microeconomic Theory Module 17- Modern Theory of cost: short run and long run

4.3 MEASUREMENT OF ECONOMIES OF SCALE: Economies of scale are usually measured in terms of cost-output elasticity (Ec ) , where Ec is defined as the percentage change in the cost of production resulting from a 1- percent increase in ∆𝐶/𝐶 output , Ec = , EC relates to the traditional measures of cost and does not show this ∆𝑄/𝑄

relationship, therefore we can rewrite this equation as ∆𝐶/∆𝑄

EC =

=

𝑀𝐶 𝐴𝐶

.

𝐶/𝑄

This equation can be used to measure Ec in different cases and also to know whether there is economies or diseconomies of scale. If Ec = 1, then the firm‘s economies of scale is equal to the dis-economies of scale. If Ec is less than one, then the firm enjoys economies of scale. Finally, if Ec is greater than one, the dis-economies of scale exceed the economies of scale.

SUMMARY ➢ Modern theory of costs does not agree with the U-shape of the cost curves. ➢ The short-run cost curve has a saucer- type shape whereas the long-run Average cost curve is either L-Shaped or inverse J-shaped. ➢ The Modern theory suggests the existence of ‘built- in- reserve capacity ‘which imparts flexibility and enables the plant to produce larger output without adding to the costs. ➢ Built –in- reserve capacity are planned by firms. ➢ Because of the U- shaped AVC curve under the traditional theory, the Plant is designed to optimally produce a single level of output (at the minimum point of AVC CURVE). ➢ In case there is any departure from the optimizing output, there arises an excess capacity or unplanned capacity

➢ The short- run Average variable costs (SAVC) has a Saucer-type shape where there is a flat- stretch corresponding to the ‘RESERVE CAPACITY ‘ or the ‘PLANNED CAPACITY ‘ – which the Plant builds to provide flexibility in the firm’s production process. ➢ Average Fixed Cost under conditions of RESERVE CAPACITY is downward slopingfalling continuously as output expands

➢ AVERAGE COST CURVE is the sum of AFC and AVC. Initially both AFC and AVC are falling, causing the Average Cost to fall. ➢ AFC continues to fall but AVC remains constant, causing AC to decline. After the Reserve capacity is fully utilized, AC starts rising.

ECONOMICS

Paper 3- Fundamentals of Microeconomic Theory Module 17- Modern Theory of cost: short run and long run

➢ The MC curve intersects the SAVC curve at its minimum point. ➢ Since the SAVC curve reaches its minimum point not at a single point but over the whole flat stretch, therefore the short-run marginal cost curve (SMC) coincides with the SAVC over the entire range of output corresponding to the flat stretch of the SAVC Curve. ➢ Over the flat stretch pertaining to the Reserve Capacity the short-run marginal cost curve coincides with the SAVC Curve.

➢ The economies and dis-economies of scale explain why under the traditional theory of costs, the LAC curve is U-shaped and under modern theory, the LAC is L –shaped.

➢ Internal economies are internal to a firm and are not shared by its competitors in the industry while external economies are those benefits of large –scale production which accrue from outside due to the growth of the whole industry. ➢ Economies of scale are usually measured in terms of cost-output elasticity (Ec ) , where Ec is defined as the percentage change in the cost of production resulting from a percent ∆𝐶/𝐶 increase in output , Ec = . ∆𝑄/𝑄

➢ We can rewrite this equation as ∆𝐶/∆𝑄

EC =

=

𝑀𝐶 𝐴𝐶

.

𝐶/𝑄

➢ This equation can be used to measure Ec in different cases and also to know whether there are economies or diseconomies of scale. ➢

If Ec = 1, then the firm‘s economies of scale is equal to the dis-economies of scale.

➢ If Ec is less than one, then the firm enjoys economies of scale. ➢ Finally, if Ec is greater than one, the dis-economies of scale exceed the economies of scale.

ECONOMICS

Paper 3- Fundamentals of Microeconomic Theory Module 17- Modern Theory of cost: short run and long run...