Modern Theory of Cost

MODERN THEORY OF COSTS The U-shaped cost curves of the traditional theory have been questioned by various writers both on theoretical a priori and on empirical grounds. Like the traditional theory, modern microeconomics distinguishes between short-run and long-run costs. SHORT-RUN COSTS: As in the traditional theory, short-run costs are distinguished into average variable costs (AVC) and average fixed costs (AFC). The average fixed cost: The fixed costs include the costs for: a) The salaries and other expenses of administrative staff; b) The wear and tear of machinery (standard depreciation allowances); c) The expenses for maintenance of buildings; d) The expenses for the maintenance of land on which the plant is installed and operates. As in the traditional theory of cost, the average fixed costs (AFC) in modern microeconomics also plots as a rectangular hyperbola (figure 1). C

AFC 0 / 3

Figure 1

X / 3

The average variable cost: The AVC of modern microeconomics includes the cost of: a) Direct labour which varies with output; b) Raw materials c) Running expenses of machinery. The SAVC in modern theory has a saucer-type shape, that is, it is broadly Ushaped but has a flat stretch over a range of output (figure 2).

C / 3 SAVC MC

MC SAVC=MC

0 / 3

Figure 2

X / 3

The flat stretch corresponds to the built-in-the-plant reserve capacity. Over this stretch the SAVC is equal to the MC, both being constant per unit of output. To the left of the flat stretch, MC lies below SAVC, while to the right of the flat stretch the MC rises above the SAVC. The falling part of the SAVC shows the reduction in cost due to the better utilization of the fixed factor and the consequent increase in skills and productivity of the variable factor (labour). With better skills the wastes in raw materials are also being reduced and a better utilization of the whole plant is reached. The increasing part of the SAVC reflects reduction in labour productivity due to the longer hours of work, the increase in cost of labour due to overtime payments (which is higher than the current wage), the wastes in materials and the more frequent breakdown of machinery as the firm operates with overtime or with more shifts. The traditional theory assumes that each plant is designed (without any flexibility) to produce optimally only a single level of output. The innovation of modern microeconomics in this field is the theoretical establishment of a short-run SAVC curve with a flat stretch over a certain range of output. In figure 2, the range of output X1 X2 reflects the planned reserve capacity which does not lead to increases in costs and the entrepreneur expects to operate his plant within the X1 X2 range. Usually firms consider that the ‘normal’ level of utilization of their plant is somewhere between two-third and three-quarters of their capacity.

The average total cost: The average total cost is obtained by adding the average fixed and the average variable costs at each level of output. The ATC is shown in figure 3.

SATC

C

MC SAVC

SAVC

MC SAVC=MC

AFC 0

Figure 3

X / 3

The ATC curve falls continuously up to the level of output (X2) at which the reserve capacity is exhausted. Beyond that level ATC will start rising. The MC will intersect the average total-cost curve at its minimum point (which occurs to the right of the level of output X2, at which the flat stretch of the AVC ends). LONG-RUN COSTS: Long-run cost curve in the modern microeconomic theory is roughly L-shaped. Long-run costs are distinguished into production costs and managerial costs: Production costs: Production costs fall sharply to begin with and then gradually as the scale of production increases. The L-shape of the production cost curve is explained by the technical economies of large scale production. Initially these economies are substantial but after a certain level of output is reached all or most of these economies are attained and the firm is said to have reached the minimum optimal scale, given the technology of the industry. Managerial costs: In the modern management science for each plant size there is a corresponding organizational-administrative set-up appropriate for the smooth operating of that plant. The cost of different techniques of management first fall up to a certain plant size. At very large scales of output managerial costs may rise, but very slowly. In summary: Production costs fall smoothly at very large scales, while managerial costs rise only slowly at very large scales. Modern theorists seem to accept that the fall in production costs more than offsets the probable rise in managerial costs, so that the LAC curve falls smoothly or remain constant at very large scales of output. Assuming that a plant is used ‘normally’ when it operates at two-third of its full capacity, we may draw the LAC curve by joining the points on the SATC curves corresponding to the two-third of the capacity of each plant size. If we assume that there are a very large number of available plant sizes the LAC curve will be continuous as shown in figure 4.

C

Cost

SATC1 SATC2 SATC3

SATC4

2/3

LAC 2/3 2/3

2/3 X

0

Output

Figure 4

The characteristics of this LAC curve are that: a) It does not turn up at very large scales of output; b) It is not the envelope of the SATC curves, but rather intersects them (at the level of output defined by the ‘normal’ capacity of each plant). If the LAC falls continuously (though smoothly at very large scales of output), the LMC will lie below the LAC at all scales as shown in figure 5. If there is a minimum optimal scale of plant (x1 in figure 6) at which all possible economies are reaped and beyond that scale the LAC remains constant, the LMC lies below the LAC until the minimum optimal scale is reached and coincides with the LAC beyond that level of output as shown in figure 6.

C LAC C

LMC

LMC

LAC=LMC

LAC 0 0

X

X

Figure 6 Figure 5

*

The above shapes of costs are more realistic than the U-shaped costs of traditional theory, as most of the empirical studies on cost have provided evidences which substantiate the hypotheses of a flat-bottomed SAVC and of an L-shaped LAC.