Managerial

Economics
Chapter 4: Costs of Production
Private & Social Cost
Private costs for a producer of a good, service, or activity
include the costs the firm pays to purchase capital
equipment, hire labor, and buy materials or other inputs.
While this is straightforward from the business side, it also is
important to look at this issue from the consumers'
perspective. Field, in his 1997 text, Environmental
Economics provides an example of the private costs a
consumer faces when driving a car:
1

The private costs of this (driving a car) include the fuel and
oil, maintenance, depreciation, and even the drive time
experienced by the operator of the car.
Private costs are paid by the firm or consumer and must be
included in production and consumption decisions. In a
competitive market, considering only the private costs will
lead to a socially efficient rate of output only if there are no
external costs.

External costs, on the other hand, are not
reflected on firms' income statements or in
consumers' decisions. However, external costs
remain costs to society, regardless of who pays for
them.
Consider a firm that attempts to save money by not
installing water pollution control equipment.
Because of the firm's actions, cities located down
river will have to pay to clean the water before it is
fit for drinking, the public may find that recreational
use of the river is restricted, and the fishing industry
may be harmed.
When external costs like these exist, they must be
added to private costs to determine social costs
and to ensure that a socially efficient rate of output
is generated.

Social costs include both the private costs and any
other external costs to society arising from the
production or consumption of a good or service.
Social costs will differ from private costs, for
example, if a producer can avoid the cost of air
pollution control equipment allowing the firm's
production to imposes costs (health or
environmental degradation) on other parties that are
adversely affected by the air pollution.
Remember too, it is not just producers that may
impose external costs on society. Let's also view
how consumers' actions also may have external
costs using Field's previous example on driving:
2


The social costs include all these private costs (fuel,
oil, maintenance, insurance, depreciation, and
operator's driving time) and also the cost
experienced by people other than the operator who
are exposed to the congestion and air pollution
resulting from the use of the car.
The key point is that even if a firm or individual
avoids paying for the external costs arising from
their actions, the costs to society as a whole
(congestion, pollution, environmental clean up,
visual degradation, wildlife impacts, etc.) remain.
Those external costs must be included in the social
costs to ensure that society operates at a socially
efficient rate of output.

Accounting and Economic Costs
Accounting cost: take care of all the payments and
charges made by the entrepreneur to the suppliers of
various productive factors known as Explicit Cost
E.g. Wages, Raw materials, fuel & power used, rent,
interest.
Economic Cost: if the money invested in the business
invested else where, would fetch interest & dividends.
Entrepreneurs time and effort would bring him salary.
EC includes (a) normal return on money capital invested by
the entrepreneur himself in his own business (b) the
wages or salary not paid to the entrepreneur but could
have been earned if the services had been sold
somewhere else.
EC includes Both Accounting & Implicit Cost
Cost Estimation & Cost
Forecasting
In a long run, a firm has to aim at optimum profits if it
has to survive in the market.
In a competitive world, profit is an index of efficiency.
Profit is governed by two variables TC & TR.
Hence behavior of costs along with changes in output
occupy an important position.
Present costs are known but this is not enough
Future behavior of costs also needs to be taken into
account since every firm plans for the future.
The broad head is forecasting under which one can
include demand, cost, sales forecasting, etc.
Methods of CE & CF
1. Engineering method
Least cost combination of factor of production can be
technically provided y the engineers & hence the
name
Any given product uses certain inputs.
Wherever these inputs can be substituted, they
provide opportunities of finding out the least cost
combination.
Given the prices of inputs and the quantities of each
used in the least cost combination, one can find out
the costs for estimated levels of output.
Cost forecasts therefore will have to be worked out on
the basis of demand forecast.
For example; IC-1, IC-2, IC-3 are Iso-costs.
Any point on each Iso-cost shows various
combinations of capital & labor within the
same cost.
If we suppose that IC-1=Rs. 10,000 then,
several combination of K(capital) + L (labor)
given by all the points on IC-1 would together
cost Rs. 10,000/-
IQ-1, IQ-2,etc., are Iso-Quant meaning equal
product curves.
Every point on the same curve would
represent the same quantity of output.

If we suppose IQ-1 for 100 units, then, all
the points on IQ-1will show 100 units.
Points t-1 then shows the least cost
combination of capital and labor since
only at this point, 100 units can be
produced at a cost of Rs. 10,000/-.
In this way if we draw an Iso-Quant map
with Iso-costs, we get the path of
expansion as shown by the dotted line
OP.
Depending upon how much the firm
expects to produce, the cost as well as
the least cost factor combinations can be
predicted with the help of the path OP.

Limitation
This method takes into account current
factor prices(e.g. current wage rates,
interest rates).
If they change over time (as they always
do), the projection may go wrong. It
becomes necessary to estimate possible
changes also.
Another limitation is that this method is
based on the current state of technology.
If the technology changes in future, the
forecasts will go wrong and will have, to be
revised.
Survivorship method
Advocated by Prof. Stigler
for using this technique, all the firms in an industry are
divided into various groups and then, over a period of
time, the growth of each group is examined.
For E.g. in the Table:
Group Share in Industry Output (%)
Base Year Current Year
Small 10 11
Medium 35 54
Large 53 35
In this table a base year is taken to compare with the current
year.
Let us say base year is 2001 and current year is 2010.
Then we find that over a period of 10 years, the share of
small firms in the total output of the industry has marginally
increased from 10% to 11%.
The share of the large firms has considerably decreased
from 55% to 35%.
However, the share of the medium-sized firms has improved
from 35% to 54%.
It thus becomes obvious that the large-sized firms are the
most inefficient because they find it difficult to survive.
While medium-sized firms are the most efficient as they
appear to grow in importance.
Because survival is taken to indicate the cost-effectiveness
and efficiency, this method is known as Survivorship method.
The lowest average cost of the medium-sized firm is then
taken as a norm.
If a firm expects to survive (& flourish), it has to aim at the
optimum size and corresponding lowest cost.
Cost-predictions of such a firm then becomes relevant.
Limitation
This method is useful only where a very high
degree of competition exists.
There too, it only gives approximations of
size and costs
It gives a broad range of output but does not
spell out the detailed cost-output relationship
in the form of a cost function
Statistical method
A variety of statistical techniques can be used for
forecasting costs.
What is required is the data regarding historical costs
and cost determinants.
For this purpose data of one firm can be used, or that of
all firms in an industry can be used.
All determinants of costs need to be carefully identified.
Effects of inflation should be properly handled.
Once the function is formulated and data are ready, one
can use regression analysis for cost forecasting.
Similarly, simple moving averages can also be used.

Limitation
Past or historical costs are the basis of these
forecasts.
They remain relevant so long as the cost function
remains the same. E.g. Change in rate of RM &
labor will necessitate to refine forecasts
Changes in technology are the most remarkable
feature of modern industrial economics. These
changes makes forecasts difficult
In case of new products, for want of historical
data, forecasts become difficult to arrive at.