Traditional Theory of Costs

Traditional Theory of Costs

Traditional Theory of Costs

Costs of production of the firm change as it varies its output per unit of time. So a distinction is made between the time period called the short-run and the long-run.

The Short-run

The short-run is a short time period that some inputs of the firm are fixed in amount. The firm can vary its output by varying the amounts of other inputs. The fixed inputs are generally called the fixed factors, while the variable input; are known as variable factors. Land and buildings, top management, plant and equipment are fixed factors, while labour and raw materials are variable factors. The firm can increase or decrease its output in the short period by varying the aggregate amount of variable factors it uses. In other words, the firm, by varying the proportion between fixed and variable factors, can increase or decrease its output.

Corresponding to fixed factors and variable factors, the cost of production of the firm in the short period is also divisible, into two categories- fixed costs and variable costs.

Fixed Costs or Supplementary Costs

These are those costs which in aggregate are absolutely invariant in the short period. Even if output becomes zero, the whole of the aggregate fixed costs would be incurred. Fixed costs are also called overhead costs or supplementary costs or indirect costs.

Variable Costs or Prime Costs

These are costs which in the aggregate vary with output. These costs are added as a result of any increase of output above zero. These costs are also called direct or prime costs.

Fixed costs are incurred over fixed factors. They include depreciation of plant, interest cost on investment and salaries of permanent managerial staff. Variable costs are costs of variable factors, such as wages and material costs. “But the categories are not necessarily fully congruent, and there may be some fixed-factor costs which are variable and some variable-factor costs which are fixed. The distinction between fixed costs and variable costs is, therefore, an independent one.”

In the traditional theory of the firm total costs are divided into two groups total fixed costs and total variance costs.

Thus,  TC = TFC+TVC

Where, TC = total costs

TFC = total fixed costs

TVC= total variable costs

The fixed costs include:

• salaries of administrative staff.
• depreciation (wear and tear) of machinery.
• expenses for building depreciation and repairs.
• expenses for land maintenance and depreciation.

The variable costs include:

• the raw materials.
• the cost of direct labour,
• the running expenses of fixed capital, such as fuel, ordinary repairs and routine maintenance.

Long-run cost curve

It means the time period during which all the factors of production are variable. A firm can change its level of production as well as scale of production during this period. It demands for the products of firm increase, the firm can expand its existing production capacity. Since all the factors of production are variable during this period, all costs are also variable. Only two types of costs exist in long-run Average Total Cost (ATC) and Marginal Cost (MC) Long-run cost curve establishes functional relationship between production and long-run costs of production. Shape of long-run curve is generally ‘U’ shape.

Characteristics of Long-Run Average Cost Curve

1. LAC is always constructed with the help of SACs?
2. LAC covers all SACS. Therefore, it is regarded as a cover of SACs also.
3. LAC is always less than can never be more than SACs because costs can be reduced only in shot run.
4. LAC can never intersect SACs. However, it touches all the SACS.
5. LAC is always ‘U’ shaped. It declines to 3 certain points, after it, it starts to rise.
6. LAC touches only one SAC at the point of minimum cost and not all the SACs.
7. The point at which the LAC touches on SAC is always the point of optimum production and minimum cost for the firm.
8. LAC can be regarded as a planning curve for a firm also, because it expresses all the optimum possibilities of production.

Important links

• Law of Diminishing Returns- Definition, Causes, Limitation etc.
• Law of Variable Proportions- Assumption, Explanation, Stages etc.
• Cost Curve: Nature, Relationship between LMC & SMC
• Importance of the Law of Diminishing Marginal Utility
• Elasticity of Demand- Definition, Degree, Measurement
• Price Elasticity- Factors & Importance
• Consumer Surplus- Definition, Measurement & Importance
• Production Function- Meaning, Explanation, Features, Types

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