Types of Cost and Their Behavior - Coursework Example

In today's globalised economy, all professionally managed organizations understand the value of cost informatio . Costs associated with each level of production and distribution should be calculated carefully to survive and grow in a competitive market place. To manage a business successfully, the manager should make plans both in the short run and strategic perspectives. The business manager has to understand the various types of cost and their behavior in the short run and long run and hence this essay. Long run costs Long run has been defined as that period of time in which all the factors of production are variable, but the state of technology is fixed(Jocelyn, 80). As mentioned in the definition, the organization can increase its factors of production to achieve higher production levels and the state of technology is the only constraint. So it means that all inputs are variable. Hence, in the long run when the inputs are increased, the output may: a) Rise more than proportionately, i.e., there are increasing returns to scale b) Rise proportionately, i.e., there are constant returns to scale c) Rise less than proportionately, i.e., there are decreasing returns to scale To inputs the average total cost of producing that output will fall. The firm's costs will rise less than the output of goods. This is called as the economies of scale as represented in the following diagram: The long run curve represented above includes short run periods as the firm expands. The LRATC curve is a track of all the SRATC curves as the firm grows. Initially, the short run average costs are at the lowest in SRAC1. As the firm expands, its average costs fall to the bottom of the U shaped curve and then begins to climb because of the diminishing returns. The firm then moves its production to the next level and the cost move to the next short run situation shown as SRAC2. In the long run the average cost is represented by the black line tangenting all the short run average cost curves. The whole LRATC is composed of infinite number of single points from SRAC curves. The LRATC curve is the boundary between unit cost levels that are attainable by the firm and unit cost levels that are unattainable. When the long run until costs are falling as the outputs increases, the firm is experiencing increasing returns to scale and thus less long run average costs. If the firm is experiencing average returns to scale then the average long run costs are same and if the firm is experiencing diminishing returns to scale then the long run average costs are increasing. Long run marginal cost Marginal cost is defined as the cost associated with producing one extra unit assuming that the extra unit produced will cause increase in production capacity. The long run marginal cost curve resembles the short run marginal cost curve as it is also U shaped. The U shape of the LRMC can be attributed to increasing and decreasing marginal returns. The calculation of cost and revenue of one extra unit is very crucial in the long run as it is essential to make the capacity increase decision. If the last unit produced gives more revenue than the cost to produce that unit, the firm should expand it s capacity. Marginal cost will increase as the firm expands due to the Law of diminishing returns. The firm should keep expanding as long as the MR > MC. "The term LRMC is used to signify the cost effect of a change which involves some alteration in the amount or timing of future investment. SRMC, on the other hand takes capacity as given, so relates only to changes in operating costs." (Turvey,11). The SRMC rises due to the capacity constraints and then fall after there is a significant increase ion the capacity expansion. Hence, in the long run the marginal cost curve is U shaped. The following diagram shows the increase and decreases of the marginal costs before and after expansion. Kinked demand curve In a non collusive oligopoly market environment, the prices of products remain stable over long periods of time. There is little movement of prices up or down which is mostly insignificant. There is price stability though there is a stiff competition among the market players as very rarely there is a competition based on prices. But when there is a price competition, there are dramatic changes in the market condition. Prices are slashed significantly and the firms in the markets end up with huge losses. Hence, firms are afraid to start a price competition. In this situation, the competition is anything but price. Branding of goods, advertising, sales promotion, emphasis on product quality or service are the common approaches adopted by companies. the theory which explains the price rigidity is non-price competition is known as the kinked demand curve theory. The following diagram shows how a whole range of cost curves between MC1 and MC2 will give the same price and output solutions to a profit maximizing oligopolist, i.e., even quite large shifts in costs will cause prices to remain fixed. As shown in the diagram, at price P1, quantity Q1: point x, the oligopolistic firm can increase the price or maintain the same price or decrease the price. If the firm increases the price, the behavior of the rivals is very crucial(Glanville, 143). If the competitors also increase the price, there is not going to be significant changes in the market share and the customer may shift over to some cheaper alternatives. But if the rivals don't increase the price then firm A will lose significantly as customer will switch over to the products/services of rival companies. Hence, the demand is highly elastic at this level which is shown as D1 in the diagram. Next, if the firm considers lowering the prices and the rival companies do not lower the prices, firm A will not have a significant gains as the demand increases at lower prices but it will create extra demand from customers which the other companies will not let happen. Hence, if all the companies decide to reduce the prices, everybody gains very little and there is no change in the market share. This behavior is represented by the inelastic part of the diagram D2. Considering the options, firm A is likely to reduce or increase the prices. Hence, in a oligopolistic market, the firms face two demand curves with different elasticities. The demand curve appears to be kinked at the current prices, represented by x in the diagram and hence, the name, kinked demand curve. References 1. Glanville, Alan. Economics from a global perspective. Oxford: Glanville Books, 2003 2. Blink, Jocelyn and Dorton, Ian. Economics. New York, Oxford University Press, 2007 3. Turvey, R, What are marginal costs and how to estimate them, Undated and Turvey (1976), Analyzing the marginal cost of water supply, Land Economics, 71(4), 158 - 168. Read More