Topic 4 - Costs Flashcards
Main Categories of Costs
- Opportunity Costs
- Sunk Costs
- User Cost
Opportunity Cost
Cost of not doing the other best alternative
* Economic Profit = Accounting profit - Opportunity Costs (if not already incurred)
Sunk Cost
Cost which cannot be recovered
- Should no longer affect your decision
User Cost
Cost per user of a durable good, needed to compensate owner during it’s lifetime including opportunity cost
User Cost Formula
User Cost = Capital Cost X (Interest Rate + Depreciation)
* Note: CAPM typically use 8% for the interest rate
* Divide by the number of users for per user cost
Price to Rent Ratio
Ratio of the price of a capital asset to it’s user cost
* ie. Price of capital asset / User cost
Price to Rent Ratio Formula
Price / User cost = 1/(Interest Rate - Depreciation)
* Note: negative sign for depreciation to capture ‘appreciation’
Price to Rent Ratio Rises
- If interest rates fall
- Depreciation increases (Appreciation reduces)
- Expectations impact demand - can be self-fulfilling
Production Costs
- Fixed Costs - Costs the firm is unable to change in the ‘short run’
- Variable Costs - Costs the firm can change in the ‘short run’
- Total Cost - Fixed Cost + Variable Costs
Long Run vs Short Run
- Short Run - Period within which variable costs can be adjusted
-
Long Run - Period within which all costs are variable
- With the exception of sunk costs
Cost of producing one more unit
Marginal Cost
Average Cost
Total Cost / Total Output
Average Fixed Cost
Fixed Cost / Output
Average Variable Cost
Variable Cost / Output
Marginal Cost Formula
Change in Total Cost / Change in Quantity
Relationship between MC and AVC
- MC drives AVC up or down
- AVC lags MC
- MC intersects AVC at the minimum of AVC
Increasing Returns to Scale
- AC and MC are falling
- Production should be increased
Decreasing Returns to Scale
- AC and MC are rising
- Production should be decreased
Constant Returns to Scale
AC and MC are flat and optimal
Retuns to Scale
Long Run MC and AVC may go down and then up as businesses grow
* Returns to scale categorise how they need to adjust to return to optimal AC
User Cost Formula - Extra
