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MODERN THEORY OF COST

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INTRODUCTION

  • Modern  theory of cost is given by Stigler, Andrews and Friedman

Features

  • The Modern theory believes in the existence of ‘built- in- reserve capacity ‘which imparts flexibility and enables the plant to produce larger output without adding to the costs.

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FEATURES

  • The short-run cost curve has a saucer- type shape whereas the long-run Average cost curve is either L-Shaped or inverse J-shaped.
  • The Modern theory of cost stresses on the role of economies of scale and dis-economies of scale.

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MODERN THEORY

Short Run Cost

Long Run Cost

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SHORT RUN COSTS

Short Run AVERAGE FIXED COST

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The fixed costs include the costs for:

  • The salaries and other expenses of administrative staff.
  • The wear and tear of machinery.
  • The expenses for maintenance of building.
  • The expenses for the maintenance of land on which the plant is installed or operates.

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SHORT RUN AVERAGE FIXED COST�

As in the traditional theory of cost, the average fixed costs in modern theory also is a rectangular hyperbola. This is shown as follows:

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AVERAGE VARIABLE COST�

  • In modern theory, Average variable cost is not U shaped rather it is saucer shaped and has a flat stretch over a range of output.
  • This flat stretch represents the ‘built in reserve capacity’ of the firm to meet seasonal and cyclical changes in the demand.

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SHORT RUN AVERAGE VARIABLE COST

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SHORT RUN AVERAGE COST�

  • The short-run Average costs consist of the Average fixed costs and Average variable costs.
  • The smooth and continuous fall in the average cost curve is because AFC curve is a rectangular hyperbola and the AVC curve first falls and then becomes horizontal within the range of reserve capacity. Beyond that it starts rising steeply. �

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SHORT RUN AVERAGE COST�

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LONG RUN AVERAGE COST�

  • Modern economists divide long run costs into production costs and managerial costs
  • In the long run, all costs are variable so long run average cost curve is L- shaped. This curve rapidly slopes downwards in the beginning but later remains flat or slopes gently downwards at its right-hand cost

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LONG RUN AVERAGE COST

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LONG RUN MARGINAL COST�

According to modern theory, shape of long-run marginal cost curve corresponds to the shape of long-run average cost curve.

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THE GIVEN FIGURE SHOWS THAT WHEN LAC IS L- SHAPED AND LAC CURVE IS FALLING THEN LMC CURVE WILL ALSO BE FALLING AND ITS FALLING PORTION WILL BE BELOW THE FALLING PORTION OF LAC CURVE.

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