PAPER No. : Fundamentals of micro economic theory

Transcription

1 Subject Paper No and Title Module No and Title Module Tag Paper3, Fundamentals of micro economic theory Module 18 Empirical evidence on the shape of cost ECO_P3_M18 Table of Contents 1. Learning Outcomes 2. Introduction 3. EMPIRICAL EVIDENCE 3.1 Statistical cost studies 3.2 Engineering cost studies 3.3 Questionnaires based studies 3.4 Statistical studies of production function 3.5 Studies based on survival technique

2 1. Learning Outcomes After studying this module, you shall be able to Know the empirical evidences on the shape of cost Identify different types of empirical cost studies Evaluatedifferent types of empirical methods of studies Analyze how the shape of cost have been empirically tested by different studies 2. Introduction The importance of cost of production in determining the production decisions of producers points to the existence of so many empirical studies to prove the shape of cost. The whole theory of costs is based on the basic and fundamental concept of cost functions. The cost functions are derived from the technological relationships implied by the production function. In fact, the theory of costs is a restatement of the theory of production in monetary terms. The shape of cost depends upon the time period, the type of industry, the economies and diseconomies of scale and so on. The shape of the long run cost has been different under traditional cost theory and the modern theory. Since, the process of production involves planning and constant vigilance, the producer aims at efficiency and maximizing gains. The Modern theory takes cognizance of managerial and technological economies to explain constant returns to scale and thus the L Shaped long run average cost. 3 Empirical Evidence

3 3.1STATISTICAL COST STUDIES: (1) Statistical cost studies is based on regression analysis to time-series and cross-section data. The procedure used in statistical cost studies begins once the data are collected by the researcher. A linear function is fitted between costs output observations. C = b 1 X 1 + u, WhereC = total variable cost, X =output u = a random variable that absorbs all influences on costs by explicit factors that do not appear in the cost function This function implies that the AVC and the MC are constant at all levels of output(refers to the flat stretch from e 1 to e 2 in fig- 1 below, as propounded by the modern theory of costs) MC = C/ X = b 1 AVC = C/X = b 1 With higher output, C = b 1 X + b 2 X 2 + u, implying increasing AVC and MC at all levels of output MC = C/ X = b 1 + 2b 2 X AVC = C/X = b 1 + b 2 X The empirical evidence from most statistical studies is that in the short run the AVC is constant over a considerable range of output and in the long-run the AC is generally L- shaped.

4 FIG 1 The MC curve intersects the SAVC curve at its minimum point. Since the SAVC curve reaches its minimum point not at a single point but over the whole flat stretch e 1 e 2, therefore the short-run marginal cost curve (SMC) coincides with the SAVC over the entire range of output corresponding to the flat stretch of the SAVC Curve. For any output less than OX 1, the SMC curve will lie below the Saucer-shaped SAVC curve and for any output higher than OX 2, the SMC curve will be above the SAVC curve. Thus, over the flat stretch pertaining to the Reserve Capacity the short-run marginal cost curve coincides with the SAVC Curve.

5 The falling portions of the SAVC Curve show the reduction in costs due to better utilization of the fixed factors and the consequent rise in productivity of the variable factors. The rising portion of the SAVC Curve depicts the rise in costs on account of diminishing returns from the variable factor and also overutilization of the fixed factors. The SAVC Curve has a flat stretch over a range of output wherein the SAVC is equal to the short run marginal cost, both being constant per unit of output. The short-run Average cost curve continues to fall even over the range of output X 1 andx 2 corresponding to the flat stretch of the SAVC Curve where in SAVC is assumed to be constant. As Average cost consists of Average fixed cost and Average variable cost and Average fixed cost continues to fall as the level of output increases. Even after the Planned Reserve capacity is exhausted, the Short-run Average cost curve continues to decline despite rise in SAVC because AFC continues to fall throughout. Eventually, the rise in short run Average cost becomes greater than the fall in Average fixed cost and the short-run Average cost starts to rise. The SAC Curve is intersected at its lowest point by the short-run marginal cost curve as in case of the traditional theory of costs. Beyond OX 3 level of output, the SAVC Curve asymptotically approaches the short-run Average cost SAC since the gap between the two gradually diminishes on account of falling AFC but the two can never coincide because AFC cannot be zero..(2) ENGINEERING COST STUDIES: This method is based on the technical relationship between inputs and outputs. The cost function includes the cost of the optimal method of producing various levels of output. The L. Cookenboo s study of the costs of operation of crude oil trunk lines employs the engineering method. The first stage involves the estimation of the production function, where output was measured as barrels of crude oil per day and the main inputs in a pipeline system are pipe-diameter, horse-power of pumps,number of pumping stations. The second stage in the engineering method is the estimation of the cost from the production function. Out of the various combinations of inputs to produce a given level of output, the least expensive combinations is chosen.the long-run cost curve is formed

6 by the least-cost combinations of inputs for the production of each level of output. The Cookenboo study concluded that the long-run costs fall continuously over the range of output covered by his study. However, it should be noted that engineering cost studies are mainly concerned with the production costs and pay less attention to other costs. (3) QUESTIONNAIRES BASED STUDIES : A Questionnaire consists of a set of well formulated questions to probe and obtain responses from respondents. Studies based on questionnaires where most of the firms reported that their costs would not increase in the long run and also would remain constant over some period of time. (4) STATISTICAL STUDIES OF PRODUCTION FUNCTION : According to the modern approach to the theory of costs, the long run average costs essentially consists of production and managerial costs and the average production costs continue to fall even at considerably large scales. The managerial costs per unit of output may rise only gradually and that too at very large scales of output. Further, modern theory of costs proponents point out that such managerial diseconomies can be controlled by using improved knowledge of management sciences. Also, the technical and production economies of large sized plants make the managerialdiseconomies seem insignificant. Production costs tend to fall continuously with increases in output in the long run.. These costs fall steeply in the beginning and then gradually as the scale of production expands. This behavior of the production costs is explained by the Technical Economies of large-scale production. Most statistical studies of production function such as Cobb-Douglas production function and CES(Constant Elasticity of Substitution) reveal constant returns to scale, when costs are constant over certain range of output. (5) SURVIVOR TECHNIQUE : George Stigler developed this technique based on the Charles Darwin Survival of the fittest doctrine. Stigler s study of the economics of scale of the steel industry of the USA concluded that small and large firms have high costs and thus inefficient but the medium sized firms constitute the optimum firms. The basic idea of this technique is that competition between different sizes of firms will lead to survival of the more

7 efficient ones. There are certain assumptions on which the validity of the theory would depend (1) The firms have same objectives (2) Firms operate in similar circumstances (3) Prices of factors and state of technology is constant (4) The firms are operating in a competitive market structure. 5. Summary STATISTICAL COST STUDIES:Statistical cost studies method is based on regression analysis to time-series and cross-section data. The procedure used in statistical cost studies begins once the data are collected by the researcher. A linear function is fitted between costs output observations. The empirical evidence from most statistical studies is that in the short run the AVC is constant over a considerable range of output and in the long-run the AC is Generally L-shaped. ENGINEERING COST STUDIES:This method is based on the technical relationship between inputs and outputs. The cost function includes the cost of the optimal method of producing various levels of output. However, it should be noted that engineering cost studies are mainly concerned with the production costs and pay less attention to other costs. QUESTIONNAIRES BASEDSTUDIES:Studies based on questionnaires where most of the firms reported that their costs would not increase in the long run and also would remain constant over some period of time. STATISTICAL STUDIES OF PRODUCTION FUNCTION:Most statistical studies of production function reveal constant returns to scale, when costs are constant over certain range of output.

8 SURVIVOR TECHNIQUE:George Stigler developed this technique based on the Charles Darwin Survival of the fittest doctrine. Stigler s study of the economics of scale of the steel industry of the USA concluded that small and large firms have high costs and thus inefficient but the medium sized firms constitute the optimum firms. The basic idea of this technique is that competition between different sizes of firms will lead to survival of the more efficient ones.