MODERN THEORY OF COST
Modern economists including Stigler, Andrews and Friedman have questioned the validity of U-shaped cost curves both theoretical as well as on empirical grounds. Also the long run costs in modern theory are not U- shaped but L- shaped.
The Modern theory suggests the existence of ‘built- in- reserve capacity ‘which imparts flexibility and enables the plant to produce larger output without adding to the costs. Built –in- reserve capacity are planned by firms.
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, which significantly enables the firm to continue production at the lowest point of average cost for a considerable period of time. The firm checks dis-economies of scale by planning in advance and enjoys the gains of production in comparison to the traditional theory where the average cost rises after the firm reaches the optimal level of output.
TYPES OF COSTS AS PER MODERN THEORY OF COST
SHORT RUN COSTS
AVERAGE FIXED COST
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.
As in the traditional theory of cost, the average fixed costs in modern microeconomics, also plots as a rectangular hyperbola. This is shown as follows:
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. The average variable cost curve is as follows:
AVERAGE COST
The short-run Average costs consist of the Average fixed costs and Average variable costs. The short-run average variable cost curve at each level of output. The smooth and continuous fall in the average cost curve is due to the fact that the 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. The curve of average cost is as follows:
LONG RUN COSTS
LONG RUN AVERAGE COST
Modern economists divide long run costs into production costs and managerial costs/ In the long run, all costs are variable and they given rise to a long run average cost curve which is roughly L- shaped. This curve rapidly slopes downwards in the beginning but later remains flat or slopes gently downwards at its right-hand cost. The long run average cost curve is as follows:
The Long run average costs curve has two main features:
- It does not rise at every large scale of output.
- It does not envelope the Short run Average Cost but intersects them.
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. 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.
