Modern Cost Theory

The modem theory of costs differs from the traditional theory of costs with regard to the shapes of the cost
curves. In the traditional theory, the cost curves are U-shaped. But in the modem theory which is based on
empirical evidences, the short-run SAVC curve and the SMC curve coincide with each other and are a
horizontal straight line over a wide range of output. So far as the LAC and LMC curves are concerned, they
are L-shaped rather than U-shaped. We discuss below the nature of short- run and long-run cost curves
according to the modem theory.

(1) Short-Run Cost Curves:

As in the traditional theory, the short-run cost curves in the modem theory of costs are the AFC, SAVC, SAC
and SMC curves. As usual, they are derived from the total costs which are divided into total fixed costs and
total variable costs.
But in the modem theory, the SAVC and SMC curves have a saucer-type shape or bowl-shape rather than a
U-shape. As the AFC curve is a rectangular hyperbola, the SAC curve has a U-shape even in the modem
version. Economists have investigated on the basis of empirical studies this behaviour pattern of the short-
run cost curves.
According to them, a modern firm chooses such a plant which it can operate easily with the available
variable direct factors. Such a plant possesses some reserve capacity and much flexibility. The firm installs
this type of plant in order to produce the maximum rate of output over a wide range to meet any increase in
demand for its product.

The saucer-shaped SAVC and SMC curves are shown in Figure 7. To begin with, both the curves first fall
upto point A and the SMC curvelies below the SAVC curve. "The falling part of the SAVC shows the
reduction in costs due to the better utilisation of the fixed factor and the consequent increase in skills and
productivity of the variable factor (labour).
With better skills, the wastes in raw materials are also being reduced and a better utilisation of the whole
plant is reached." So far as the flat stretch of the saucer-shaped SAVC curve over Q:102 range of output is
concerned, the empirical evidence reveals that the operation of a plant within this wide range exhibits
constant returns to scale.
The reason for the saucer-shaped SAVC curve is that the fixed factor is divisible. The SAV costs are constant
over a large range, up to the point at which all of the fixed factor is used. Moreover, the firm's SAV costs
tend to be constant over a wide range of output because there is no need to depart from the optimal
combination of labour and capital in those plants that are kept in operation.
Thus there is a large range of output over which the SAVC curve will be flat. Over that range, SMC and
SAVC are equal and are constant per unit of output. The firm will, therefore, continue to produce within
Q1Q2 reserve capacity of the plant, as shown in Figure 7.
After point B, both the SAVC and SMC curves start rising. When the firm departs from its normal or the
load factor of the plant in order to obtain higher rates of output beyond Q2, it leads to higher SAVC and
SMC. The increase in costs may be due to the overtime operations of the old and less efficient plant leading
to frequent breakdowns, wastage of raw materials, reduction in labour productivity and increase in labour
cost due to overtime operations. In the rising portion of the SAVC curve beyond point B, the SMC curve lies
above it.
The short-run average total cost curve (SATC or SAC) is obtained by adding vertically the average fixed
cost curve (AFC) and the SAVC curve at each level of output. The SAC curve, as shown in Figure 8,
continues to fall up to the OQ level of output at which the reserve capacity of the plant is fully exhausted.
Beyond that output level, the SAC curve rises as output increases. The smooth and continuous fall in the
SAC curve upto the OQ level of output is due to the fact that the AFC curve is a rectangular hyperbola and
the SAVC curve first falls and then becomes horizontal within the range of reserve capacity. Beyond the OQ
output level, it starts rising steeply. But the minimum point M of the SAC curve where the SMC curve
intersects it, is to the right of point E of the SAVC curve. This is because the SAVC curve starts rising
steeply from point E while the AFC curve is falling at a very low rate.

(2) Long-Run Cost Curves:

Empirical evidence about the long-run average cost curve reveals that the LAC curve is L-shaped rather than
U-shaped. In the beginning, the LAC curve rapidly falls but after a point "the curve remains flat, or may
slope gently downwards, at its right-hand end." Economists have assigned the following reasons for the L-
shape of the LAC curve.

1. Production and Managerial Costs:

In the long run, all costs being variable, production costs and managerial costs of a firm are taken into
account when considering the effect of expansion of output on average costs. As output increases,
production costs fall continuously while managerial costs may rise at very large scales of output. But the fall
in production costs outweighs the increase in managerial costs so that the LAC curve falls with increases in
output. We analyse the behaviour of production and managerial costs in explaining the L-shape of the LAC
curve.

Production Costs:

As a firm increases its scale of production, its production costs fall steeply in the beginning and then
gradually. The is due to the technical economies of large scale production enjoyed by the firm. Initially,
these economies are substantial. But after a certain level of output when all or most of these economies have
been achieved, the firm reaches the minimum optimal scale or minimum efficient scale (MES).

Given the technology of the industry, the firm can continue to enjoy some technical economies at outputs
larger than the MES for the following reasons:

(a) from further decentralisation and improvement in skills and productivity of labour; (b) from lower repair
costs after the firm reaches a certain size; and

(c) by itself producing some of the materials and equipment cheaply which the firm needs instead of buying
them from other firms.

Managerial Costs:

In modern firms, for each plant there is a corresponding managerial set-up for its smooth operation. There
are various levels of management, each having a separate management technique applicable to a certain
range of output. Thus, given a managerial set-up for a plant, its managerial costs first fall with the expansion
of output and it is only at a very large scale output, they rise very slowly.

To sum up, production costs fall smoothly and managerial costs rise slowly at very large scales of output.
But the fall in production costs more than offsets the rise in managerial costs so that the LAC curve falls
smoothly or becomes flat at very large scales of output, thereby giving rise to the L-shape of the LAC curve.
2. Technical Progress:

Another reason for the existence of the L-shaped LAC curve in the modern theory of costs is technical
progress. The traditional theory of costs assumes no technical progress while explaining the U-shaped LAC
curve. The empirical results on long-run costs conform the widespread existence of economies of scale due
to technical progress in firms

3. Learning:

Another reason for the L-shaped long-run average cost curve is the learning process. Learning is the product
of experience. If experience, in this context, can be measured by the amount of a commodity produced, then
higher the production is, the lower is per unit cost.

The consequences of learning are similar to increasing returns. First, the knowledge gained from working on
a large scale cannot be forgotten. Second, learning increases the rate of productivity. Third, experience is
measured by the aggregate output produced since the firm first started to produce the product.

Learning-by-doing has been observed when firms start producing new products. After they have produced
the first unit, they are able to reduce the time required for production and thus reduce their per unit costs. For
example, if a firm manufactures airframes, the fall observed in long-run average costs is a function of
experience in producing one particular kind of airframe, not airframes in general