COSTS

ISOQUANTS ISOCOST LINES

LCC TYPES OF COST PRODUCER’S EQUILIBRIUM
SHORT RUN COSTS EXPANSIONARY PATH
LONG RUN COSTS LEAST COST COMBINATIONS
 Cost is defined as the monetary value spent by a company for the production
of products and operating the business. Cost essentially means the total
amount of money a company has to spend to keep it up and running.
1.Fixed Costs (FC): Fixed costs are expenses that do not vary with the level of production or output.
These costs remain constant regardless of the quantity produced. Examples include rent, salaries of
permanent employees, insurance premiums, and lease payments.

2.Variable Costs (VC): Variable costs change in direct proportion to the level of production or output.
These costs increase as production increases and decrease as production decreases. Examples include
raw materials, direct labor, and utilities.

3.Total Costs (TC): Total costs are the sum of fixed costs and variable costs. Mathematically,
TC = FC + VC.
4.Average Fixed Costs (AFC): Average fixed costs are calculated by dividing total fixed costs by the
quantity of output produced. AFC decreases as production increases because the fixed costs are spread
over a larger output quantity.
5.Average Variable Costs (AVC): Average variable costs are calculated by dividing total variable
costs by the quantity of output produced. AVC typically decreases initially with increased production due
to economies of scale but may eventually start increasing due to diminishing returns.
6.Average Total Costs (ATC): Average total costs are calculated by dividing total costs by the
quantity of output produced. ATC = AFC + AVC. Similar to AVC, ATC often follows a U-shaped curve as
production increases.
7.Marginal Costs (MC): Marginal cost represents the additional cost incurred by producing one more
unit of output. It is calculated as the change in total cost divided by the change in quantity produced
(ΔTC / ΔQ). It's essential for decision-making as it helps determine the most cost-effective production
level.
8.Sunk Costs: Sunk costs are expenditures that have already been incurred and cannot be recovered.
In decision-making, these costs should not influence choices since they are irrelevant to current and
future decisions.
9.Opportunity Costs: Opportunity cost refers to the value of the next best alternative foregone when
a particular choice is made. It's not a monetary cost but represents the benefits sacrificed by choosing
one option over another.
10.Explicit Costs: Explicit costs are direct, out-of-pocket expenses that a business incurs, such as
payments for labor, materials, and other resources.
11.Implicit Costs: Implicit costs are non-monetary costs that arise from using resources for a
particular purpose. They include the opportunity cost of using resources that could have been employed
in an alternative way.
Most typically, an isoquant shows combinations of capital and labor, and
the technological tradeoff between the two—how much capital would be
required to replace a unit of labor at a certain production point to generate
the same output. Labor is often placed along the X-axis of the isoquant
graph, and capital along the Y-axis.

Due to the law of diminishing returns—the economic theory that predicts

that after some optimal level of production capacity is reached, adding other
factors will actually result in smaller increases in output—an isoquant curve
usually has a concave shape. The exact slope of the isoquant curve on the
graph shows the rate at which a given input, either labor or capital, can be
substituted for the other while keeping the same output level.
 Factor K represents capital, and Factor L stands
for labor. The curve shows that when a firm moves
down from point (a) to point (b) and it uses one
additional unit of labor, the firm can give up four
units of capital (K) and yet remain on the same
isoquant at point (b). If the firm hires another unit
of labor and moves from point (b) to (c), the firm
can reduce its use of capital (K) by three units but
remain on the same isoquant.
•The isoquant curve assists companies and
businesses in making adjustments to their
manufacturing operations, to produce the most
goods at the most minimal cost.
•The isoquant curve demonstrates the principle of
the marginal rate of technical substitution, which
shows the rate at which you can substitute one
input for another, without changing the level of
resulting output.
The Properties of an Isoquant Curve

Property 1: An isoquant curve slopes downward, or is negatively sloped.

This means that the same level of production only occurs when increasing units of input are
offset with lesser units of another input factor. This property falls in line with the principle of
the Marginal Rate of Technical Substitution (MRTS). As an example, the same level of output
could be achieved by a company when capital inputs increase, but labor inputs decrease.

Property 2: An isoquant curve, because of the MRTS effect, is convex to its origin.
This indicates that factors of production may be substituted with one another. The increase in
one factor, however, must still be used in conjunction with the decrease of another input
factor.

Property 3: Isoquant curves cannot be tangent or intersect one another.

Curves that intersect are incorrect and produce results that are invalid, as a common factor
combination on each of the curves will reveal the same level of output, which is not possible.
Property 4: Isoquant curves in the upper portions of the chart yield higher outputs.
This is because, at a higher curve, factors of production are more heavily employed. Either
more capital or more labor input factors result in a greater level of production.

Property 5: An isoquant curve should not touch the X or Y axis on the graph.
If it does, the rate of technical substitution is void, as it will indicate that one factor is
responsible for producing the given level of output without the involvement of any other
input factors.

Property 6: Isoquant curves do not have to be parallel to one another.

The rate of technical substitution between factors may have variations.

Property 7: Isoquant curves are oval-shaped.

This allows firms to determine the most efficient factors of production.
 Iso-cost Lines
Iso-cost line represents the price of factors along with the amount of money an organization
is willing to spend on factors.
In other words, it shows different combinations of factors that can be purchased at a certain
amount of money.
For example, a producer wants to spend Rs. 300
on the factors of production, namely X and Y. The
price of X in the market is Rs. 3 per unit and price
of Y is Rs. 5 per unit.
In such a case, the iso-cost line is shown in Figure-10
if the producer spends the whole amount of money
to purchase X, then he/she can purchase 100 units of
X, which is represented by OL. On the other hand, if
the producer purchases Y with the whole amount,
then he/she would be able to get 60 units, which is
represented by OH.
If points H and L are joined on X and Y axes respectively, a straight line is obtained, which is
called iso-cost line. All the combinations of X and Y that lie on this line, would have the same
amount of cost that is Rs. 300. Similarly, other iso-cost lines can be plotted by taking cost
more than Rs. 300, in case the producer is willing to spend more amount of money on
production factors.
With the help of isoquant and iso-cost lines, a producer can determine the point at which inputs yield
maximum profit by incurring minimum cost. Such a point is termed as producer’s equilibrium.

Determination of Producer’s Equilibrium:

Producer’s equilibrium can be obtained with the help of isoquant and iso-cost line. An
isoquant enables a producer to get those combinations of factor that yield maximum output.

On the other hand, iso-cost line provides the ratio of prices of factors of production and
the amount that a producer is willing to spend. For attaining equilibrium, a producer needs
to obtain a combination that helps in producing maximum output with the least price.
Figure- 11 shows the equilibrium position obtained with the help of isoquant
and iso-cost line:
As shown in Figure-11, the producer can
produce 60 units of output by using any
combinations that is R, Q, and S, on curve
IP’. He/she would select the combination
that would obtain the lowest cost. It can be
seen from Figure-11 that Q lies on the
lowest iso- cost line and would yield same
profit as on R and S points, at the lowest
cost. In such a case, Q is the point of
equilibrium; therefore, it would be selected
by the producer.
 Expansion Path
In case, after attaining equilibrium, if a producer is willing to increase its production, then
he/she needs to determine the combination that is required to reach a new equilibrium state.
Let us consider Figure-11 in which the producer is willing to produce 60 units of output. Now,
the producer wants to produce 80 units of output instead of 60 units.
In such a case, the equilibrium would be achieved at the point Q’, which is shown
in Figure-12:
In Figure-12, Q,’ would be the equilibrium point for
producing 80 units of output. This is because at point Q,’
iso-cost line is tangent to isoquant curve of IP’. Similarly,
the equilibrium point for producing 100 and 120 units are
Q.” and Q,'”, respectively. When the points Q, Q’, Q”, and
Q.'” are joined, a straight line is obtained, which is called
expansion path or scale line.
This line is termed as scale line because producer needs to
adjust its scale of production according to this line to
achieve the output he/she desires.
 Law of Substitution or Principle of Least Cost
Combination

The objective of profit maximization can be achieved by two ways, one by increasing output
and other by minimizing the cost. The minimization of cost can be possible by deciding the use
of more than one resource in substitution of other resources.

The objective of factor-factor relationship is two fold:

1) Minimization of cost at a given level of Output.
2) Optimization of output to the fixed factors through alternative resource use combinations.
y =f (x1, x2, x3, x4…………….. xn)
Y is the function of x1 and x2 while other inputs are kept at constant. The relationship can be
better explained by the principle of least cost combination.
Principle of Least Cost combination:
A given level of output can be produced using many different combinations of two
variable inputs. In choosing between the two completing resources, the saving in the
resource replaced must be greater than the cost of resource added.
The principle of least cost combination states that if two factor inputs are considered
for a given output the least cost combination will be such where their inverse price ratio is
equal to their marginal rate of substitution.

Marginal Rate of substitution:

MRS is defined as the units of one input factor that can be substituted for a single
unit of the other input factor.
So, MRS of x2 for one unit of x1 is
Number of unit of replaced resource (x2)
= ——————————————————–
Number of unit of added resource (x1)
Price Ratio (PR) =
Cost per unit of added resource
= ————————————————–
Cost per unit of replaced resource
Price of x1
= ———————–
Price of x2

Therefore the least cost combination of two inputs can be obtained by equating MRS with
inverse price ratio.
i.e. x2 * Px2 = x1 * Px1
This combination can be obtained by following algebraic method or Graphic method.
What are Short Run and Long Run Cost Curves?
Both the short and long run cost curves are the graphical representation of
the relationship between cost and output. Read about the relationship between short run
and long run average cost curve below.

•Both the short-run and long-run average cost curves have similar features.
•The short-run curve is U-shaped. The production costs are lower as the fixed charges are
dispersed. It happens with an increase in production. The costs reach a minimum point, after
which it increases.
•The long-run curve is also U-shaped. The same features of the short-run curve lead to this
shape. However, the curve is less pronounced as the longer time absorbs the cost changes.
There are also no fixed costs.
•The long-run average cost curve encapsulates the short-run curves.
•The long-run curve also connects the lowest (minimum price) points of the curve. It hence
shows the lowest production price for the company. Producing at that rate and quantity will be
beneficial for the company.
•The long-run total cost curve is derived by linking or joining the minimum points of the
short-run total cost curves. It signifies the lowest cost of producing any specific quantity of
goods
Long Run Cost Curve
There are no variable costs in the long run, which helps determine the minimum price
point for production. The company can change fixed and variable factors, eliminating the
concept of fixed factors. There are multiple costs involved in the long run cost curve, such as
stated below.
•Long Run total costs: This is the minimum cost of production for a given output level in a company. It
will be equal to or less than the average short run cost curve in economics. The long run total cost
curve (LTC curve) is derived by joining the minimum points of the different short run cost curves (STC
curve) at varying output levels.
•Long Run Average cost (LAC) curve: The long run average cost curve definition explains it as
the cost of every unit in the long run. The features of long run average cost curve make it possible to
derive it from the SAC curve.
The variable factors of long run average cost curve can include plant, machinery, workforce, raw
material, lease, electric bills, etc.
•In contrast to the nature of short run cost curve, the long-run period has no fixed factors. The period is
long, so the company can change any production factors to increase or decrease the output. It can create a
new plant or use more raw materials to change the output level.
•The long run cost curve thus differs from the short period and can bring variation in all factors. In the long
run, the cost curves represent the graphical relationship between the variable costs and output
•In the image, the X axis shows the different output levels, while the Y axis shows the corresponding cost of
production.
•SAC1, 2, and 3 are the short run cost curves explained in the diagram. They show varying operation scales.
•The company is producing the optimum output level in all three cases. The level leads to the lowest
production cost, the lowest point in the SAC curves.
How does the Long Run work?
•For example, in SAC1, the company produces OM' '' output at the
PM"' cost level. OM is at the SAC2.
•In the long run, there can be different scales of operations. Thus,
the diagram has different SAC1, SAC2, and SAC3. There would be
only one SAC curve if it were a short-term period. The average
output costs would only rise or fall in that curve, depending on the
production levels.
•The SAC2 curve has the lowest point of all three curves. It means
that the OM production level is optimum for the company, where
the average cost of production is the least.
•The long run cost curves are called LAC in the diagram. It can be
seen that the LAC envelopes all three SAC curves and is tangent to
them. It connects all three minimum cost points of average costs.
Difference Between Short Run and Long Run Cost

Short Run Cost Long Run Cost

In the short run, a firm is In the long run, all inputs can be
constrained by at least one fixed adjusted, and a firm has more
input, such as a factory or flexibility to optimize its production
specialized labor. process for maximum efficiency.
A firm’s costs are partially fixed and In the long run, a firm’s costs are
partially variable. entirely variable
Fixed costs cannot be changed in the The firm can adjust all inputs,
short run, while variable costs can including land, labor, capital, and
be adjusted to some extent raw materials, to minimize its costs
and maximize its output.
Basic Concepts of Revenue

Revenue, in simple words, is the amount that a firm receives from the sale of the
output. According to Prof. Dooley, ” The Revenue of a firm is its sales receipts or income.‘
In a firm, revenue is of three types:

Total Revenue
This is simple. The Total Revenue of a firm is the amount received from the sale of the
output. Therefore, the total revenue depends on the price per unit of output and the number
of units sold. Hence, we have
TR = Q x P Where,
• TR – Total Revenue
•Q – Quantity of sale (units sold)
•P – Price per unit of output
 Marginal Revenue
Marginal Revenue is the amount of money that a firm receives from the sale of an additional unit.
In other words, it is the additional revenue that a firm receives when an additional unit is sold.
Hence, we have
MR = TRn – TRn-1 Or MR=ΔTR/ΔQ Where,
•MR – Marginal Revenue
•ΔTR – Change in the Total revenue
•ΔQ – Change in the units sold
•TRn – Total Revenue of n units
•TRn-1 – Total Revenue of n-1 units
Average Revenue
Average Revenue, as the name suggests, is the revenue that a firm earns per unit of output sold.
Therefore, you can get the average revenue when you divide the total revenue with the total units
sold. Hence, we have,
AR=TR/Q Where,

•AR – Average Revenue TR – Total Revenue Q – Quantity of commodity sold

What is the Break-Even Point?
In a business scenario, the break-even point is a perimeter at which the total expenses of
the enterprise equals the total revenue generated. Reaching this point indicates that a business
has overcome all the expenses and no more in a state of loss.
Calculation of break-even point.
Break-even point (Q) = Total Fixed Cost / (Price per unit–Variable cost per unit) = Fixed
Cost / Gross Profit Margin
Where,
•Fixed cost refers to the cost incurred in a business unit,
which doesn’t depend upon the volume of production. For
example, rent, loans, insurance premiums, etc. comes under
fixed cost.
•Variable cost is the cost to produce one unit of product.
The break-even point is the point where total revenue =
total cost, or price per unit = cost per unit. In Figure 21.1 the
firm breaks even at two different points B and B'. At both
the points there is neither profit nor loss.
Example
Let us understand this equation by taking a break even analysis example mentioned as
follows.

A factory ABC Enterprises produces a particular kind of good wherein the total fixed costs
stands at Rs.50,000 and variable cost to produce a good is Rs.30. The company sold these
goods with a sale price per unit of Rs.50.

In this case,
Break-even point = 50,000/ (50-30) = 2500 units
So, from the above break-even analysis, it is evident that BEP (break-even point) for ABC
enterprises stands at 2500. This means a company will have to sell at least 2500 units of the
product to overcome these fixed and variable costs incurred for production.
This can further help companies in determining the total sales achieved by the company then.
They need to multiply the break-even point with the sale price per unit to do so. In this case,
the value of total sales made by the company at their break-even point will be equal to
(2500*50) Rs.1,25,000.
 Applications of Break-Even Analysis
•Planning in New Businesses
New businesses have a lot to plan before they introduce a facility and start manufacturing goods for
sale. To ensure the plans regarding cost and pricing of goods are done right, break even analysis is a
necessity. One will be able to analyze and state if the new business idea is productive or not.
•Introduction of New Products
For cases, a company wishes to introduce the production of new products in its business unit; the
study of break-evens can emerge very significant. Before they start producing the goods, analyzing
break-even will help them understand the cost and pricing strategy.
•Business Model Modification
Change in a business model may have an impact on your businesses productivity. The change of
model doesn’t necessarily mean it will affect the costs and expenses, but if that’s the case, it will help
you change your selling price accordingly. Hence, analyzing break-even in this scenario is both
feasible and important.
Further, while discussing, the term marginal costing and break even analysis may appear frequently.
Marginal cost is the extra cost incurred in producing one extra unit of a good. This can help
determine how variable costs can affect the volume of production in a business unit.
Importance of Break-Even Analysis
•Determines the Size of Units to be Sold: It’s helps a company in determining the number of units
that needs to be sold in order to cover the cost. Variable cost and selling price of an individual product
along with the total cost, are required to evaluate the break-even analysis.
•Budgeting and Setting Targets: It allows a company to set a budget and fix a goal and work
accordingly since the owner knows at which point their company can break even. It also helps the
company in setting an achievable target.
•Organizing the Margin of Safety: In times of a financial breakdown, when the company is not
performing well, it helps in deciding the minimum number of sales the company requires to make a
profit. With the margin of safety reports, the management of the company can take its business decisions
accordingly.
•Monitors and Controls Cost: The fixed and variable cost of a product can affect the profit margins of
a company. Therefore, the break-even analysis can help the management detect if any effects are
changing the cost.
•Helps to Design Pricing Strategy: If the selling price of a product is increased then the quantity of
product to be sold for break-even will be reduced. And like that, if the selling price is reduced, then a
company needs to sell extra to break even. So it also helps in designing the pricing strategy of a product.
 There are standard acronyms for each cost concept, expressed in terms of the following descriptors:
•SR = short run (costs spent on non-reusable materials e.g raw materials)
•LR = long-run (cost spent on renewable materials e.g equipment)
•A = average (per unit of output), M = marginal (for an additional unit of output)
•F = fixed (unadjustable), V = variable (adjustable), T = total (fixed plus variable), C = cost
From the various combinations we have the following short-run cost curves:
•Short-run average fixed cost (SRAFC)
•Short-run average total cost (SRAC or SRATC)
•Short-run average variable cost (AVC or SRAVC)

•Short-run marginal cost (SRMC)

•Short-run fixed cost (FC or SRFC)
•Short-run total cost (SRTC)
•Short-run variable cost (VC or SRVC) and

The following long-run cost curves:

•Long-run average total cost (LRAC or LRATC)
•Long-run marginal cost (LRMC)
•Long-run total cost (LRTC)
SHORT RUN COST CURVES RELATIONSHIP BETWEEN MC & AC

CONCEPT OF PROFIT HAS THREE ASPECTS IN ECONOMICS

The firm earns normal profits – If the average cost = the average revenue.
It earns super-normal profits – If the average cost < the average revenue.
It incurs losses – If the average cost > the average revenue.