Cost Concepts

Introduction
◼ Cost is defined in simple terms as a sacrifice or foregoing which
has already occurred or has potential to occur in future with an
objective to achieve a specific purpose measured in monetary
terms.
◼ Cost results in current or future decrease in cash or other assets,
or a current or future increase in liability.
◼ Determinants of cost:
 Price of inputs
 Productivity of inputs
 Technology
 Level of output
◼ Mathematically we can express the cost function as:
C= f(Q, T, Pf)
where C=cost; Q=output; T=technology; Pf = price of inputs.
 Kinds of Costs
◼ Accounting Costs/ Explicit Costs/ Out of Pocket
Costs
 Which can be identified, measured and accounted for;
e.g. cost of raw materials, wages and salary and
capital costs like cost of the factory building.
 Which result in cash outflow or increase in liability
◼ Opportunity Costs
 Help in evaluation of the alternative uses of an input
other than its current use in production

◼ Implicit Costs
 Do not involve cash outflow or reduction in assets, or increase in
liability; e.g. owner working as manager in own building
 Important for opportunity cost measurement
 Costs in Short Run
Costs

◼ Fixed Costs
 Do not vary with output; e.g.
C TFC plant, machinery, building.
 Total Fixed Cost (TFC)
curve is a straight line,
parallel to the quantity axis,
O indicating that output may
Quantity
increase to any level without
Costs
causing any change in the
fixed cost.
TFC  In the long run plant size
may increase hence FC
curve may be step like,
where each step showing
FC in a particular time
O period.
Quantity
 Costs in Short Run
Costs
TC ◼ Variable Costs
TVC
 Costs that vary with level of
output and are zero if no
production; e.g. cost of raw
TFC materials, wages.
 Normally TVC is like a straight
O line starting from origin.
Quantity
 TVC may be an inverse S
Costs TC shaped upward sloping curve,
TVC
due laws of variable
proportions.
◼ Total cost (TC)
 Sum of TFC and TVC
 Slope of TC curve is
TFC
determined by that of the TVC.
O
Quantity 7
 Average and Marginal Cost
◼ Average Cost (AC) is total cost per unit of output.
 AC =(TC/Q)
 AC=AFC+AVC
◼ AFC= TFC/Q
◼ AVC= TVC/Q
◼ Marginal cost (MC) is the change in total cost due to a
unit change in output.
 MCQ= TCQ- TCQ-1
◼ Since the fixed component of cost cannot be altered,
MC is virtually the change in variable cost per unit
change in output.
 Also known as rate of change in total cost.

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 Average and Marginal Cost Functions
Contd…

MC ◼ AC curve is U shaped
AC/MC
◼ When both AFC and AVC fall,
AC also falls and when AVC
AC rises AC starts increasing.
AVC ◼ When average costs decline,
MC lies below AC.
◼ When average costs are
constant (at their minimum),
MC equals AC.
AFC  MC passes through the
lowest point of AC curves.
O
Quantity ◼ When average costs rise, MC
curve lies above them.
 Costs in Long Run

◼ All costs are variable in the long run since factors of

production, size of plant, machinery and technology can
be varied in the long run.
◼ The long run cost function is often referred to as the
“planning cost function” and the long run average cost
(LAC) curve is known as the “planning curve”.
◼ As all costs are variable, only the average cost curve is
relevant to the firm’s decision making process in the long
run.
◼ The long run consists of many short runs, therefore the
long run cost curve is the composite of many short run
cost curves.

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 Costs in Long Run

◼ In the long run the firm may increase plant size to increase output.
◼ As output is increased from q0 to q1 capacity at SAC1 is overworked.
◼ Hence the firm shifts to a higher plant size SAC2.
◼ This shift would lower the average cost of the firm.
◼ The same process would be repeated if the firm increases its output
further to q2.
◼ It shows scalloping curve as the plant costs are not smoothened.
AC, MC MC1
MC2 SAC3
SAC MC3
SAC2
1 LAC

O q0 q1 q2 Quantity
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 Long Run Average Cost
◼ The LAC function can be shown as an envelope curve of the short run
cost functions.
◼ Each of the SAC curves represents the cost conditions for a plant of a
particular capacity.
◼ LAC curve envelopes SAC1, SAC2, SAC3, showing the average cost of
production at different levels of output turned out by plants 1, 2 and 3.
◼ LMC curve corresponds to LAC curve.

LMC
AC, MC SMC1 SAC1
SMC2 SMC3 SAC3
LAC
SAC2

O
q1 q2 q3 Quantity
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 Long Run Marginal Cost

◼ Long run marginal cost (LMC) curve joins the points on

the short run marginal cost (SMCs) curves that are
associated with short run average costs corresponding
to each level of output on the LAC curve.
◼ The optimum plant size is II, assuming sufficient
demand.
◼ Optimal level of output is Oq*, where long run and short
run marginal and average costs are all equal.
◼ LMC must be less than LAC when the latter is
decreasing
◼ It would be equal to LAC when the latter reaches its
minimum.
◼ LMC is greater than LAC when the latter is increasing.

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problems
◼ Suppose the firm faces a cost function of
C=8+4q +q²
◼ Find out fixed cost, average variable cost
& Marginal cost?

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 Costs of a Multi Product Firm
◼ Assuming that a multi product firm manufactures two goods, with the
same plant and machine.
◼ Total cost (TC) of production would be the sum of TFC and the total of
variable costs (C1 and C2) of producing both the products, times the
quantities of the two goods (Q1 and Q2).
TC= TFC+C1Q1+ C2Q2
◼ If the two products are produced in fixed proportions, then we can use
the concept of weighted average cost (ACw) defined as:

ACw (Q)= F + C1 ( X 1Q) + C2 ( X 2Q)

Q
(where X1 and X2 are the proportions in which products 1 and 2 are
produced (or the weights used in calculating average costs) and Q is
the total output. )

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 Summary
◼ Total Revenue is the total amount of money received by a firm from goods
sold (or services provided) during a certain time period. Average Revenue is
the revenue earned per unit of output sold.
◼ Marginal Revenue is the revenue a firm gains in producing one additional unit
of a commodity. Profit is the difference between Total Revenue and Total
Cost; the profit function shows a range of outputs at which the firm makes
positive (or supernormal) profits.
◼ Economies of scale refer to the efficiencies associated with larger scale
operations; it is a situation in which the long run average costs of producing a
good or service decrease with increase in level of output.
◼ Economies of scope refer to a situation in which average costs of
manufacturing a product are lower when two complementary products are
produced by a single firm, than when they are produced separately.
◼ Learning by doing refers to the process by which producers learn from
experience, while technological change is an increase in the range of
production techniques that provides new vistas to producing goods.

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