UNIT - 4

The firm’s costs determine its supply. Supply along with demand determines price. To under-
stand the process of price determination and the forces behind supply, we must understand the
nature of costs. We study some important concepts of costs, and traditional and modern theories
of cost.
Cost concepts
Costs are very important in business decision-making. Cost of production provides the floor to
pricing. It helps managers to take correct decisions, such as what price to quote, whether to place
a particular order for inputs or not whether to abandon or add a product to the existing product
line and so on.

Ordinarily, costs refer to the money expenses incurred by a firm in the production process. But in
economics, cost is used in a broader sense. Here, costs include imputed value of the
entrepreneur’s own resources and services, as well as the salary of the owner-manager.

There are various concepts of cost that a firm considers relevant under various circumstances. To
make a better business decision, it is essential to know the fundamental differences and uses of
the main concepts of cost.

Accounting and Economic Costs:

Money costs are the total money expenses incurred by a firm in producing a commodity. They
include wages and salaries of labour; cost of raw materials; expenditures on machines and
equipment; depreciation and obsolescence charges on machines; buildings and other capital
goods; rent on buildings; interest on capital borrowed; expenses on power, light, fuel,
advertisement and transportation; insurance charges, and all types of taxes.

There are the accounting costs which an entrepreneur takes into consideration in making
payments to the various factors of production. These money costs are also known as explicit
costs that an accountant records in the firm’s books. But there are other types of economic costs
called implicit costs. Implicit costs are the imputed value of the entrepreneur’s own resources
and services.

The salary of the owner-manager who is content with having normal profits but does not receive
any salary, estimated rent of the building if it belongs to the entrepreneur, and interest on capital
invested by the entrepreneur himself at the market rate of interest. Thus economic costs include
accounting costs plus implicit costs, that is, both explicit and implicit costs.

Production Costs:
The total costs of production of a firm are divided into total variable costs and total fixed costs.
The total variable costs are those expenses of production which change with the change in the
firm’s output. Larger output requires larger inputs of labour, raw materials, power; fuel, etc.
which increase the expenses of production. When output is reduced, variable costs also diminish.
They cease when production stops altogether. Marshall called these variable costs as prime costs
of production.

1
The total fixed costs, called supplementary costs by Marshall, are those expenses of production
which do not change with the change in output. They are rent and interest payments, depreciation
charges, wages and salaries of the permanent staff, etc. Fixed costs have to be incurred by the
firm, even if it stops production temporarily. Since these costs are over and above the usual
expenses of production, they are described as overhead costs in business parlance.

Actual Costs and Opportunity Costs:

Actual costs refer to the costs which a firm incurs for acquiring inputs or producing a good and
service such as the cost of raw materials, wages, rent, interest, etc. The total money expenses
recorded in the books of accounts are the actual costs.

Opportunity cost is the cost of sacrifice of the best alternative foregone in the production of a
good or service. Since resources are scarce, they cannot be used to produce all things
simultaneously. Therefore, if they are used to produce one thing, they have to be withdrawn from
other uses. Thus the cost of the one is the alternative forgone. It is the opportunity missed or
alternative forgone in having one thing rather than the other or in putting a factor-service to one
use instead of the other.

The cost of using land for wheat growing is the value of alternative crop that could have been
grown on it. The real cost of labour is what it could get in some alternative employment. The
cost of capital to the capitalist is the amount of interest he could earn elsewhere. The normal
earnings of management are what an entrepreneur could earn as a manager in some other joint
stock company. In this way, opportunity cost is the cost of the opportunity missed or alternative
forgone.

Importance of Opportunity Cost:

The concept of opportunity cost is very important in the following areas of managerial
decision making:
(i) Decision-Making and Efficient Resource Allocation:
The concept of opportunity cost is very important for rational decision-making by the producer.
Suppose, a producer has to decide whether he should produce black and white T.V. or colour
T.V. from his given resources. He can come to rational decision only by measuring opportunity
cost of production of both types of T.V. and by comparing these products with existing market
prices.

As a result, efficient allocation of resources will also be possible. A resource will always be used
in that business where it will have the highest opportunity cost. For example, if a graduate is
receiving Rs. 3,000 as a shop assistant but can earn Rs. 5,000 as a clerk, then he will join the job
of a clerk leaving the shop because his opportunity cost is high.

(ii) Determination of Relative Prices of Goods:

If the same group of resources can produce either a colour T.V. or four black and white T. V.s,
the price of a colour T.V. will be kept equal to at least a four-fold price of a black and white T.V.
Hence, the concept of opportunity cost is useful in the determination of relative prices of various
goods.

2
(iii) Determination of Normal Remuneration of a Factor:
Opportunity cost determines the price for the best alternative use of a factor of production.
Suppose a manager can earn Rs. 20,000 per month as a lecturer in a management school, the firm
will have to pay him at least Rs. 20,000 for continuing his service as a manager.

Hence, it is obvious that the concept of opportunity cost has special importance in management.

Direct Costs and Indirect Costs:

Direct costs are the costs that have direct relationship with a unit of operation, i.e., they can
be easily and directly identified or attributed to a particular product, operation or plant. For
example, the salary of a branch manager, when the branch is a costing unit, is a direct cost.
Direct costs directly enter into the cost of production but retain their separate identity.

On the other hand, indirect costs are those costs whose source cannot be easily and definitely
traced to a plant, a product, a process or a department, such as electricity, stationery and
other office expenses, depreciation on building, decoration expenses, etc. All the direct costs
are variable because they are linked to a particular product or department. Therefore, they vary
with changes in them. On the contrary, indirect costs may or may not be variable.

Private and Social Costs:

Private costs are the costs incurred by a firm in producing a commodity or service . These
include both explicit and implicit costs. However, the production activities of a firm may lead
to economic benefit or harm for others. For example, production of commodities like steel,
rubber and chemicals, pollutes the environment which leads to social costs.

On the other hand, production of such services as education, sanitation services, park facilities,
etc. leads to social benefits. Take for instance, education which not only provides higher incomes
and other satisfactions to the recipients but also more enlightened citizens to the society. If we
add together the private costs of production and economic damage upon others such as
environmental pollution, etc., we arrive at social costs.

Incremental Costs and Sunk Costs:

Incremental costs denote the total additional costs associated with the marginal batch of
output. These costs are the additions to costs resulting from a change in the nature and level of
business activity, e.g., change in product line or output level, adding or replacing a machine,
changes in distribution channels, etc. In the long-run, firms expand their production, employ
more men, materials, machinery and equipment. All these expenses are incremental costs.

Sunk costs are the costs that are not affected or altered by a change in the level or nature of
business activity. It cannot be altered, increased or decreased by varying the level of activity or
the rate of output. All past or actual costs are regarded as sunk costs. Thus, sunk costs are
irrelevant for decision making as they do not vary with the changes expected for future by the
management, whereas incremental costs are relevant to the management for business making.

3
Explicit Costs and Implicit Costs:
Explicit costs are those payments that must be made to the factors hired from outside the
control of the firm. They are the monetary payments made by the entrepreneur for purchasing
or hiring the services of various productive factors which do not belong to him. Such payments
as rent, wages, interest, salaries, payment for raw materials, fuel, power, insurance premium, etc.
are examples of explicit costs.

Implicit costs refer to the payments made to the self-owned resources used in production.
They are the earnings of owner’s resources employed in their best alternative uses. For example,
a businessman utilizes his services in his own business leaving his job as a manager in a
company.

Thus, he foregoes his salary as a manager. This loss of salary becomes an implicit cost of his
own business. Implicit costs are also known as imputed costs. They are important for calculation
of profit and loss account. They play a crucial role in the analysis of business decisions.

Historical and Replacement Costs:

The historical cost is the actual cost of an asset incurred at the time the asset was acquired.
It means the cost of a plant at a price originally paid for it. In contrast, replacement cost means
the price that would have to be paid currently for acquiring the same plant. So historical costs are
the past costs and replacement costs are the present costs.

Price changes over time cause a difference between historical costs and replacement costs. For
example, suppose that the price of a machine in 1995 was Rs. 1, 00,000 and its present price is
Rs. 2, 50,000, the actual cost of Rs. 1, 00,000 is the historical cost while Rs. 2, 50,000 is the
replacement cost.

The concept of replacement cost is very useful for the management. It projects a true picture
while the historical cost gives poor projection to the management. Historical cost of assets is
used for accounting purposes, in the assessment of net worth of the firm, while the
replacement cost is used for business decision regarding the renovation of the firm.

Past Costs and Future Costs:

Past costs are the costs which have been actually incurred in the past. They are beyond the
control of the management because they are already incurred. These costs can be evaluated
with retrospective effect. On the contrary, future costs refer to the costs that are reasonably
expected to be incurred in some future periods.

They involve forecasting for control of expenses, appraisal of capital expenditure decisions on
new projects as well as expansion programmes and profit-loss projections through proper costing
under assumed cost conditions.

The management is more interested in future costs because it can exercise some control over
them. If the management considers the future cost too high, it can either plan to reduce them or
find out sources to meet them. These costs are also called avoidable costs or controllable costs.

4
Business Costs and Full Costs:
Business costs are the costs which include all the payments and contractual obligations
made by the firm together with the book cost of depreciation on plant and equipment. They
are relevant for the calculation of profits and losses in business, and for legal and tax purposes.

In contrast, full costs consist of opportunity costs and normal profit. Opportunity costs are the
expected earnings from the next best use of the firm’s resources. Normal profit is the minimum
profit required for the existence of a firm.

Common Production Costs and Joint Costs:

Sometimes, two or more than two products emerge from a common production process and from
a single raw material. For example, the same piece of leather may be used for slippers or shoes.
Such products present some peculiar and important problems for the management. They are
identifiable as separate products only at the end of the process. So the costs incurred upto this
point are common costs. Thus, common costs are the costs which cannot be traced to separate
products in any direct manner.

When an increase in the production of one product results in an increase in the output of another
product, such products are joint products and their costs are joint costs. For example, when gas is
produced from coal, coke and other products also emerge automatically. Likewise, wheat and
straw, cotton and cotton seeds may be its other examples.

Shutdown Costs and Abandonment Costs:

Shutdown costs are the costs that are incurred in the case of a closure of plant operations. If the
operations are continued, these costs can be saved. These costs include all types of fixed costs,
the costs of sheltering plant and equipment, lay-off expenses, employment and training of
workers when the operation is restarted.

On the other hand, abandonment costs are the costs which are incurred because of retiring
altogether a plant from use. These costs are related to the problem of disposal of assets. For
example, the costs are related to the discontinuance of tram services in Delhi.

These concepts of costs are very important for the management when they have to make deci-
sions regarding the continuance of existing plant, suspension of its operations or its closure.

Out-of-Pocket Costs and Book Costs:

The costs which include cash payments or cash transfers that may be recurring or non-recurring
are called out-of-pocket costs. All the explicit costs such as rent, wages, interest, transport
charges, etc. are out-of-pocket costs. They are also called explicit costs.

Book costs are the actual business costs which enter into book accounts but are not paid in cash.
They are considered while finalising the profit and loss accounts. For example, depreciation
which does not require current cash payments. They are also called imputed costs. Book costs
may be converted into out-of-pocket costs. If a factor of production is owned, that is book cost.
But, if it is hired, that is out-of-pocket cost.

5
Urgent Costs and Postponable Costs:
Urgent costs are those costs that are necessary for the continuation of the firm’s activities. The
cost of raw materials, labour, fuel, etc. may be its examples which have to be incurred if
production is to take place. The costs which can be postponed for some time, i.e., whose
postponement does not affect the operational efficiency of the firm are called postponable costs.
For example, maintenance costs which can be postponed for the time-being. This distinction of
cost is very useful during war and inflation.

Escapable Costs and Unavoidable Costs

Escapable costs are the costs which can be reduced by contraction in business activities. Here,
net effect on costs is important. However, it is difficult to estimate indirect effects such as the
closure of an unprofitable business unit which will reduce costs but will increase the other
related expenses like transportation charges, etc. On the other hand, unavoidable costs are the
costs which do not vary with changes in the level of production, but they are unavoidable such as
fixed costs.

Incremental Costs and Marginal Costs

There is close relation between marginal cost and incremental cost. But they have difference
also. In reality, incremental cost is used in a broad sense in relation to marginal cost. Marginal
cost is the cost of producing an additional unit of output, while incremental cost is defined as the
change in cost resulting from a change in business activities.

In other words, incremental cost is the total additional cost related to marginal quantity of output.
The concept of incremental cost is very important in the business world because, in practice, it is
not possible to use every unit of input separately.

The Cost Function:

The cost function expresses a functional relationship between total cost and factors that deter-
mine it. Usually, the factors that determine the total cost of production (C) of a firm are the
output (0), the level of technology (T), the prices of factors (P f) and the fixed factors (F).
Symbolically, the cost function becomes
C=f (Q, T, Pf, F)
Such a comprehensive cost function requires multi-dimensional diagrams which are difficult to
draw. In order to simplify the cost analysis, certain assumptions are made. It is assumed that a
firm produces a single homogeneous good (q) with the help of certain factors of production.
Some of these factors are employed in fixed quantities whatever the level of output of the firm in
the short run. So they are assumed to be given.

The remaining factors are variable whose supply is assumed to be known and available at fixed
market prices. Further, the technology which is used for the production of the good is assumed to
be known and fixed. Lastly, it is assumed that the firm adjusts the employment of variable
factors in such a manner that a given output Q of the good q is obtained at the minimum total
cost, C.

Thus the total cost function is expressed as:

C=f (Q)

6
Which means that the total cost (C) is a function if) of output (Q), assuming all other factors as
constant. The cost function is shown diagrammatically by a total cost (TC) curve. The TC curve
is drawn by taking output on the horizontal axis and total cost on the vertical axis, as shown in
Figure 1.

It is a continuous curve whose shape shows that with increasing output total cost also increases.
The total cost function and the TC curve relate total cost to output under given conditions. But if
any of the given conditions such as the technique of production change, the cost function is
changed.

For instance, if there is an improved technique of production, the cost of production for any
given output will be less than before which will shift the new cost curve TС 1below the old curve
TC, as shown in Figure 1. On the other hand, if the prices of factors rise, the cost of production
will increase which will shift the cost curve upwards from TC to TС2 as shown in Figure 1.
Cost-Output Relation:
The Cost-output relation is discussed in the traditional and modem theories of costs under the
short-run and long-run cost analysis which are explained as under.

The Traditional Theory of Costs:

The traditional theory of costs analyses the behaviour of cost curves in the short run and the long
run and arrives at the conclusion that both the short run and the long run curves are U-shaped but
the long-run cost curves are flatter than the short-run cost curves.

(A) Firm’s Short-Run Cost Curves:

The short run is a period in which the firm cannot change its plant, equipment and the scale of
organisation. To meet the increased demand, it can raise output by hiring more labour and raw
materials or asking the existing labour force to work overtime.

Short-Run Total Costs:

The scale of organisation being fixed, the short-run total costs are divided into total fixed
costs and total variable costs:
TC = TFC + TVC

Total Costs or TC:

7
Total costs are the total expenses incurred by a firm in producing a given quantity of a
commodity. They include payments for rent, interest, wages, taxes and expenses on raw
materials, electricity, water, advertising, etc.

Total Fixed Costs or TFC:

Are those costs of production that do not change with output. They are independent of the level
of output. In fact, they have to be incurred even when the firm stops production temporarily.
They include payments for renting land and buildings, interest or borrowed money, insurance
charges, property tax, depreciation, maintenance expenditures, wages and salaries of the
permanent staff, etc. They are also called overhead costs.

Total Variable Costs or TVC:

Are those costs of production that change directly with output. They a rise when output
increases, and fall when output declines. They include expenses on raw materials, power, water,
taxes, hiring of labour, advertising etc., They are also known as direct costs.

The relation between total costs, variable costs and fixed costs is presented in Table 1, where
column (1) indicates different levels of output from 0 to 10 units. Column (2) indicates that total
fixed costs remain at Rs. 300 at all levels of output. Column (3) shows total variable costs which
are zero when output is nothing and they continue to increase with the rise in output.

In the beginning they rise quickly, and then they slow down as the firm enjoys economies of
large scale production with further increases in output and later on due to diseconomies of
production, the variable costs start rising rapidly. Column (4) relates to total costs which are the
sum of columns (2), and (3) i.e., TC – TFC + TVC. Total costs vary with total variable costs
when the firm starts production.

The curves relating to these three total costs are shown diagrammatically in Figure 2. The TC
curve is a continuous curve which shows that with increasing output total costs also increase.
This curve cuts the vertical axis at a point above the origin and rises continuously from left to
right. This is because even when no output is produced, the firm has to incur fixed costs.

8
The TFC curve is shown as parallel to the output axis because total fixed costs are the same (Rs.
300) whatever the level of output. The TVC curve has an inverted-S shape and starts from the
origin О because when output is zero, the TVCs are also zero. They increase as output increases.

So long as the firm is using less variable factors in proportion to the fixed factors, the total
variable costs rise at a diminishing rate. But after a point, with the use of more variable factors in
proportion to the fixed factors, they rise steeply because of the application of the law of variable
proportions. Since the TFC curve is a horizontal straight line, the TC curve follows the TVC
curve at an equal vertical distance.

Short-Run Average Costs:

In the short run analysis of the firm, average costs are more important than total costs. The units
of output that a firm produces do not cost the same amount to the firm. But they must be sold at
the same price. Therefore, the firm must know the per unit cost or the average cost. The short-run
average costs of a firm are the average fixed costs, the average variable costs, and the average
total costs.

Average Fixed Costs or AFC equal total fixed costs at each level of output divided by the
number of units produced:
AFC = TFC /Q

The average fixed costs diminish continuously as output increases. This is natural because when
constant total fixed costs are divided by a continuously increasing unit of output, the result is
continuously diminishing average fixed costs. Thus the AFC curve is a downward sloping curve
which approaches the quantity axis without touching it, as shown in Figure 3. It is a rectangular
hyperbola.

9
Short-Run Average Variable Costs (or SAVC) equal total variable costs at each level of
output divided by the number of units produced:
SAVC = TVC/Q

The average variable costs first decline with the rise in output as larger quantities of variable
factors is applied to fixed plant and equipment. But eventually they begin to rise due to the law
of diminishing returns. Thus the SAVC curve is U-shaped, as shown in Figure 3.

Short-Run Average Total Costs (or SATC or SAC) are the average costs of producing any given
output.

They are arrived at by dividing the total costs at each level of output by the number of
units produced:
SAC or SATC = TC/Q TFC/Q + TVC/Q = AFC+ AVC

Average total costs reflect the influence of both the average fixed costs and average variable
costs. At first average total costs are high at low levels of output because both average fixed
costs and average variable costs are large. But as output increases, the average total costs fall
sharply because of the steady decline of both average fixed costs and average variable costs till
they reach the minimum point.

This results from the internal economies, from better utilisation of existing plant, labour, etc. The
minimum point В in the figure represents optimal capacity. As production is increased after this
point, the average total costs rise quickly because the fall in average fixed costs is negligible in
relation to the rising average variable costs.

The rising portion of the SAC curve results from producing above capacity and the appearance
of internal diseconomies of management, labour, etc. Thus the SAC curve is U- shaped, as
shown in Figure 3.

Why is SAC curve U-shaped?

The U-shape of the SAC curve can also be explained in terms of the law of variable proportions.
This law tells that when the quantity of one variable factor is changed while keeping the
quantities of other factors fixed, the total output increases but after some time it starts declining.

10
Machines, equipment and scale of production are the fixed factors of a firm that do not change in
the short run. ’On the other hand, factors like labour and raw materials are variable. When
increasing quantities of variable factors are applied on the fixed factors, the law of variable
proportions operates.

When, say the quantities of a variable factor like labour are increased in equal quantities,
production rises till fixed factors like machines, equipment, etc. are used to their maximum
capacity. In this stage, the average costs of the firm continue to fall as output increases because it
operates under increasing returns.

Due to the operation of the law of increasing returns when the variable factors are increased
further, the firm is able to work the machines to their optimum capacity. It produces the optimum
output and its average costs of production will be the minimum which is revealed by the
minimum point of the SAC curve, point В in Figure 3.

It the firm tries to raise output after this point by increasing the quantities of the variable factors,
the fixed factors like machines would be worked beyond their capacity. This would lead to
diminishing returns. The average costs will start rising rapidly. Hence, due to the working of the
law of variable proportions the short-run AC curve is U-shaped.

Short Run Marginal Cost:

A fundamental concept for the determination of the exact level of output of a firm is the marginal
cost.

Marginal cost is the addition to total cost by producing an additional unit of output:
SMC = ∆ТС/∆Q

Algebraically, it is the total cost of n + 1 units minus the total cost of n units of output MC n =
TCn+1 – TCn. Since total fixed costs do not change with output, therefore, marginal fixed cost is
zero. So marginal cost can be calculated either from total variable costs or total costs. The result
would be the same in both the cases. As total variable costs or total costs first fall and then rise,
marginal cost also behaves in the same way. The SMC curve is also U-shaped, as shown in
Figure 3.

Conclusion:
Thus the short-run cost curves of a firm are the SAVC curve, the AFC curve, the SAC curve and
the SMC curve. Out of these four curves, the AFC curve is insignificant for the determination of
the firm s exact output and is, therefore, generally neglected.

(B) Firm’s Long-Run Cost Curves:

In the long run, there are no fixed factors of production and hence no fixed costs. The firm can
change its size or scale of plant and employ more or less inputs. Thus in the long run all factors
are variable and hence all costs are variable.

The long run average total cost or LAC curve of the firm shows the minimum average cost of
producing various levels of output from all-possible short-run average cost curves (SAC). Thus

11
the LAC curve is derived from the SAC curves. The LAC curve can be viewed as a series of
alternative short-run situations into any one of which the firm can move.

Each SAC curve represents a plant of a particular size which is suitable for a particular range of
output. The firm will, therefore, make use of the various plants up to that level where the short-
run average costs fall with increase in output. It will not produce beyond the minimum short-run
average cost of producing various outputs from all the plants used together.

Let there be three plants represented by their short-run average cost curves SAC 1 SAC2and
SAC3 in Figure 4. Each curve represents the scale of the firm. SAС 1depicts a lower scale while
the movement from SAC2 to SA С1 shows the firm to be of a larger size. Given this scale of the
firm, it will produce up to the least cost per unit of output. For producing ON output, the firm can
use SAC1or SAC2 plant.

The firm will, however, use the scale of plant represented by SAC 3since the average cost of
producing ON output is NB which is less than NA, the cost of producing this output on the
SAC2 plant. If the firm is to produce OL output, it can produce at either of the two plants. But it
would be advantageous for the firm to use the plant SA C2 for the OL level of output.
But it would be more profitable for the firm to produce the larger output OM at the lowest aver-
age cost ME from this plant. However, for output OH, the firm would use the SAС 1 plant where
the average cost HG is lower than HF of the SAC 2 plant. Thus in the long-run in order to produce
any level of output the firm will use that plant which has the minimum unit cost.
If the firm expands its scale by the three stages represented by SAC1SAC2and SAC3curves, the
thick wave-like portions of these curves form the long-run average cost curve. The dotted
portions of these SAC curves are of no consideration during the long run because the firm would
change the scale of plant rather than operate on them.
But the long-run average cost curve LAC is usually shown as a smooth curve fitted to the SAC
curves so that it is tangent to each of them at some point, as shown in Figure 5, where
SAC1,SAC2, SAC3, SAC4 and SAC5are the short-run cost curves. It is tangent to all the SAC
curves but only to one at its minimum point.
The LAC is tangent to the lowest point E of the curve SAC3 in Figure 5 at OQ optimum output.
The plant SAC3 which produces this OQ optimum output at the minimum cost QE is the
optimum plant, and the firm producing this optimum output at the minimum cost with this opti-
mum plant is the optimum firm. If the firm produces less than the optimum output OQ, it is not
working its plant to full capacity and if it produces beyond it is overworking its plants. In both

12
the cases, the plants SAC2 and SAC4 have higher average costs of production than the plant
SAC3

The LAC curve is known as the “envelope” curve because it envelopes all the SAC curves.
According to Prof. Chamberlin, “It is composed of plant curves; it is the plant curve. But it is
better to call it a “planning” curve because the firm plans to expand its scale of production over
the long run.”

The long-run marginal cost (LMC) curve of the firm intersects SAC 1 and LAC curves at the
minimum point E.

LAC Curve Flatter than SAC Curve:

Though the long-run average cost (LAC) curve is U-shaped, yet it is flatter than the short-run
average cost (SAC) curve. It means that the LAC curve first falls slowly and then rises gradually
after a minimum point is reached.

1. Initially, the LAC gradually slopes downwards due to the availability of certain economies of
scale like the economical use of indivisible factors, increased specialisation and the use of
technologically more efficient machines or factors. The returns to scale increase because of the
indivisibility of factors of production.

When a business unit expands, the returns to scale increase because the indivisible factors are
employed to their maximum capacity. Further, as the firm expands, it enjoys internal economies
of production. It may be able to install better machines, sell its products more easily, borrow
money cheaply, procure the services of more efficient manager and workers, etc. All these
economies help in increasing the returns to scale more than proportionately.

2. After the minimum point of the long-run average cost is reached, the LAC curve may flatten
out over a certain range of output with the expansion of the scale of production. In such a
situation, the economies and diseconomies balance each other and the LAC curve has a disc
base.

3. With further expansion of scale, the diseconomies like the difficulties of coordination,
management, labour and transport arise which more than counterbalance the economies so that

13
the LAC curve begins to rise. This happens when the indivisible factors become inefficient and
less productive due to the over expansion of the scale of production. Moreover, when supervision
and coordination become difficult, the per unit cost increases. To these internal diseconomies are
added external diseconomies of scale.

These arise from higher factor prices or from diminishing productivities of factors. As the indus-
try continues to expand, the demand for skilled labour, land, capital, etc. rises. Transport and
marketing difficulties also emerge. Prices of raw materials go up. All these factors lead to
diminishing returns to scale and tend to raise costs.

Conclusion:
The LAC curves first falls and then rises more slowly than the SAC curve because in the long
run all costs become variable and few are fixed. The plant and equipment can be altered and
adjusted to the output. The existing factors can be worked fully and more efficiently so that both
the average fixed costs and average variable costs are lower in the long run than in the short run.
That is why, the LAC curve is flatter than the SAC curve.

Similarly, the LMC curve is flatter than the SMC curve because all costs are variable and there
are few fixed costs. In the short-run, the marginal cost is related to both the fixed and variable
costs. As a result, the SMC curve falls and rises more swiftly than the LMC curve. The LMC
curve bears the usual relation to the LAC curve. It first falls and is below the LAC curve. Then
rises and cuts the LAC curve at its lowest point E and is above the latter throughout its length, as
shown in Figure 6.

The Modern Theory of Costs:

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.

14
(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:1Q2 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 Q 2, it leads

15
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:

16
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
mini mum 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 ne

eds 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.

In order to draw such an LAC curve, we take three short-run average cost curves SAC 1SA С2,
and SAC3representing three plants with the same technology in Figure 9. Each SAC curve
includes production costs, managerial costs, other fixed costs and a margin for normal profits.
Each scale of plant (SAC) is subject to a typical load factor capacity so that points A, В and С
represent the minimal optimal scale of output of each plant.

By joining all such points as A, В and С of a large number of SACs, we trace out a smooth and
continuous LAC curve, as shown in Figure 9. This curve does not turn up at very large scales of

17
output. It does not envelope the SAC curves but intersects them at the optimal level of output of
each plant.

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.

The period between which technical progress has taken place, the long-run average costs show a
falling trend. The evidence of diseconomies is much less certain. So an upturn of the LAC at the
top end of the size scale has not been observed. The L-shape of the LAC curve due to technical
progress is explained in Figure 10.

Suppose the firm is producing OQ1 output on LAC1curve at a per unit cost of ОС1 If there is an
increase in demand for the firm’s product to OQ 2,with no change in technology, the firm will
produce OQ2 output along the LAC1 curve at a per unit cost of ОС2. If, however, there is
technical progress in the firm, it will install a new plant having LAC 2 as the long-run average
cost curve. On this plant, it produces OQ2 output at a lower cost OC2 per unit.
Similarly, if the firm decides to increase its output to OQ 3 to meet further rise in demand
technical progress may have advanced to such a level that it installs the plant with the
LAC3 curve. Now it produces OQ3output at a still lower cost OC3 per unit. If the minimum points,
L, M and N of these U- shaped long-run average cost curves LAC 1, LAC2 and LAC3 are joined
by a line, it forms an L-shaped gently sloping downward curve LAC.

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.

18
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.

One can, therefore, draw a “learning curve” which relates cost per airframe to the aggregate
number of airframes manufactured so far, since the firm started manufacturing them. Figure 11
shows a learning curve LAC which relates the cost of producing a given output to the total
output over the entire time period.

Growing experience with making the product leads to falling costs as more and more of it is
produced. When the firm has exploited all learning possibilities, costs reach a minimum level, M
in the figure. Thus, the LAC curve is L-shaped due to learning by doing.

Relation between LAC and LMC Curves:

In the modern theory of costs, if the LAC curve falls smoothly and continuously even at very
large scales of output, the LMC curve will lie below the LAC curve throughout its length, as
shown in Figure 12.

If the LAC curve is downward sloping up to the point of a minimum optimal scale of plant or a
minimum efficient scale (MES) of plant beyond which no further scale economies exist, the
LAC curve becomes horizontal. In this case, the LMC curve lies below the LAC curve until the

19
MES point M is reached, and beyond this point the LMC curve coincides with the LA С curve,
as shown in Figure 13.

Conclusion:
The majority of empirical cost studies suggest that the U-shaped cost curves postulated by the
traditional theory are not observed in the real world. Two major results emerge predominantly
from most studies. First, the SAVC and SMC curves are constant over a wide-range of output.

Second, the LAC curve falls sharply over low levels of output, and subsequently remains
practically constant as the scale of output increases. This means that the LAC curve is L-shaped
rather than U-shaped. Only in very few cases diseconomies of scale were observed, and these at
very high levels of output.

Economies of Scale and the LAC Curve:

The shape of the LAC curve depends fundamentally upon the internal economies and
diseconomies of scale, while the shift in the LAC curve depends upon external economies and
diseconomies of scale. The LAC curve first declines slowly and then rises gradually after a
minimum point is reached.

Initially, the LAC curve slopes downwards due to the availability of certain internal economies
of scale to the firm like the economical use of indivisible factors, increased specialisation, use of
technologically more efficient machines, better managerial and marketing organisation, and ben-
efits of pecuniary economies. All these economies lead to increasing returns to scale. It means
that as output increases, the LAC curve declines, as shown in Figure 14 where the LAC curve
falls gradually up to point M.

20
The economies of scale exist only up to this point which is the optimum point of the LAC curve.
If the firm expands its output further than this optimum level, diseconomies of scale arise. The
diseconomies of scale result from lack of coordination, inefficiencies in management, and
problems in marketing, and increases in factor prices as the firm expands its scale.

As a result, there are decreasing returns to scale which turn the LAC curve upwards, as shown in
the figure where the LAC curve starts rising from point M. Thus internal economies and
diseconomies of scale are built into the shape of the LAC curve because they accrue to the firm
from its own actions as it expands its output level. They relate only to the long run.

On the other hand, external economies and diseconomies of scale affect the position of the LAC
curve. External economies of scale are external to a firm and accrue to it from actions of other
firms when the output of the whole industry expands. They reflect interdependence among firms
in an industry.

They are realised by a firm when other firms in the industry make inventions and evolve
specialisation in production processes thereby reducing its per unit cost. They also arise to firms
in an industry from reductions in factor prices. As a result, per unit cost falls and the LAC curve
unfits downwards as shown by the shifting of the LAC curve to LAC in Figure 15.

On the contrary, external diseconomies shift the LAC curve upwards. External diseconomies
arise solely through a rise in the market prices of factors used in an industry. When an industry
expands, the increase in the demand for factors like labour, capital, equipment, raw materials,
power, etc. rises and when the industry is unable to meet this demand due to shortages, per unit
cost of firms rises. As a result, the LAC curve shifts upwards, as shown by the shifting of the
LAC curve to LAC in Fig. 15.

21