Definition

• Economic analysis of cost is tightly bound

to economic analysis of production

Analysis of Costs
• Cost function used in economic analysis is
simply the production function expressed in
monetary rather than physical units

Cost Function Cost Function

• Remember production function • All the limiting assumptions used in

Q = f(L, K, Land …) specifying SR production function are
apply to SR cost function as well
• Cost function can be expressed as
C = f(Q, T, Pi ) • The only additional assumption needed
to determine SR cost function pertains
where C = cost, Q = output,
to the price of the inputs used in
T = Technology and production process
P = Price of the inputs

Short run Short-Run Cost Functions

• A period of time so short that the
• Fixed Cost
firm cannot alter the quantity of
some of its inputs • Variable Cost
• Total Cost
Typically some inputs are fixed inputs in the
short run, e.g. plant and equipment. • Average Costs
– Fixed Cost
Output has to be increased by using
– Variable Cost
additional units of variable input like
unskilled labour and raw materials – Total Cost
• Marginal Cost
Fixed inputs determine/restrict the scale of
the firm’s operation (output)

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 Total costs for firm X
Short-Run Cost Functions Output TFC TVC TC
(Q) (Rs) (Rs) (Rs)
• Fixed Cost: Costs that do not vary with
0 12 0 12
output 1 12 10 22
2 12 16 28
3 12 21 33
– Firm has to bear those costs even there is no 4 12 28 40
output 5 12 40 52
6 12 60 72
7 12 91 103
– Also called plant cost as they determined
plant size in the SR

– Shape of Fixed Cost (FC) curve is a straight line

from origin, parallel to quantity axis FC

Total costs for firm X

Short-Run Cost Functions Output TFC TVC TC
(Q) (Rs) (Rs) (Rs)

• Variable Costs: Costs that vary with 0 12 0 12 TVC

1 12 10 22
output 2 12 16 28
3 12 21 33
– Equal to zero if there is no output 4 12 28 40
– Total Variable Cost (TVC) curve is an inverse 5 12 40 52
6 12 60 72
S shaped upward slopping curve starting 7 12 91 103
from origin
– As more and more units of variable factor are
added in production, its productivity goes
on increasing TFC
– This leads to fall in per unit cost in the
beginning

Short-Run Cost Functions Short-Run Cost Functions

– When total product (Q) increases at • Total Cost: Sum of TFC & TVC
an increasing rate, total variable cost
(TVC) increases at a decreasing rate – S shaped curve obtained by summation of
TFC & TVC

– When total product (Q) increases at

a decreasing rate, total variable cost
(TVC) increases at an increasing rate

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 Total costs for firm X
Output TFC TVC TC
(Q) (Rs) (Rs) (Rs) TC Short-Run Average Cost Functions
0 12 0 12 TVC
1 12 10 22
2
3
12
12
16
21
28
33
•Average Total Cost (AC)= TC/Q
4 12 28 40
5 12 40 52 •Average Variable Cost (AVC)=TVC/Q
6 12 60 72
7 12 91 103 •Average Fixed Cost (AFC)= TFC/Q

•AC = AFC + AVC

TFC

Costs (Rs)
TC AC Q TVC AVC AC, AFC, AVC
12 0 0 -
22 22 1 10 10 • As Q increased, FC remaining same, AFC falls steeply
28 14 2 16 8 at first and then gently
33 11 3 21 7
40 10 4 28 7 • AVC and AC curves are both U shaped
52 10.4 5 40 8
72 12 • AC being sum of AFC & AVC, lies above both AFC &
6 60 10
103 14.7 7 91 13 AVC
AC
AVC • With both AFC & AVC fall, AC also falls

• AVC soon reaches its minimum and start rising, while

AFC continues to fall

AFC • However, rise in AVC compensates the fall in AFC and

AVC pulls AC up after the later reaches a minimum
Q

Costs (Rs)
TC AC Q TVC AVC
12 0 0 -
Marginal Cost
22 22 1 10 10 • Marginal Cost = TC/Q =  TVC/Q as
28 14 2 16 8
33 11 3 21 7
fixed cost cannot be altered
40 10 4 28 7
52 10.4 5 40
• MC first decreases then increases
8
72 12 6 60 10 • Changes in marginal coat reflect changes
103 14.7 7 91 13 AC in marginal productivity
AVC
– At the beginning because of increasing
marginal returns marginal cost falls

AFC – When firm experiences diminishing

marginal returns, marginal cost of output
increases
Q

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 Remember average and marginal output!! Costs (Rs) Q TC MC AC
- MC
0 12
10
1 22 22
6
2 28 14
5
3 33 11
7
4 40 10
12
5 52 10.4
20
6 72 12
31
7 103 14.7
AC

AFC

Relationship between Marginal Cost & Relationship between Marginal Cost &
Average cost Average cost

• When AC decline, MC lies below AC

– Because MC is below AC, MC pulls down AC

• When AC is minimum, MC=AC, MC passes

through the minimum points of AC curve

• When term grades are below GPA, GPA falls • When AC rises, MC lies above them
• When term performance improves, GPA does not – MC pulls up AC
improve until term grades exceed GPA
• Term grades first pull down GPA and then eventually
pull it up

Costs (Rs) Q TC MC AC
The Relationship Between Marginal and 0 12 -
MC
10
Average Cost 1 22
6
22
2 28 14
5
3 33 11
7
4 40 10
12
5 52 10.4
20
6 72 12
31
7 103 14.7
AC
AVC

AFC

Q
23

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 Summary of Relationship
• Over the output range for which TVC is
Short-Run Cost Functions
increasing at a decreasing rate, both AVC
and MC decrease but MC is less than AVC

• MC reaches its minimum point at output at

which TVC reaches its inflection point; at its
minimum, MC is less than AVC

• For all output levels beyond the minimum of

AVC, both AVC and MC increase with MC
rising at a faster rate (MC lies above AVC)

• MC is equal to AC when AC is minimum

Fixed, variable, and total costs: Media Corp. Average and marginal costs: Media Corp.
TFC TVC

Variable Costs
Fixed Costs

Meaning In accounting, fixed costs are Variable costs are expenses Problem
expenses that remain constant that change directly and
for a period of time irrespective proportionally to the changes
of the level of outputs. in business activity level or • Popo Cola’s TVC function is as follows
volume. TVC = 50Q – 10Q2 + Q3 ; Q is output
Incurred when Even if the output is nil, fixed The cost increases/decreases A. Find the level of output when MC is minimum
costs are incurred. based on the output B. What is the level of output where AVC is minimum
C. What is the value of AVC & MC at output of ‘B’
Also known as Fixed costs are also known as Variable costs are also referred
overhead costs, period costs or to as prime costs or direct costs
supplementary costs. as it directly affects the output Ans.
levels.
A. MC = 50 – 20Q + 3Q2 ; for min. MC, d(MC)/dQ=0
Nature Fixed costs are time-related i.e. Variable costs are volume-
they remain constant for a related and change with the - 20 + 6Q = 0  Q = 20/6; SOC; d2 (MC)/dQ2 = 6 > 0
period of time. changes in output level. B. AVC = 50 – 10Q + Q2 ; FOC d(AVC)/dQ = 0; Q = 5
Examples Depreciation, interest paid on Commission on sales, credit SOC d2 (AVC)/dQ2 = 2 > 0
capital, rent, salary, property card fees, wages of part-time
taxes, insurance premium, etc. staff, etc.
C. At Q = 5; AVC = MC = 25

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 Long-run cost functions
• In LR, all costs are variable

• Often considered to be the firm’s planning

horizon
• LR consists of many SRs

• So. LR curve is the composite of many SR curves

• Firm’s LR cost curve is derived from firm’s

expansion path and shows the minimum
long-run total costs of producing various
levels of output

Long-run costs Short & long-run AC curves

• Like short-run average cost curve, firm’s
long-run average cost curve is U-shaped

Relationship between short-run • Recall that the shape of short-run

average cost curve is determined
and long-run AC curves primarily by increasing and diminishing
marginal returns of the variable inputs

• A different principle shapes the long-run

cost curve

Relationship between short-run and Deriving long-run average cost curves

long-run AC curves
SRAC1
• When plant size and other fixed inputs
increases in LR, SR curves shift to the
right
Costs

• Let us assume that in LR, firm operates 1st factory

with five different plant sizes and can
switch over to a different plant size
depending upon cost considerations
• Thus, SAC1 , SAC2, SAC3 …. relate AVC
in respective plant size O
Output

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 Deriving long-run average cost curves Deriving long-run average cost curves

SRAC1 SRAC1
SRAC2 SRAC2 SRAC3
Costs

Costs
2nd factory
3rd factory

O O
Output q0 q1 Output

Deriving long-run average cost curves

• As output increases from q0 to q1 in SR, the firm can
continue to produce along SRAC1 utilizing its SRAC5
SRAC1
installed capacity of I SRAC4
SRAC2 SRAC3
• At output level q1 the capacity is overworked and it
would be cost effective for the firm to shift to a
higher plant size say II and so on
Costs

5th factory
• The shifting from SRAC1 to SRAC2 would lower AVC 4th factory
of the firm

• LRAC curve envelopes SRAC curves

• LRAC curve is a sequence of points, each of which

lies on different AC curve
O
Output

Deriving long-run average cost curves Deriving a long-run average cost curve: choice of factory size

SRAC1 SRAC5
SRAC4
SRAC2 SRAC3

LRAC LRAC
Costs

Costs

LRAC curve:
is envelope of the SRAC curves
O O
Output Output

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Different shapes of long-run average cost curves Different shapes of long-run average cost curves
(a) Economies of scale: Decreasing Cost Industry
• LRAC curve is an idealized
representation of production condition
in LR
• LRAC curve showing the lowest cost at

Costs
which the firm is able to produce a
given quantity of output in the LR, when
no inputs are fixed
LRAC
• Economics of scale exists when a firm’s
average costs falls as it increases
output O Output

Different shapes of long-run average cost curves Different shapes of long-run average cost curves

(b) Diseconomies of scale: Increasing Cost Industry (c) Constant costs: Constant Cost Industry

LRAC
Costs

Costs

LRAC

O Output O Output

A typical long-run average cost curve A typical long-run average cost curve

LRAC Economies Constant Diseconomies LRAC

of scale costs of scale
Costs
Costs

O Output O
Output

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Different shapes of long-run average cost curves
Economy of Scale - Examples
• Firms may encounter Economics of
scale for several reasons
• https://www.youtube.com/watch?v=6ihehRMt
– Technology may make it possible to RWc
increase production with a smaller
proportional increase in at least one input
– Both worker and managers can become • https://www.youtube.com/watch?v=nabM5MG
more specialized , enabling them to become q_NY
more productive, as output expands
– Large firms like Wal-Mart may be able to
purchase inputs at a lower cost than smaller
companies (more bargaining power)

Different shapes of long-run average cost curves

• Economics of scale do not continue forever
Long-Run Cost Curves
• LRAC curve in most industries has a flat Long-Run Total Cost (LTC) = f(Q)
segment that often stretches over a substantial
range of output called constant returns of scale Long-Run Average Cost (LAC) =
– As these firms increase their output, they
will have to increase their inputs
proportionately
LTC/Q
• Finally, very large firms will experience
increasing average costs as managers begin to Long-Run Marginal Cost (LMC) =
have difficulty coordinating the operation

• Under such circumstances, firm will experience

dis-economics of scale
 LTC/Q

Long-run average and marginal costs

Lessens Learnt

LRMC • If the SR marginal cost (MC) of

producing the current output is greater
LRAC than the LRMC, then the firm should
Costs

build a larger plant

• If the SR marginal cost (MC) of

producing the current output is less
than the LRMC, then the firm should
operate with a similar plant
O Output

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 Profit Maximization: MR=MC
Magnitude of profit/loss depends on the position of Rs MC
AC curve AC

a
PM
Profit
b
AC

D
MR
O Qm Q

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