Chapter 4

Cost Theory and Analysis

À Costs depend on Firm’s production

function and Market’s inputs’ supply
function.
À Given the relationship between
combinations of inputs and the level of Q,
and the input prices the costs associated
with different levels of Q can be
determined.
À Costs of production vary due to the
variations in level of Q and changes in
factor prices.

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 Significance
À Cost of Production is the basis of Product
Pricing Decisions.
À Resource Allocation decisions are based on
the basis of analysis of cost.
À Decisions to add a new product is based on
the basis of comparing additional revenues
to the additional costs.
À Decisions on capital investment are made by
comparing the rate of return on investment
with the opportunity cost of the funds.

À For non-profit sector (government agencies),

decisions are based on the principle : value
of benefits exceeds the cost of the project.
Cost Function
À Firm’s cost function examines the relation
between a firm’s costs of production and its
volume of output.
À To determine the cost of producing certain
level of output – 1. quantities of various
inputs 2. prices of inputs are necessary.

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À Cost function can be derived from production
function by adding information about factor
prices.
C = f (Q, P1, I1, P2, I2, ……..Pn, In)
C = Cost of Production
Q = Level of Output
P1, P2 …= Prices of various factors
I1, I2… = Quantities of factor inputs 1, 2, etc.

À If L and K are the amounts of the factors of

production and Q is the level of output,
then
L = f1 (Q) and K = f2 (Q).
À Total cost for producing the output level Q
is
C = (L X PL ) + (K X PK ) or
C = PL X f1 (Q) + PK X f2 (Q) or
C = f (Q).
Since PL and PK are constant, C is only a
function of Q.

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À Total Cost (TC) is an increasing function of
output.
À An increase in input price, would lead to an
increase in the cost of production.
À The relationship between TC and Q though
is unique in direction, is varying in terms of
magnitude.
Types of Cost
À Economic Cost: Payments made by a firm to
all the factors (hired + self owned) used in
the production.

À Explicit Cost: Payments made to the factors

hired outside the control of the firm.
À Known as out-of-pocket costs.
À Implicit Cost: Payments made to the self-
owned resources used in production.
À Also known as opportunity cost, book cost or
non-cash costs.
À Opportunity Cost: Value of resource in its
next best use, i.e., if it were not being used
for the present purpose.
À Value of the next best alternative that must
be sacrificed or foregone.

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À Direct Cost: Costs which can be directly
attributed to production of a given product.
À raw material, labor and machine time
involved in the production of each unit.
À Indirect Cost: Costs that can not easily and
accurately be separated and attributed to
individual units of production, except on
arbitrary basis.
À Stationery and other administrative
expenses, depreciation of plant and
buildings.
À Direct (Separable) and Indirect (Common
Costs).

À In a multi-product firm, raw material cost is

separable product-wise but management
cost is not separable.
À Sunk Costs: Expenditures that have been
made in the past or that must be paid in
future as a part of a contractual agreement.
À Such costs are invariance with the decision,
hence are irrelevant for decision making.
À Consultant fee, Cost of inventory, future
rental payments that must be paid in future
as a part of a contractual agreement.

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À Marginal Cost: Change in TC associated with
a one-unit change in Q.
À Incremental Cost: Total additional costs of
implementing a managerial decision which
vary with the decision.
À Referred to as relevant costs, incurred as a
result of the decision under consideration.
À Cost associated with adding a new product
line, acquiring a major competitor etc.

À Historical Cost: Actual cost incurred at the

time the asset was acquired.
À Price at which that asset was acquired
originally in the past.
À Replacement Cost: Price that would be
required to be paid if a new asset is to
replace the old one.
À Two costs (HC & RC) differ due to price
variations over time.

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À For managerial decisions HC may not be
appropriate.
À Private Costs: Costs incurred by an
individual firm engaged in relevant activity.
À Includes both explicit and implicit costs that
a firm incurs in production.
À Social Costs: Costs incurred by the society
as a whole.
À External costs passed on to persons (society
at large) not involved in the activity in any
direct way.

À True picture of real or social costs of Q

would be obtained, if external costs will be
included in the production costs.
À Ignoring external costs may lead to an
inefficient allocation of resources in society.
À Fixed Costs: Costs in total which do not vary
with changes in output. TFC ≠ f (Q).
À Must be incurred even if output level is zero.
À Independent of the level of Q of the firm.
À Variable Costs: Costs which vary with the
level of output. TVC = f (Q).

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À LR Costs: Refer to costs across all possible
production capacities.
À Costs when all factors of production are
subject to change. In LR all costs are
variable costs.
À SR Costs: Stand for costs within a given
production capacity.
À Costs when at least one of the factors of
production is fixed.
À Total Costs: Sum total of explicit and implicit
costs. In the SR, STC = TFC + TVC.

À Average Cost: Stands for per unit cost.

Calculated as TC / Q. In SR, SAC = AFC +
AVC.
À TC is useful for break-even & profit analysis.
À AC is relevant for estimating profit margin
per unit of sales.
À MC is significant in deciding the optimum
level of output.

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 Class Assignment 1.
A furniture shop makes 100 chairs per month and
sells them at $ 15 per piece. The expenses on rent
of the shop, cost of material are worth $ 500, the
wage bills stand at $ 240 and electricity bill is $ 50
per month. The shop has invested $ 5000 of which
$2500 is the own fund and the remaining $2500 is
a loan from a bank at the interest rate of 18% per
annum. Assuming imputed costs of owners’ time,
own shop and own savings of $ 2500 for the
month are $300, $100 and $ 25 respectively.
Q. Calculate the explicit and implicit costs and find
out the Business profit and Economic profit.

SR Cost-Output Relationship
À Assuming two inputs L and K, Total Cost,
TC = (L X PL) + (K X PK)
À If L is the variable input & K is the fixed
input, then TVC = L X PL and TFC = K X PK
À AVC = TVC / Q
À ATC = TC / Q, TFC / Q + TVC / Q,
AFC + AVC
À MC = ∆ TC / ∆Q
À If factor prices PK = 50$, PL = 30$ and K =
2, the various calculations of TFC, TVC, TC,
AFC, AVC, AC and MC are as follows:

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 SR Production Function & Cost Output Relationship
L Q AP MP TFC TVC TC AFC AVC AC MC

0 0 - - 100 0 100 - - - -

1 15 15.0 15 100 30 130 6.7 2.0 8.7 2.0

2 31 15.5 16 100 60 160 3.2 1.9 5.1 1.9

3 48 16.0 17 100 90 190 2.1 1.9 4.0 1.8

4 59 14.8 11 100 120 220 1.7 2.0 3.2 2.7

5 68 13.6 9 100 150 250 1.5 2.2 3.7 3.3

6 72 12.0 4 100 180 280 1.4 2.5 3.9 7.5

7 73 10.4 1 100 210 310 1.3 2.9 4.2 30.0

À AFC falls continuously as output expands

because TFC is invariance to Q.
À AP and AVC as well as MP and MC are
inversely related.
À AVC first falls as Q expands, after a certain
point the relationship is reversed.
À The shape of AVC is due to the Law of
Diminishing Returns.
À AC first falls as Q increases but again after a
certain point the trend is reversed. Since ATC
= AFC + AVC, the shape of ATC follows from
those of AFC and AVC.

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À Trend of MC is derived from MP. Influenced
by the Law of Variable Returns.
À TFC curve is horizontal.
À TVC curve starts from origin.
À TC curve starts from a point above the
origin and then follows the shape of the TVC
curve.
À TC and TVC curves are parallel.
À MC curve passes through the minimum
points of both the AVC and ATC curves.

Cost

Total cost

Fixed cost

TFC

Output

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 Cost

Variable cost

Output

STFC

STFC

Q
0

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 STVC STVC

STC
STFC, STVC, STC
STVC

STFC

Q
0

13
AFC

P E

F
R

AFC
0
Output
Q S
S
S
S

AVC

AVC

Q
O

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 Relationships between Product Curves and Cost Curves

AP
AP
&
MP MP

Labor

Maximum MP
And Minimum MC
MC
Maximum AP
Cost And Minimum AVC
AVC

output

Relationships between Product Curves and Cost Curves

À Over the range of rising MP, MC is falling.

À When MP is at maximum, MC is at minimum.
À Over the range of rising AP, AVC is falling.
À When AP is at maximum, AVC is minimum.
À Over the range of Diminishing Marginal
Product, MC is rising.
À Over the range of Diminishing Average
Product, AVC is rising.

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 SR Average and Marginal Cost Curves
Cost
AC
MC

AC & MC increase as the physical

limit to plant capacity is
approached
AVC

A
Point of Diminishing Returns
Output

À SR Average Cost Curves are U- shaped.

À MC curve intersects both the AVC and AC
curves at their minimum points.
À The point of Diminishing Returns
corresponds to point A at which MC begins
to increase.
Class Assignment 2.
If the total cost function of a firm TC = 120
+ 50Q – 10Q2 + Q3 , find out the various
cost as given below by putting the value of Q
from 0 to 10.

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 Cost –output Relationships

Q TFC TVC TC AFC AVC AC MC

0
1
2
3
4
5
6
7
8
9
10

LR Cost-Output Relationship
À In LR being factors are not fixed, all LR costs
are variable.
À In LR, the firm is concerned with optimum
firm size whereas SR is concerned with
optimum Q within a given plant size.
À In LR firms change the scale of their
operations by varying all inputs.
À Given factor prices and specific production
function, the least-costs associated with
various levels of Q, yields LR TC schedule.

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 LR Cost-Output Relationship

Output (Q) LTC LAC LMC

0 - - -

50 150 3.00 3.00

125 200 1.60 0.67

250 250 1.00 0.40

300 300 1.00 1.00

325 350 1.08 2.00

LTC

B
A
LTC

LMC
Q LAC
Economies of scale

LAC

LMC
Diseconomies of scale

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À The LTC curve is first concave & then
convex as looked from the output axis.
À At the point of inflexion on LTC curve (A),
LMC takes the minimum value.
À At point of kink on LTC curve (B), LAC
assumes the minimum value.
À LAC is the least when LMC = LAC.
À LAC curve is falling when LMC < LAC.
À LAC curve is rising when LMC > LAC.

À In the presence of Returns to scale & fixed

input prices:
À 1. When Returns to scale are increasing, LTC
increases as Q increases but at a less than
proportionate rate.
À 2. When Returns to scale are constant, LTC
& Q move in the same direction and same
proportion.
3. When returns to scale are decreasing, LTC
increases at a faster rate than does Q.

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 LAC Curve: The Envelope Curve
À LAC curve envelopes all SAC curves, for the
LR cost can not exceed the SR cost.
À LAC curve is known as Planning curve as it is
a guide to the producer to plan for the
future expansion of Q.
À LAC is the locus of the tangency points of
the SAC curves.
À LAC curve is U-shaped as SAC curves are
but it is more flatter than the SAC curves.

LAC
SAC 1 SAC 2 SAC 3

LAC

A B

0 Q
N1 N2 N N3

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À The points of tangency between SAC curves
and LAC represent the least cost way of
producing particular Q.
À As SAC1 is tangent to LAC curve at point A, it
indicates the least cost output point.
À Point B depicts the lowest AC along SAC1.
À Decision to produce output level at N2 is
possible by choosing at point B on the first
plant to minimize AC.
À The firm could reduce AC further with a
larger plant associated with another SAC.

À Optimum output in the LR is at ON level.

À A firm’s LAC is the lowest cost per unit at
which the firm can produce a given level of
output by varying all the factors.

Economies and Diseconomies of Scale

À Economies of scale mean the reductions in
per unit cost of production (LAC) when a
firm expands its output.
À Diseconomies of scale refer the increase in
AC as output goes up.

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 Economies of scale are two types:
1. Real Economies (Internal Economies)
2. Pecuniary Economies (Ext. Economies)
À Internal economies accrue to a firm by
expanding the scale of production to the
optimum point.
À Helps in better use of underutilized inputs.
À Associated with a reduction in inputs used-
raw materials, labor, capital etc.
À Internal economies are broadly divided into:

1. Production Economies
2. Selling and Marketing Economies
3. Managerial Economies
4. Transport and Storage Economies
À Production Economies:
a. Labor economies:
À Labor economies are achieved as the scale
of output increases.
Division of Labor & Specialization.
Time saving and Automation

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 b. Technical economies:
À Are associated with the ‘fixed capital’.
À Arise from the use of better plant, machinery,
equipment & techniques of production.
Specialization and indivisibilities of capital.
Economies of superior techniques.
Economies of the use of by-products.
c. Inventory economies:
À To meet the random changes in the input & output
sides of the operation of the firm.
Inventories in raw materials
Inventories in ready products

À Selling and Marketing Economies:

À Associated mostly with the distribution of the
product of a firm.
Advertising economies
Large-scale promotion
Exclusive dealers with obligation for
maintaining service departments
Model-change economies
À Managerial Economies:
À Concerned with both the production and
distribution activities of the firm.

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 Specialization of Management
Decentralization of Decision Making
Mechanization of managerial function
À Transport and Storage Economies:
À Concerned partly with production side and
partly on the selling side of the firm.
Causes of Internal economies:
À Indivisibilities: Larger scale of production
makes better use of certain factors of
production which can not be used in parts.

À Specialization: Large scale of production

makes it possible to introduce better division
of labor leads to more units of output at a
lesser average cost.
À Pecuniary Economies (External Economies):
À These economies are common to all the
firms in an industry
À Lower prices of its raw materials, bought at
special discounts from its suppliers.
À Lower costs of external finance.
À Lower advertising prices to larger firms for
large scale advertisement.

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À Transport rates are often lower if the
amounts of goods transported are large.
Causes of External economies:
À Localization of Industries: Concentration of
firms at a particular place results in
endowing in certain advantages to the
firms.
À Specialization: Growth of an area induces
the emergence of firms supplying
specialized services at a lower cost.
Diseconomies of scale: Beyond a certain
point, firm compels to produce more output
at an increasing cost per unit.

À Internal Diseconomies are:

Limits of the Entrepreneur
Managerial hierarchy
Reduction in efficiency
À External Diseconomies are:
High demand for specialized labor
Rise in rental cost due to over-concentration
Trade unions

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 In l e
re crea sca
tu to
rn sin u rns
st g re t
o ing
sc as
al e LAC
e
Constant returns D ecr
to scale
AC

Q1 Q2
o Q
Economies of Constant Diseconomies of scale
scale cost

Economies of Scope
À Refers to reduction in production costs by
producing a set of different goods together
rather than separately.
À Efficiencies arise when a firm produces more
than one product.
À Exist when the TC of producing given
quantities of two goods in the same firm is
less than producing those quantities in two
single-product firms.

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À Measured in terms of saving in cost (SC) of
production.
À Saving in cost is measured as
C(Q1) + C(Q2) – C(Q1,Q2)
SC = ------------------------------------
C(Q1,Q2)
À C(Q1), C(Q2) represents the cost of producing
output Q1,Q2 respectively and C(Q1,Q2) the
joint cost of producing both outputs.
À With economies of scope, the joint cost is
less than the sum of individual costs, SC > 0

À With diseconomies of scope, SC is negative.

À Larger the value of SC, the greater the
economies of scope.
Class Assignment:3
À A firm will produce X at $ 50,000 per 1000
units and Y at $ 30,000 per 1000 units if it
produces only one of these products.
However 1000 units of each type of X and Y
can be produced for a total of $ 70,000 if
both are produced together. Find out the
saving in cost.

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