Cost Theory and Analysis

Economic concept of Costs: Opportunity Cost, Explicit & Implicit

Costs, Sunk Cost, Marginal Cost and Incremental Cost, Cost of
Long Lived Assets, Production and Cost, Short-Run Cost Functions,
Long-Run Cost Functions
Cost Analysis – A Rationale
• Awareness of different variants of costs associated with the production of
different levels of output hold key to managerial decision making at level of an
individual firm.

• Significant resource allocation decisions are made only after a thorough

analysis of costs involved in production.

• A profit-maximizing firm, will arrive at the decision to add a new product by

comparing additional revenues to the additional costs associated with that
new product.

• Decisions on capital investment (acquiring new machinery) are made by

comparing the rate of return on investment with the opportunity cost of funds
used to make the capital acquisition.
Economic Concepts of Cost
Opportunity Costs
• A logical measure of cost of a product or factor input is what must be given up
to obtain that product or factor.
• In general, opportunity cost of any decision is the value of the next best
alternative that must be foregone.
• Towards maximizing firm’s value, effective managers must view costs from this
perspective.
• Opportunity costs are incurred whenever budget resources are allocated to
one department rather than another.
Explicit and Implicit Costs
• Full opportunity cost of a business is not accounted for owing to failure of
considering implicit costs.
• Explicit costs represents costs involving actual payments to counterparties,
while Implicit costs are value of foregone opportunities, but not involving an
actual cash outflow.
Economic Concepts of Cost
Explicit and Implicit Costs
A bakery has an inventory of wheat that was purchased at Rs. 3 per kg which is
now worth Rs. 6 per kg in the market. The firm is considering using this wheat to
make a new whole wheat jumbo bread that will be sold to retailers for Rs. 20 per
unit. 1 kg of wheat is required to make each unit of bread, while other costs in
aggregate amounts to Rs. 15 per unit of output.

Traditional Approach Economic Approach

Price of finished product 20 20
Less: Cost of wheat 3 6
Less: Other Costs 15 15
Net Profit 2 -1

• Economists suggests that costs incurred in the past generally are irrelevant for
decision making. The above analytical conclusion can vary upon considering
this view.
Economic Concepts of Cost
Sunk Costs
• These represents the expenditures that have been made in the past or that
must be paid in the future as part of a contractual agreement.
• Examples: Cost of inventory and future rental payments that must be paid a
part of a long-term lease.

Monthly rental payments on the warehouse is Rs. 1000, but the firm finds it no
longer needs the space. The firm offers to sub-lease space but finds that the best
offer is for Rs. 800 per month. Is the offer worth accepting?

Marginal Cost (MC) vs. Incremental Cost (IC)

• MC refers to the change in total cost associated with a one-unit change in
output.
• It is integral to short-run decisions about profit maximizing rates of output.
• IC refers to the total additional cost of implementing a managerial decision. Example:
Cost of introducing a new product-line, acquiring a major competitor, etc.
• MC is a sub-category of IC indicating the additional cost associated with the decision to
make marginal variations in the rate of output.
Economic Concepts of Cost
Cost of Long-Lived Assets
• Another area where the cost concept differs in accounting and economic terms
is in the context of capital equipments that may last for a number of years.
• Accounting approach to measuring the periodic cost of these assets is to
combine historical cost and one of several depreciation methods to assign part
of the historical cost to each year of the defined life of the asset so that the
total expenses over the life will equal the historical cost.
• The total historical cost will be exhausted entirely over the pre-defined life of
the asset. But, it may still have considerable value to the firm after this period,
which remain un-reflected in the accounting statement.

• Economic approach determines the cost as the difference between the market
value of the asset at the beginning and the end of the period.
• Under this approach, it is possible for some assets to actually increase in value
over time, implying that their cost was negative for that period.
Production and Cost
• Cost function relates cost to the rate of output. The production function and
the prices of inputs forms the basis for a cost function.
• Minimum cost of given rate of output can be derived by multiplying the
efficient rate of each input by their respective prices and summing the costs.
CMin = Kor + Low
C: Cost, Ko: Optimum level of capital input, Lo: Optimum level of labor input
• A production function Q = 100K0.5L0.5 has an Expansion Path K = (w/r)L.
• In other words, if the price of labor is Rs. 2 and the price of capital is Rs. 1, the
expansion path will be K = 2L, and the firm would expand by adding inputs at
the rate of 2 units of capital for each additional unit of labor

Rate of Inputs and Output (Units) Cost (Rs.), r=1 w=2

K L Q Capital Labor Total
2 1 141 2 2 4
4 2 283 4 4 8
6 3 424 6 6 12
8 4 565 8 8 16
10 5 707 10 10 20
Short-Run Cost Functions
• Managerial decision making is facilitated by information that shows the cost of
each rate of output.
• A production process combining variable amounts of labor with a fixed capital
of 10 units, w: Rs. 100 and r: Rs. 100 generates the following table.

Input Rate (in units) Rate of Output Costs (in Rs.)

Capital Labor (in units) TFC TVC TC
10 0 0 1000 0 1000
10 2 1 1000 200 1200
10 3.67 2 1000 367 1367
10 5.10 3 1000 510 1510
10 6.77 4 1000 677 1677
10 8.77 5 1000 877 1877
10 11.27 6 1000 1127 2127
10 14.60 7 1000 1460 2460
10 24.60 8 1000 2460 3460
Short-Run Cost Functions
• These cost functions can be represented graphically as below.
• Total Fixed Cost (TFC) curve is indicated by a horizontal line as TFC remains constant
at different levels of output.
• Total Variable Cost (TVC) curve begins at the origin, increases at a decreasing rate
upto the output rate of 3 units and thereafter it increases at an increasing rate.
• Total Cost (TC) has the same shape as TVC curve but it begins at the point
representing level of FC on the vertical axis.
• The above cost functions relate an output rate to the total cost of producing that
output rate.
Short-Run Cost Functions
• Cost functions representing cost per unit of output can also be determined and are often
more useful in managerial decision making.
• Managers of a firm tend to compare cost per unit of output to the market price of that
output.
• Four such measures are:
 Average Total Cost or Average Cost (AC) = TC ÷ Q
 Average Variable Cost (AVC) = TVC ÷ Q
 Average Fixed Cost (AFC) = TFC ÷ Q
 Marginal Cost (MC) = ΔTC ÷ ΔQ
Output AFC AVC AC MC
0 - - - -
1 1000 200 1200 200
2 500 184 684 167
3 333 170 503 143
4 250 169 419 167
5 200 175 375 200
6 167 188 355 250
7 143 209 351 333
8 125 307 432 1000
Short-Run Cost Functions
Output AFC AVC AC MC
0 - - - -
1 1000 200 1200 200
2 500 184 684 167
3 333 170 503 143
4 250 169 419 167
5 200 175 375 200
6 167 188 355 250
7 143 209 351 333
8 125 307 432 1000
Short-Run Cost Functions
• MC constitutes the slope of TC curve. In other words, MC can be determined as the
first derivative of TC function with respect to output.
MC = d(TC) ÷ d(Q)
• Per unit cost functions for many production systems have the U-shaped curves.
• At low rates of output, there is too little of the variable input relative to the fixed
input. As the variable input is increased, output rises rapidly and the cost per unit
falls.
• To begin with, TC increases at a decreasing rate. In other words, slope of the TC
curve (i.e. MC) is falling.
• Owing to law of diminishing marginal returns, additional units of variable input
result in smaller additions to the output and ultimately MC rises.
• When MC exceeds AC, AC begins to rise. As long as MC < AC, AC will decline.
• Thus, the MC curve intersects both AC and AVC curves from below at their
minimum points.
Short-Run Cost Functions
Following total cost function is provided
TC = 1000 + 10Q – 0.9Q2 + 0.04Q3
Find the rate of output that results in minimum AVC?

MC is the first derivative of the TC function

d(TC) ÷ d(Q) = MC = 10 – 1.8Q + 0.12Q2

Based on the given TC function, TVC = 10Q – 0.9Q2 + 0.04Q3

Using TVC function, AVC function can be derived as below
AVC = TVC ÷ Q = 10 – 0.9Q + 0.04Q2

Minimum point of AVC occurs when AVC = MC, thus equating AVC and MC functions and
solving for Q as below.
10 – 0.9Q + 0.04Q2 = 10 – 1.8Q + 1.12Q2
-0.08 Q2 + 0.9 Q = 0
Q(-0.08Q + 0.9) = 0

Roots to this equation: Q1 = 0, Q2 = 11.25

Alternative approach is identifying minimum point of AVC by setting first derivative of AVC
(with respect to Q) equal to zero and solving for Q.
d(AVC)/d(Q) = - 0.9 + 0.08Q = 0 or 0.08Q = 0.9 or Q = 11.25
Long-Run Cost Functions
• Firms operate in the short-run but plan in the long-run.

• At any point in time, firm has one or more fixed factors of production. Thus,
the production decisions are arrived at using short-run cost curves.

• However, most firms can change the scale of their operation in the long-run by
varying all factor inputs, and in doing so, move to a preferred short-run
function.

• A direct correspondence exists between returns to scale in production and the

long-run cost function for the firm.

• Example: If returns to scale are increasing, inputs are increasing less than in
proportion to increases in output. Given the fact that input prices are constant, TC
also increases less than in proportion to the output.
Increasing Returns to Scale Cost Increases at Decreasing Rate
Decreasing Returns to Scale Cost Increases at Increasing Rate
Constant Returns to Scale Cost Increases at Constant Rate
Long-Run Cost Functions
Long-Run Cost Functions
• The production process of majority of the firms is initially marked by increasing
returns to scale and thereafter by decreasing returns to scale.
• Owing to this, long-run total cost curve first increases at a decreasing rate and
then increases at an increasing rate
• Such nature of total cost curve is associated with a U-shaped long-run average
cost curve.
Long-Run Cost Functions
• A firm can possibly pursue different scales of operation adopting different plant
sizes.
• The short-run average cost curves associated with each scale of operation can
be graphically depicted as below.
 Long-Run Cost Functions

• An output rate of Q1 could be produced by plant size 1 at an AC of C1 or by plant size 2 at an

AC of C2.
• Cost is lower for plant size 1 and thus point ‘a’ is one point on the Long-run Average Cost
(LAC) curve.
• LAC curve can be obtained by identifying similar points for different rates of output.
• For output rates zero to Q2, plant size 1 is most efficient. For Q2 – Q3, plant size 2 is efficient,
and for Q3 – Q4, plant size 3 is most suitable economically.
• The scallop shaped dark portions of SAC curves represents LAC curve of the firm. It is an
envelope curve and the firm wants to be on this curve in the long-run.
Long-Run Cost Functions
• Firms usually have various alternative plant sizes to choose from, and there is a SAC
curve corresponding to each.
• Only one point or a very small arc of each SAC curve will lie on the LAC curve.
• Long-run Marginal Cost (LMC) curve intersects LAC curve at its minimum point, which is
also the minimum point of relevant SAC curve. Further, the Short-run Marginal Cost
(SMC) curve also intersects the relevant SAC curve at its minimum point.
• Thus ‘a’ constitutes a unique point on the LAC curve where the following condition is
satisfied.
SAC = SMC = LAC = LMC
Long-Run Cost Functions

• LAC curve serves as a long-run planning mechanism for the firm.

• Consider a firm operating in the short-run with SAC7 and producing an output rate of Q*
• At SAC7 the firm incurs an AC of C1. If the future demand projections indicate that firm
will continue to sell only Q* units of output, then profit can be enhanced by increasing
the scale of plant size to match with SAC10 .
• With the new plant, AC for the output rate Q* would be C2 and the firm’s profit per unit
would increase by C1 – C2.
• In other words, firm’s total profit will go up by (C1 – C2)Q*