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 Session Objectives
‡ Define Cost of Production
‡ Identify different types
‡ Illustrate total Cost of firm
‡ Compute and represent the Cost Curves
of a firm with change in output
‡ Assess break even point of firm
‡ Determine equilibrium point of firm in view
of satisfying its profit motive
‡ Cost analysis refers to the study of behavior of cost in
relation to one or more production criteria namely;
‡ Size of output
‡ Scale of operations
‡ Price of factors of production
‡ Other variables
‡ Thereby Cost plays a very important role in managerial
decisions involving a selection between alternative
courses of action.
‡ The Cost of Production of an individual firm has an
important influence on the market supply of a commodity
 | 
 


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A producer while considering his cost of production is
concerned about the costs incurred on buying raw materials,
labour, capital, etc. which can¶t be called as actual cost. But
often the producers forget to include in what is called foregone
income or opportunity cost.
The opportunity cost of the production of any good is the next
best alternative good that could be produced with these
resources but is sacrificed.
For example, a country with its given amount of resources can
produce cars, automobiles and could invest in education and
health, but these are scarified to produce armaments. Hence,
the total economic cost of producing armaments should indeed
the loss of value of cars, automobiles and services of education
and health that could be produced.
( V      


Explicit costs are those costs, which are paid out; say for
example an entrepreneur pays out rent for the use of land,
wage for labour, interest for capital, which are normally
recorded in the book-keeping accounts.
Implicit costs are those which are not recorded in the accounts
but are important foe decision making. Say for example, an
entrepreneur having an MBA¶s degree runs his own business.
He never includes the price of his own service while accounting
the costs. Implicit costs are also called imputed cost because
the imputed values of own land; own labour are considered
while calculating the actual cost for decision making.
 ±  


Incremental are those costs which occur by

business decision, say to replace a machine, change in
product, design or quality, change in technology, etc.
Sunk costs are those costs which are already
incurred and cannot be recovered. Depreciation of a
machine is the best example of a sunk cost.
È    


Private costs are those, which are actually incurred by
an individual or a firm for its business activity. The sum
of all explicit and implicit costs constitutes private costs.
Social costs on the other hand, are the total costs to be
borne by the society on accounts of production of a
good. It includes the private cost as well as all those,
which could bestow benefit but caused loss to the
society by the production of a good. It might produce
pollution; health hazards, etc. are the examples of
social costs.
Economic costs includes both these private costs and
social costs. However, the net social cost is the total
social cost minus the private cost.
ß
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Accounting costs are all those costs, which are generally
recorded in the account books. All the explicit costs
which are paid out say for example, payments for raw
materials, labour, capital, etc. are mentioned in the
account books is called accounting cost. Economic costs
constitutes the normal return on the money capital
invested by the entrepreneur himself, the salary for his
own service, opportunity cost of his own factor inputs,
etc.
Thus, V   

  
  

The economic cost, not accounting cost alone, is
important for decision making. Therefore, economic
profit equals total revenue less economic cost.
 Cost Function and Cost Curves
Cost is a function of output, i.e., C=f (Q . It increases as output increases and
declines if you decrease the output. The technical relation between cost and
output is called cast function. Since there is short run production and long
run production, there arises short run costs and long run costs.

    


In the short run, the capital, prices of the factors of production and
technology are assumed to be constant.
Thus, C= f (Q, K, T, P
The equation represents that cost (C increases or decreases with output
(Q . If technology (T or the prices of any factor input (P changes, the cost
curve either shifts upward and downward depending on whether the price
and technology has increased or decreased.
Since, in the short run production, we have fixed factor and variable
factor(s , we have fixed cost and variable costs. Therefore, total cost (TC in
the short run production constitutes total fixed cost (TFC and total variable
cost (TVC .
TC = TFC + TVC
Fixed costs are incurred on hiring the fixed factors like expenses on
plant and machinery, equipments, land and building, etc. Fixed costs
are also called overhead costs. Variable costs are the costs incurred
on variable factors such as, labour, raw materials, fuel, power, etc.,
these are also called prime costs or direct costs. Since, fixed costs
are independent of output and variable cost varies with output, total
cost is a function of output.
ð| 
The behaviour of the short run cost curves with respect to the output
levels are shown below: !"ð"#$ðð
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ð
 


7000
 | 

6000
5000 TF
4000
TV
3000
2000 T
1000
0
0 1000 2000 3000
ð    


  
 ' |


‡

 is cost per unit and can be obtained by dividing the
total costs by the total output produced.
Since TC = TFC + TVC
AC = TC/Q = TFC + TVC/Q
or TC/Q = TFC/Q + TVC/Q
or AC = AFC + AVC

Since AFC = TFC/Q

AVC = TVC/Q

‡ ' 
is an addition made to the total cost by producing one

extra unit of output.
Symbolically, MC = TC(n ± TC(n-
It can also be calculated as MC = TC/ Q
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‡  
ð |

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The behavior of the actual total cost (ATC is dependent on the
behavior of the average variable cost curve (AVC and average
fixed cost (AFC . Since, AFC is falling through out and AVC is
also falling in the beginning, ATC must fall. Afterwards, ATC is
constant because AVC started rising and the rise is neutralized
by the fall in AFC. But when the rise in AVC is much higher
than the fall in AFC, it leads to ATC to rise. Thus, ATC takes
shape of µU¶.
 
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‡ The relationship of AC and MC can also be shown graphically as
follows:
AC & MC MC
AC

O q q q( Output
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i.e., AVC = TVC/Q
Average variable cost is the variable cost per unit of output. In
the beginning AVC falss because per unit cost is decreasing
because of the occurrence of increasing returns. But beyond
the normal capacity of the plant AVC goes up because of the
operation of diminishing marginal returns.

‡  ' 
'|
Marginal cost in an addition to the total cost by producing one
more unit of output. In other words marginal cost of n units is
equal to the difference between total cost of n unit of output and
total cost of (n- units of output.
i.e., MC(n = TC(n -TC(n-
It can also be described as that marginal cost is a change in
total cost (TC due to a small change in output (Q .
i.e., MC = TQ/ Q
 Òelationship between Average cost
(AC and Marginal Cost (MC
‡ The relation between the average cost (AC and marginal cost
(MC is the same as that between any other marginal and
average quantities. That is, when marginal cost is less than AC,
AC falls. When MC is greater than AC, AC rises.

‡ Say for example Sachin Tendulkar has scored (
 runs in

one days. So his average score works out to be (
/
=
. Now
if he adds  runs by managing the th match, his marginal
score is  and total score is (.

‡ Since his marginal score (  at the th match is less than his

average score of
 (When he played
matches , therefore,
his average score after the th match will decrease.
i.e., (/ = 8.±
 Long Òun Costs
‡ Long run period in which full adjustment of plant and machinery is
possible. Hence, no factor is fixed and therefore, there is no fixed
cost.
‡ Long run average cost (LAC is obtained by dividing long run total
cost by output.
i.e., LAC = LTC/Q
Long run average cost curve depicts the least possible average cost
for producing various levels of output.
In order to understand how the long run average cost curve is
derived; consider the following three short run average cost curve.
These short run average cost curves are also called plant curves. In
the short run there is possibility of only one short run average cost
curve or plant curve. Thus, the entrepreneur in the short run can
select ant output which is feasible by the single plant. But in the long
run the entrepreneur can move from one plant to the other and can
select any output he wants tp produce.
Suppose, in the long run there are three technically possible plants
available represented as SAC , SAC(, and SAC± in the figure below:
Average cost

SAC SAC( SAC±

O q q( q± q Output

In the figure, till oq( level of output the entrepreneur produces on

plant SAC but beyond oq(, he would not like to produce on plant
SAC . Because, beyond oq( level of output he can operate on plant
SAC( which reduces his unit cost compared to SAC . Now he can
expand his output up to oq level of output on the same plant SAC(.
‡ It is, thus, clear that in the long run the firm has a choice in the
employment of a plant, and it will employ that plant which yields
minimum possible unit cost for producing a given level of
output, if we relax our assumption that only three plant curves
are technically available. If there are innumerable plants
possible at any level of output the entrepreneur wishes to
produce. Then the long run average cost curve (LAC will be a
smooth and continuous curve. This long run average cost curve
LAC is so drawn as to be tangent to each of the short run
average cost curves as shown in the figure below:
‡ Since an infinite number of short run average cost curves are
assumed, every point on the long run average cost curve will be a
tangency point with some short run average cost curve that shows
the least possible average cost producing any output, when all
productive factors are variable.
‡ If a firm desires to produce a particular output in the long run, it will
pick up a point on the long run average cost curve corresponding to
that output and then it will build a relevant plant and operate on the
corresponding short run average cost curve.
‡ Thus, if the firm wants to produce oq level of output it would produce
at point G on sac(. And oq± at point L on SAC±. If it wants to
produce oq( level of output, corresponding to this output, at point k
the firm can construct a new plant and operate on it. The long run
average cost curve is nothing but the locus of all the short run
average cost curves or it is an envelope of the short run average cost
curves.
 Saucer shaped short run Average variable
cost curve (SAVC

‡ In recent years it is proved that SAVC is not U-shaped rather

saucer type shape.
‡ The saucer type shape of the average variable cost curve
implies that there is a flat stretch over a certain range of output
in it. It has been pointed out that this flat stretch in the short run
averages cost curve is due to reserve capacity that is
consciously built in plant size while designing it.
‡ This reserve capacity is built in the plant size with a view to
impart flexibility in production so that the firm expand output
over a certain range without a rise in unit cost to meet any
greater for its output.
 SAVC & SMC

SMC SAVC

Òeserve capacity

O Output

 
  .


The decline in average variable cost as the output is expanded in

the beginning has been explained as:
Better utilization of the fixed factor with increase in the variable
factor.
( The improvement in the skill and productivity of labour i.e.,
specialization.
 On the other hand, the rising part as SAVC is given by:
Fall in labor productivity due to long hours of work.
( Wastage of raw material.
± Breakdown of machine due to long period operation.
In the initial stages, when SAVC curve falls, marginal cost curve
(MC lies below it, in its flat stretch position the marginal cost
curve coincides with it and ultimately with it and ultimately when
the SAVC curve rises after the full utilization of the reserve
capacity of the plant, the marginal cost curve lies above it.
 Average Total cost curve
‡ Now, it is interesting to note that the shape of the short run ATC
curve, when SAVC carve has a saucer shape type. Since, ATC is
obtained by adding AFC and AVC and AFC falls continuously as
output is expanded the SATC declines up to the level of output at
which reserve capacity is fully exhausted. Beyond that level of output,
SATC will be rising with further increase in output. The SATC and
SAVC are shown in the figure below:
Costs
SATC
SMC SAVC

AFC

O Output
%0
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Long run average cost is L-shaped due to the economies of
scale. Even after a sufficiently large scale of output, the long
run average cost doesn¶t rise; it may either remain constant
or go on falling at a slower rate. At a very large scale
production, the managerial cost per unit of the output may
rise but the technical or production economies would more
than offset the managerial diseconomies so that total long
run average cost doesn¶t rise or even falls continuously.

Cost

L-shaped LAC

LAC

O Output
 However, still there is controversy that the long run average cost
curve is really L-shaped or U-shaped. Two explanations have
been given for the L-shape LAC.
Firm continues to enjoy some technical or production economies
ever after optimum scale is reached. Secondly, modern development
in managerial science ensuring to set us optimum managerial
advantage which restricts LAC to rise again.

%0
% "|
    

Empirically the following two explanations have been provided for
the existence of L-shaped long run average cost curve.
ð  


Economic theory assumes that technology remains unchanged,
therefore, U-shaped appears, but in real world technological
progress takes place over time. Therefore, L shaped curve may
appear. Time series data shows that LAC is not U-shaped.
If the entrepreneur expands output by introducing new technology
each and every time, so that the short run average cost (or plant
curves shifts downward, and operate at the minimum unit cost. The
locus of these points that constitute the long run average cost (LAC
would take L shape.
 ISOCOST LINE
‡ An iso-cost line shows various combinations of two factors that the
firm can buy with a given outlay. The following shows the various
combinations of two factors that a firm can buy with its fixed outlay of
Òs. . The prices of labour and capital are assumed to be Òupees (
and ± Òespectively.
|ð|!V
#%V) We can derive isocost line by representing
this data on a graph sheet. This is shown below:
Combinatio Labor Capital K
n
A  (
B

C  ±
D 

E ((
O
L
F ± 
‡ A higher isocost line represents higher outlay and lower
isocost line represents lower outlay. That is a higher isocost
line can buy more of factor inputs than the lower one. This is
shown in the following isocost map.

Isocost Map
Capital 




±
(


 (   8  Labor
 OPTIMAL FACTOÒ COMBINATION
‡ A firm may decide to produce particular level of Output and
then attempt to minimize the cost by choosing most economical
or optimal factor combination. This practice is called
minimization of cost subject to output constraints. Or, else it
may choose to optimize output subject to budget/ cost
constraint.
‡ |
   /    
Say for example, the firm has decided to produce
 units of
output. In order to gain higher profit, the firm would try to
produce the selected level of output at a minimum possible
cost. In the figure below, the
 units of output can be
produced at the lowest level possible cost of Òs. 8
(represented by the price line MN . Though, still lowest budget
line AB is available with the value of Òs.  is not capable of
producing the required level of output. Points P and Q can also
produce the required output but imposes higher cost to the firm.
Thus, point E is the stable equilibrium point where the firm
optimizes its objective by producing
 units at the least
possible cost of Òs. 8.
Capital

M P
Òs. 
Òs. 8
A
K E

Òs.  Q
IQ=
 units
 Output maximization subject to budget
constraints
‡ Say, the firm has to maximize its output at the given outlay
represented by the isocost line V in the figure below. The
firm is in equilibrium at point E where the highest possible
isoquant II is tangent to the given isocost line employing OK
amount of capital and OL amount of labor.
 Managerial Uses of Cost Analysis
‡ To maintain focus on relevant cost
differentiating from irrelevant cost
‡ To be able to recognise the possibility of
diminishing return in short run production
processand be aware that this will cause
the marginal cost to increase as output
increases
 Keywords:
‡ Accounting Cost: Money cost that are paid by
the producer
‡ Average fixed Cost: Total fixed cost divided by
total unit of output
‡ Average Variable Cost: Total variable cost
divided by total unit of output
‡ Oppurtunity Cost: Cost of foregone alternative
products
‡ Total Cost:Aggregate of fixed and variable costs
 Assignment
‡ Money cost is also called as:
‡ Economic profit is the difference between
TÒ and ------------
‡ Total cost is the sum----------------------
‡ The MC Curve is --------------shaped