In This Lecture…
Concepts of Costs: Economic Costs, Accounting Costs, Sunk Costs
Short-run and Long-run Costs: Total, Average and Marginal Costs
Cost Schedules, Cost Curves, Characteristics and their Relationships
Business Firm
An entity that employs factors of production (resources) to produce goods and services to be sold to consumers, other firms, or the government.
Why Do Business Firms Arise in the First Place?
Firms are formed when benefits can be obtained from individuals working as a team.
Economic Cost
Economic cost is the cost to a firm for utilizing economic resources in production, including opportunity cost.
Accounting Cost
Accounting cost is that cost which includes actual expenses plus depreciation charges for capital equipment.
Sunk Cost
A cost incurred in the past that cannot be changed by current decisions and therefore cannot be recovered.
Explicit and Implicit Cost
Explicit Cost - A cost incurred when an actual (monetary) payment is made.
Implicit Cost - A cost that represents the value of resources used in production for which no actual (monetary) payment is made.
Production and Cost:Short and Long Run
Short Run - A period of time in which some inputs in the production process are fixed.
Long Run - A period of time in which all inputs in the production process can be varied (no inputs are fixed).
Short-run Cost
The short-run costs are the costs over the period during which some factors are in fixed supply – like plant, machinery etc.
It is a sum total of fixed cost and variable cost incurred by the producer in producing the commodity.
Long-run Cost
The long-run costs are the costs over the long period enough to permit changes in all factors of production.
It is a sum total variable cost incurred by the producer in producing the commodity.
Fixed and Variable Costs
Fixed Costs – The cost incurred in those inputs whose quantity cannot be changed as output changes.
Variable Costs – the cost incurred in those inputs whose quantity can be changed as output changes.
Costs in Short-run
Fixed Costs (FC) - Costs that do not vary with output; the costs associated with fixed inputs.
Variable Cost (VC) - Costs that vary with output; the costs associated with variable inputs.
Total Cost (TC) - The sum of fixed costs and variable costs. TC = TFC + TVC
Marginal Cost (MC) - The change in total cost that results from a change in output: MC = ΔTC/Δ Q.
Fixed Cost / Overhead Cost
Fixed Costs (FC) - Costs that do not vary with output; the costs associated with fixed inputs.
Overhead expenses, Wages/Salaries, Depreciation of Machinery, Insurance Amount etc.
Output TFC
01234
1010101010
Fixed Cost / Overhead Cost
Cost 20
15
10 TFC 5
O 1 2 3 4 Output
Total Fixed Cost Curve (TFC Curve) – Horizontal line
Total Variable Cost/ Prime Cost
Variable Cost (VC) - Costs that vary with output; the costs associated with variable inputs.
Cost of direct labor, Running expenses like cost of raw materials, fuels etc.
Output TVC
01234
010183045
Total Variable Cost/ Prime Cost
Cost 40
TVC
30
20
10
0 1 2 3 4 Output
Total Variable Cost Curve (TVC Curve) – Inverse S-shaped Curve
Total Cost
Total Cost (TC) - The sum of fixed costs and variable costs. TC = TFC + TVC
It is the aggregate of all costs of producing any given level of outputOutput TFC TVC TC
01234
1010101010
010183045
1020284055
Total Variable Cost/ Prime Cost
Cost TC 50
TVC
40
30
20 TFC 10
TFC
0 1 2 3
4 Output
Total Cost Curve (TC Curve) – Inverse S-shaped Curve
Fixed Cost vs. Variable Cost
Fixed Cost (FC) Variable Cost (VC)
1. FC are incurred in fixed FOP.
2. FC do not change with the change in output.
3. FC cannot be changed during short-run.
4. FC can never be zero even at zero level of output.
5. Production at the loss of FC may continue.
6. TFC curve is parallel to x-axis.
1. VC are incurred in variable FOP.
2. VC changes with the change in the level of output.
3. VC can be changed during short-run.
4. VC can be zero at zero level of output.
5. Production at the loss of VC will not continue.
6. TVC curve is inverse S-shaped.
Average Fixed, Variable and Total Cost
Average Fixed Cost (AFC) - Total fixed cost divided by quantity of output: AFC = TFC / Q.
Average Variable Cost (AVC) - Total variable cost divided by quantity of output: AVC = TVC / Q.
Average Total Cost (ATC), or Unit Cost - Total cost divided by quantity of output: ATC = TC / Q.
Average Fixed Cost, Average Varible Cost & Average Cost
Average Fixed Cost, Average Variable Cost & Average Cost
Average Fixed Cost, Average Variable Cost & Average Cost
Average Fixed Cost, Average Varible Cost & Average Cost
Average Fixed Cost, Average Varible Cost & Average Cost
Average Fixed Cost, Average Variable Cost & Average Cost
Average Cost Curve is U-shaped
Basis of AFC : AC includes AFC and AFC falls continuously with increase in output. Once AVC reaches its minimum point and starts rising, its rise is initially offset by the fall in AFC. Hence, AC continues to fall. After a certain point the rise in AFC becomes greater than the fall in AFC and AC starts rising
Average Cost Curve is U-shaped
Basis of Law of Variable Proportion : According to this Law initially when variable factor is combined with the fixed factor, production increases at an increasing rate implying AC falls till the best combination of fixed and variable factors is attained. Beyond this point, AC starts to rise.
AFC, AVC and AC Curves Cost AC AVC A C B A1 C1
B1 AFC
A2 C2
O A4 B2 C3 Output
Short run AC curve is a vertical summation of AFC and AVC curves.
AVC = A2A4, AFC = A1A4. AC = AVC + AFC = A2A4 + A1A4 = AA4
AC and AVC CurveAVC is a part of AC as AC = AVC + AFCThe minimum point of AC will always be
to the right of minimum point of AVCBoth AVC and AC are U-shaped curvesThe difference between AC and AVC
decreases with the rise in the level of output as AC is the aggregation of AVC and AFC; and, AFC falls continuously as output increases. AVC and AC never meets each other as AFC is a rectangular hyperbola and can never touch x-axis
Marginal Cost
Marginal Cost (MC) - The change in total cost that results from a change in output: MC = ΔTC/Δ Q.
Short run MC can be estimated from TVC as well
MC = TCn – TCn-1
= (TFCn + TVCn) - (TFCn-1 + TVCn-1)
= (TFCn + TVCn) - (TFCn + TVCn-1)
= TVCn - TVCn-1
Marginal Cost
Output TFC TVC TC MC
01234
1010101010
010183045
1020284055
-108
1215
Marginal Cost
Cost MC
O Output
MC curve is U-shaped curve due to Law of Variable Proportion
MC and AC
Cost MC AC
O a b Output
MC and AC
Both MC and AC are derived from TC. MC= ΔTC/ΔQ and AC = TC/QBoth AC and MC curves are U-shaped,
reflecting the law of variable proportion.When AC is falling MC is below ACWhen AC is rising MC is above ACWhen AC is neither falling or rising AC=MCThere is a range over which AC is falling but
MC is rising (ab)MC curve cuts AC from its minimum point.
MC and AVC
Cost MC AC
AVC AFC O a b
Output
MC and AVC
Moth MC and AVC are derived from TVC. MC= ΔTVC/ΔQ and AVC = TVC/QBoth AVC and MC curves are U-shaped,
reflecting the law of variable proportion.When AVC is falling MC is below AVCWhen AVC is rising MC is above AVCWhen AVC is neither falling or rising
AVC=MCThere is a range over which AVC is falling
but MC is rising (ab)MC curve cuts AVC from its minimum point.The minimum point of AVC curve occurs to
the right of the minimum point of MC curve.
Production and Costs in the Long Run
In the short run, there are fixed costs and variable costs; therefore, total cost is the sum of the two.
A period of time in which all inputs in the production process can be varied (no inputs are fixed). In the long run, there are no fixed costs, so variable costs are total costs.
Long-Run Average Total Cost (LRATC) Curve
A curve that shows the lowest (unit) cost at which the firm can produce any given level of output.
A firm attempts to maximize long run profits by selecting a short scale of plant that minimizes its costs.
Long-Run Average Total Cost
Curve (LRATC ) There are three
short-run average total cost curves for three different plant sizes.
If these are the only plant sizes, the long-run average total cost curve is the heavily shaded, blue scalloped curve.
Long-Run Average Total Cost
Curve (LRATC ) The long-run average
total cost curve is the heavily shaded, blue smooth curve.
The LRATC curve is not scalloped because it is assumed that there are so many plant sizes that the LRATC curve touches each SRATC curve at only one point.
Economies of Scale Economies of Scale exist when inputs
are increased by some percentage and output increases by a greater percentage, causing unit costs to fall.
Constant Returns to Scale exist when inputs are increased by some percentage and output increases by an equal percentage, causing unit costs to remain constant.
Diseconomies of Scale exist when inputs are increased by some percentage and output increases by a smaller percentage, causing unit costs to rise.
Why Economies of Scale?
Up to a certain point, long-run unit costs of production fall as a firm grows. There are two main reasons for this:
Growing firms offer greater opportunities for employees to specialize.
Growing firms can take advantage of highly efficient mass production techniques and equipment that ordinarily require large setup costs and thus are economical only if they can be spread over a large number of units.
Why Diseconomies of Scale?
In very large firms, managers often find it difficult to coordinate work activities, communicate their directives to the right persons in satisfactory time, and monitor personnel effectively.
Economies of Scale
The lowest output level at which average total costs are minimized.
LAC and LMC Costs
LMC LAC
O X Output
Increasing Decreasing Returns to Scale Returns to
Scale Constant Returns to Scale
LAC and LMC
Both LMC and LAC curves are flatter U-shaped curves are compared to SMC and SAC
LMC cuts LAC at its minimum pointWhen LAC is falling LMC is below itWhen LAC is rising LMC is above itWhen LAC is neither falling or rising
LMC = LAC
A firm’s cost curves will shift if there is a change in:TaxesInput pricesTechnology.
Shifts in Cost Curves