Introduction Cost is the basis of many important decisions Cost & revenue are the 2 main factors Relation between cost & output is called cost

function Determinates of cost function :

Production Function Prices of Inputs

Cost of Production = Total Expenses Incurred + Normal Profit Expected by Producer

It provides basis to a product pricing Firm’s overall profitability is determined by the

level of cost relating to revenue

Types of Costs

Short run – It is a short period of time with in which the firm can varies output by varying the amount of variable factors

E.g. Labour, Raw Material Long run – It is a period of time in which the

quantity of all factors such as variable as well as fixed can be changed

E.g. Capital Equipment & plant

Cost Functions• 1. Total Variable Cost (TVC) – The cost of all variable

resources E.g. Cost of labor, materials, office supplies

• 2. Total Fixed Cost (TFC) – The cost of all fixed inputs E.g. Cost of the building, large pieces of machinery,

certain taxes

• 3. Total Cost (TC) - the sum of all costs incurred in production This the sum of TVC and TFC.

Total Cost (TC) = TFC + TVC f(Q)OR

4. Average Variable Cost (AVC) – This is variable cost per product.

5. Average Fixed Cost (AFC) – This is fixed cost per product.

AFC = TFC/Q

6. Average Total Cost (ATC) – This is total cost per product.

ATC = TC/Q AFC + AVC

7. Marginal Cost (MC) – This is the cost of producing an additional unit of the product.

MC = TCn – TCn-1

OR

NATURE OF COSTS

• Actual cost: cost incurred in production

• Opportunity cost: return from the second best use of firm’s resources which the firm foregoes in order to avail the return

• Explicit / Accounting Costs : Actual money spent in purchasing or hiring services of factor.

Explicit cost is the monetary payment made by the entrepreneur for purchasing or hiring the services of various productive factors, which do not belong to him. This cost is in the nature of contractual payment and includes rent for land, wages to the labour , interest on capital, payments for raw materials, advertisement, power etc.

NATURE OF COSTS Implicit / Imputed cost: Cost of self-owned

and self-employed resources. Implicit cost of production as “cost of self-

owned, self employed resources that are frequently overlooked in computing the expenses of a firm”. it is the amount that could be earned in the best alternatives use of the entrepreneur's money and time

• Accounting costs: Cost as stated in books of accounts (explicit cost only)

• Incremental Costs: Total additional cost of implementing a managerial decision

• Historical Cost:

• Replacement Cost : Cost incurred in replacing

NATURE OF COSTS

SHORT-RUN COST FUNCTIONS

Q TFC TVC TC AFC AVC ATC MC

0 60 0 60 - - - -

1 60 20 80 60 20 80 20

2 60 30 90 30 15 45 10

3 60 45 105 20 15 35 15

4 60 80 140 15 20 35 35

5 60 135 195 12 27 39 55

Explanation • Total fixed cost is constant in the above fig.• TVC increases as no of units produced

increases.• But Fixed cost remain constant irrespective of

per unit produced• So that as TVC increases TC also increases in

the same proportion • Therefore TC = TVC + TFC

Explanation • AVC is in U shape • Output AVC & vice versa • Therefore ATC also • Falling path of ATC is mainly influenced by falling

of AFC where as rising path of ATC is due to rising of AVC

• When MC<AVC, AVC is falling• When MC>AVC, AVC is rising• When MC=AVC, AVC is at its minimum• MC will always rise more sharply than the AVC• AFC declines steadily as output increases

Short-Run & Long-Run Total Cost Curves

• The firm’s long-run total cost curve consists of the lowest parts of the short-run total cost curves. The long-run total cost curve is the lower envelope of the short-run total cost curves.

Short-Run & Long-Run Average Cost Curves

LAC

SRACs

output

Q1Q2

Q3

Explanation • In long run firm can change its output because

all inputs can be changed• 3 SAC curves are of 3 different plants • Q2 is the least cost combination as it has the

minimum point of tangent to LAC• In other two cases SAC curves are tangent to

LAC curve but at that point of tangency neither SAC nor LAC is minimum

• LAC curve stresses economies of scale

RELATIONSHIP B/W LONG-RUN & SHORT-RUN AVERAGE COST CURVES

RELATIONSHIP B/W LONG-RUN & SHORT-RUN AVERAGE COST CURVES

SR RELATIONSHIP BETWEEN PRODUCTION AND COST

• A firm’s cost structure is intimately related to its production process

• Costs are determined by the production technology and input prices

SR RELATIONSHIP BETWEEN PRODUCTION AND COST

In order to illustrate the relationship, consider the production process described in table

Total Input (L) Q (TP) MP0 01 1,000 1,0002 3,000 2,0003 6,000 3,0004 8,000 2,0005 9,000 1,0006 9,500 5007 9,850 3508 10,000 1509 9,850 -150

SR RELATIONSHIP BETWEEN PRODUCTION & COST

• Total variable cost (TVC) is the cost associated with the variable input, in this case labor

• Assume that labor can be hired at a price (w) of Rs 500 per unit

TOTAL I/P (L) Q (TP) MP

TVC (wL)

MC (∆TVC/ ∆Q)

0 0 0

1 1000 1000 500 0.5

2 3000 2000 1000 0.25

3 6000 3000 1500 0.16

4 8000 2000 2000 0.25

5 9000 1000 2500 0.5

6 9500 500 3000 1

7 9850 350 3500 1.4

8 10000 150 4000 3.33

9 9850 -150 4500

SR RELATIONSHIP BETWEEN PRODUCTION & COST• TP and TVC are mirror images of each other• When TP increase at an increasing rate, TVC increase at a decreasing

rate

RELATION B/W MP & MC

• When MP is increasing, MC is decreasing

• When MP is decreasing, MC is increasing

• Also when MP= AP at max AP, MC = AVC at min AVC

Total Input (L) Q MP

TVC (wL) MC

0 0 01 1,000 1,000 500 0.502 3,000 2,000 1,000 0.253 6,000 3,000 1,500 0.174 8,000 2,000 2,000 0.255 9,000 1,000 2,500 0.506 9,500 500 3,000 1.007 9,850 350 3,500 1.438 10,000 150 4,000 3.339 9,850 -150 4,500

SHORT-RUN COST FUNCTIONS

Average Variable CostAVC = TVC = w L

Q Q= w = w

Q/L APL

Marginal Cost

TC/Q = TVC/Q = (w L)/Q = w = w

Q/L MPL

EXERCISE

Given Total Cost function:TC = 1000 + 10 Q – 0.9 Q 2 + 0.04 Q 3

Find the rate of O/P that result in minimum Average Variable cost

LR RELATIONSHIP B/W MARGINAL COST AND AVERAGE COST

• All I/Ps to a firm’s production can be changed.

• No fixed i/ps and fixed costs.

• All cost of productions are variable.

• The rate of change of long run total cost function is also known as long run marginal cost.

• Average of the long run marginal cost over a period of time is known as long run average cost

Scale of Production Total Product (o/p)Rs LRTC in Rs. LRMC in Rs. LRAC in Rs.

A 10K 50K 5 5

B 20K 90K 4 4.5

C 30K 120K 3 4

D 40K 150K 3 3.75

E 50K 200K 5 4

F 60K 260K 6 4.3

Relation between LRMC and LRAC

LR RELATIONSHIP B/W PRODUCTION & COST

LONG RUN AVERAGE COST (LRAC)

Economies of scale• When LRAC declines with increase in o/p firm experiences

economies of scale.• Per-unit cost of product is falling .

Diseconomies of scale• When LRAC increases with increase in o/p firm experiences

diseconomies of scale.• Per-unit cost of product is rising

LONG-RUN COST FUNCTION: GENERAL SHAPE

Factors affecting economies and diseconomies of scale

Economies of scale • Specialization in use of labour and capital.• Productive capacity of capital equipment rises faster then

purchase rate.• Discounts from bulk purchases.• Lower cost of raising capital funds.• Efficient management techniques.• Spreading of promotional and research and development

costs.

Diseconomies of scale • Disproportionate rise in transportation costs.• Input market imperfections.(wage rates driven up)• Management coordination and control problems• Disproportionate rise in staff and direct labour.

Factors affecting economies and diseconomies of scale

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