MANAGERIAL

ECONOMICS

PRESENTATION TOPIC

THEORY OF COST
Apeejay Institute of Technology
School of Management
Greater Noida
PRESENTED BY
Akash Siraunjia(M200905)

N.S ParthSarthi(M200949)

Nitin Gupta(M200955)

Alok Ranjan(M200906)
CONTENT
INTRODUCTION

SHORT RUN COST

LONG RUN COST

CONCLUSION
What is cost?
The firm’s decision on profit maximizing output
depends on the behavior of its costs as well as
on the behavior of its revenue
A firm’s cost of production is commonly thought
of as its monetary expenses.
In order to produce a good, every firm makes use
of various factor & non-factor inputs.
In common parlance the amount spent on the
use of these inputs is called cost of production
However, the firm’s money expenditure on inputs
is only a part of the cost picture.
Money Cost
The amount spent in terms of money for the
production of a commodity is called money
cost.
Wages paid to laborers
Interest on loans
Rent paid for premises
Expenditure on raw materials & machinery
Insurance
Taxes
Payments for power, light & fuel
Transportation charges etc
Real cost
The mental & physical efforts &
sacrifices undergone with a view to
producing a commodity are its real
cost.
In other words, real cost refers to
the pains, the discomfort &
disutility involved in supplying the
factors of production by their
owners.
Accounting cost
It refers to cash payments which
firms make for factor & non factor
inputs, depreciation & other book
keeping entries.
It is also called actual cost,
acquisition cost or absolute cost or
explicit cost or direct cost.
Opportunity cost
The opportunity cost is the cost of
next best alternative foregone.
It is also called alternative cost.
It refers both to the explicit &
implicit cost
Economic cost
Economic cost may be defined as those
monetary payments a firm must make to
those outsiders who supply resources &
non expenditure payments of self owned &
self employed resources which they could
have earned in their best alternative
opportunities.
Thus, the accounting cost refers only to
explicit costs while economic costs refers
both to explicit costs as well as implicit
costs
 Economists versus Accountants
How an Economist How an Accountant
Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs
Social cost
The social cost is the total cost to
society of an economic activity.
The economic organization of every
society is characterized by certain social
costs such as pollution & noise which
are not taken by firms in determining
their price levels
Social cost is the opportunity cost to
society rather than just one firm or
individual.
Private cost
Private cost is the cost incurred by
an individual firm for producing a
commodity.
It includes both the explicit cost as
well as implicit cost.
Private cost is equal to social costs
minus external costs.
Explicit costs
Many inputs are bought or hired by
the firms
The monetary payments which
firm makes to those outsiders who
supply labor services, material,
fuel, transportation services, power
& so forth are called explicit costs.
Implicit costs
The cost of using resources owned
by the firm or contributed by its
owners is called implicit cost in
economics.
Theories of cost

Traditional theory Modern theory

The main difference b/w traditional &

modern theories of cost is that the
traditional economists believe that
average & marginal cost curves are ‘U’
– shaped while the modern economists
believe them to be ‘L’ – shaped.
 Short run cost

Total cost Marginal cost

(always the variable cost

Average cost
Total fixed
Cost
Average fixed
Total variable cost
cost
Average variable
cost
Total Cost

Total cost is the cost of all the resources

necessary to produce any particular
level of output.
The total costs are the sum of total fixed
costs & total variable costs.
The cost of fixed factors are total fixed
costs & those of variable factors are
called total variable costs
TC = TFC + TVC
Total Fixed Cost
The costs of fixed inputs are called total
fixed costs.
TFC = Units of fixed factors ×Price of the
factor
Production may be maximum or zero
unit, fixed costs remain the same.
These costs are also called
Supplementary costs or indirect costs,
over-head costs.
Total Variable costs

Variable costs are those costs

which are incurred on the use of
variable factors of production.
These are also called, Prime Costs
or Direct Costs or Avoidable costs.
 Total Cost
Output Fixed Costs Variable cost Total cost

0 10 0 10

1 10 10 20

2 10 18 28

3 10 24 34

4 10 28 38

5 10 32 42

6 10 38 48

7 10 46 56

8 10 62 72
Total Costs

cost
TC
VC

FC

Output
Average Cost (AC)

Average cost is the cost per unit of

output.

It is the total cost of producing any

given output divided by the number
of unit produced.
Average Fixed Cost

Average fixed cost is per unit fixed

cost.

It is total fixed cost divided by

output.

AFC = FC
Q
Average Variable cost

The average total cost is the total

cost per unit of output.

AC = TC = AFC + AVC

Q
 Average cost

AC
COST

X
O OUTPUT
 Why is the short run Average Cost
Curve ‘U’ – Shaped?

Interaction of Average Fixed Cost &

Average Variable Cost.

Application of law of Variable

Proportions
Marginal Cost

Marginal Cost is the increase in

total cost when output is increased
by one unit.

MC = TC = TCn – TCn – 1

Q
Output of Change in Total Cost Change in Total Marginal Cost
Cloth(me.) output TC Cost MC
Q Q TC/ Q

0 - 120 - -
10 10 180 60 6
22 12 240 60 5
36 14 300 60 4.28
52 16 360 60 3.75
70 18 420 60 3.33
86 16 480 60 3.75
100 14 540 60 4.28
112 12 600 60 5
137 7 780 60 8.75
148 5 900 60 12
 Marginal cost
COST MC

OUTPUT
 Relation b/w Average & marginal
Cost
When AC falls, MC is less than AC
When AC rises, MC is greater than
AC
AC remains same when MC stands
equal
 AC & MC Curve

MC AC
COST

OUTPUT
 Long run total cost

Since all inputs are variable in the

long run, there is only one long – run
total cost curve.

The long – run total cost is the

minimum cost at which each level of
output can be produced
Long run Total Costs

LTC
cost

Output
 Long run Average Cost Curve or
Envelope Curve

Long – run average cost refers to

minimum possible per unit cost of
producing different quantities of
output in the long run period.
 Long Run Average Cost Curve

SAC3
LAC

C1 SAC1 SAC2
Average cost

C3
C2

O Q1 Q2 Q3

Output
 Long run Marginal Cost

The long – run marginal cost

attributable to an additional unit of
output when all inputs are optionally
adjusted.
Long Run Marginal Cost
Cost per Unit

MC long run

Output
 Modern theory of cost
 According to the modern theory long-run costs
are mainly of two types
 Production cost &
 Managerial cost
 On accounts of increase in production,
production cost goes on falling continuously
due to technical economies of scale.
 On the contrary, as the scale of production is
enlarges managerial costs may rise.
 Since fall in production is more than rise in
managerial – cost, long – run average cost curve
falls smoothly or remains constant at very large
scales of output.
LRAC curve

Costs per unit ($)

LRAC
Units of output
 Case Study

Q. A firm producing hockey sticks has a

production
function given by Q=2√KL. In the short run,
the firm’s amount of capital equipment is
fixed at K=100. The rental rate for K is Rs. 1
and the wages rate is Rs. 4.
(1). Calculate the firm’s short run total and
average cost.
(2). What are STC, SAC and SMC for
producing 25 sticks.
CONCLUSION
The theory of cost is a fundamental concern of
Managerial economics. Opportunity cost includes
both EXPLICIT and IMPLICIT costs. The cost
function relates to specific rates of output. The
basis for the cost function is the production
function and prices of inputs. In the short run the
rate of one input is fixed. In long run all costs are
variable. Profit contribution analysis is used to
determine the output rate necessary to earn a
specified profit rate.