COST THEORY AND ANALYSIS

NATURE OF COSTS

Actual cost: cost incurred in production

Opportunity cost: return from the second best use of

firms resources which the firm foregoes in order to
avail the return

Explicit / Accounting Costs : Actual money spent in

purchasing or hiring services of factor

Implicit / Imputed cost: Cost of self-owned and selfemployed resources

NATURE OF COSTS

Fixed costs: Costs which do not change with change

in O/P

Variable or Prime costs: Costs which change with

change in level of O/P

Accounting costs: Cost as stated in books of

accounts (explicit cost only)

Economic Costs: includes both explicit & implicit cost

NATURE OF COSTS

Marginal cost: Change in total cost

associated with a one-unit change in output

Incremental Costs: Total additional cost of

implementing a managerial decision

NATURE OF COSTS

Private cost: Actually incurred or provided for by an

individual for its business activity

Social cost: Cost to society on account of production

of good

Original cost: cost incurred originally

Replacement cost: cost incurred in replacing

EXERCISE

A Carpenter makes 100 chairs per month & sells them at

Rs 150 per piece. His expenses on rent of shop, cost of
wood & other materials are worth Rs 5000. He employs 2
workers whose monthly wage bill stand at Rs 2400 & pays
electricity bill of Rs 500 per month. He has invested Rs
50,000 in the form of machines, tools & inventories of
which Rs 25,000 is from his own fund & remaining 25,000
is a loan from bank at interest rate of 18% p.a. Assuming
imputed cost of his own time, own shop & own savings of
Rs 25000 as Rs 3000, Rs 1000 & Rs 250 respectively,
find:
Explicit cost
Implicit cost
Accounting profit
Economic profit

ANSWERS

Explicit cost : Rs 8275

Implicit cost: Rs 4250
Accounting profit: Rs 6725
Economic profit: Rs 2475

COST FUNCTION

C = f (S, O, P, T)
Where:
C: Cost of O/P
S: Size of plant
O: level of O/P
P: price of I/Ps used in production
T: nature of technology

SHORT-RUN COST FUNCTIONS

Total Cost = TC = f(Q)

TC = TFC + TVC
Total Fixed Cost = TFC
Total Variable Cost = TVC

SHORT-RUN COST FUNCTIONS

Average Fixed Cost = AFC = TFC/Q

Average Variable Cost = AVC =TVC/Q

Average Total Cost = ATC = TC/Q

Average Total Cost = AFC + AVC

Marginal Cost = TC/Q =TVC/Q

SHORT-RUN COST FUNCTIONS

Q

TFC

TVC

TC

60

60

AFC

AVC

ATC

MC

60

20

80

20

60

20

80

60

30

90

30

15

45

10

60

45

105

20

15

35

15

60

80

140

15

20

35

35

60

135

195

12

27

39

55

Cost

250

Total Cost Function

200

TC

150

TVC

100

TFC

50

0
0

Cost

Output

90

Per Unit Cost Function

80
70

MC

60
50
40

AC

30

AVC

20

AFC

10
0

Output

SHORT RUN COST FUNCTION: IMPORTANT

OBSERVATIONS

AFC declines steadily over the range of

production

In general, AVC, AC, and MC are U shaped

When MC<AVC, AVC is falling
When MC>AVC, AVC is rising
When MC=AVC, AVC is at its minimum

The distance between AC and AVC

represents AFC

SR RELATIONSHIP BETWEEN PRODUCTION AND

COST

A firms cost structure is intimately related to its

production process
Costs are determined by
technology and input prices

the

production

SR RELATIONSHIP BETWEEN PRODUCTION AND COST

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

Total
Input
(L)
0
1
2
3
4
5
6
7
8
9

Q (TP)
0
1,000
3,000
6,000
8,000
9,000
9,500
9,850
10,000
9,850

MP
1,000
2,000
3,000
2,000
1,000
500
350
150
-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)

MC
(TVC/
Q)

TVC
(wL)

MP

1000

1000

500

0.5

3000

2000

1000

0.25

6000

3000

1500

0.16

8000

2000

2000

0.25

9000

1000

2500

0.5

9500

500

3000

9850

350

3500

1.4

10000

150

4000

3.33

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)
0
1
2
3
4
5
6
7
8
9

Q
0
1,000
3,000
6,000
8,000
9,000
9,500
9,850
10,000
9,850

MP
1,000
2,000
3,000
2,000
1,000
500
350
150
-150

TVC
(wL)
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500

MC
0.50
0.25
0.17
0.25
0.50
1.00
1.43
3.33

SHORT-RUN COST FUNCTIONS

Average Variable Cost

AVC = 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 PRODUCTION & COST

All I/Ps variable

No fixed costs
LR cost structure of firm is related to firms long
run production process which is described by
RTS
Economists hypothesize that a firms long-run
production function may exhibit at first IRS then
CRS & finally DRS

LR RELATIONSHIP B/W PRODUCTION & COST

IRS:
A proportional increase in all I/Ps increases O/P by a
greater percentage than costs
Costs increase at a decreasing rate
CRS:
A proportional increase in all I/Ps increases O/P by same
percentage as costs
Costs increase at a constant rate
DRS:
A proportional increase in all I/Ps increases O/P by a
smaller percentage than costs
Costs increase at an increasing rate

LR RELATIONSHIP B/W PRODUCTION & COST

LONG-RUN COST CURVES

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q

Long-Run Marginal Cost = LMC = LTC/Q

DERIVATION OF LONG-RUN COST CURVES

LAC
It shows the lowest average cost of producing each
level of O/P when the firm can build the most
appropriate plant to produce each level of O/P

RELATIONSHIP B/W LONG-RUN & SHORT-RUN

AVERAGE COST CURVES

RELATIONSHIP B/W LONG-RUN & SHORT-RUN

AVERAGE COST CURVES

LONG-RUN COST FUNCTION

When LAC declines: firm experiences

economies of scale (per-unit costs are
falling)

When LAC increases: firm experiences

diseconomies of scale (per-unit costs are
rising)

LONG-RUN COST FUNCTION: GENERAL SHAPE

ECONOMIES OF SCALE
Internal

External
Pecuniary economies

Real economies

Quantity discounts

Specialization
Indivisibility
Advertising

Team work

Lower cost of capital

transportation
Sales promotion

DISECONOMIES OF SCALE
Congestion

Scarcity of
resources

Difficulty in
Coordination &
control

MANAGERIAL USES OF COST FUNCTIONS:

DETERMINING OPTIMUM OUTPUT LEVEL

O/P level at which AC is minimum

Necessary condition: (AC) / Q = 0
Sufficient condition: 2(AC) / Q2 > 0

MANAGERIAL USES OF COST FUNCTIONS:

DETERMINING OPTIMUM SCALE

Value of plant size (K) at which total cost (C) is

minimum
Necessary condition: C / K = 0
Sufficient condition: 2C / K2 > 0

SPECIAL TOPICS IN COST THEORY

(1) PROFIT CONTRIBUTION ANALYSIS

Total Revenue = TR = (P)(Q)
Total Cost = TC = TFC + (AVC)(Q)
Profit = TR -TC

Profit = = PQ - [TFC + (AVC)(Q)]

Q = TFC +
P - (AVC)
Profit contribution = P - AVC

EXAMPLE
Fixed cost = Rs 10,000
Price = Rs 20
AVC = Rs 15
How much O/P should the firm produce to
have a profit of Rs 20,000?
Answer: 6000 units

(2) BREAKEVEN VOLUME (TR = TC)

(zero economic profit)
= TR - TC = 0
TR = TC

(P)(Q) = TFC + (AVC)(Q)

QBE =

TFC

(P - AVC)

EXAMPLE
Fixed cost = Rs 10,000
Price = Rs 20
AVC = Rs 15
How much O/P should the firm produce in order
to break even?

Answer: 2000 units

Also : TR = 20Q
TC = 10,000 + 15Q
TR = TC

LINEAR BREAKEVEN ANALYSIS

P = 10
TFC = 200
AVC = 5

LINEAR BREAKEVEN ANALYSIS: SHORTCOMINGS

Assumes constant prices

Assumes constant average variable costs

EXCERCISE

Petersen & Lewis Page # 239: Breaking even

on Microcomputer software

NONLINEAR BREAKEVEN ANALYSIS

TR/TC

TC

350
300

TR

250
200
150
100
50
0

Profit

40
30
20
10
0

-10
-20
-30
-40
-50

(3) OPERATING LEVERAGE

Operating Leverage = TFC/TVC
Degree of Operating Leverage (or profit elasticity) = DOL

DOL = % = / = * Q = E
%Q
Q/Q
Q
= PQ - TFC + (AVC)(Q)
= Q(P - AVC) - TFC

= Q(P - AVC)

DOL = Q(P - AVC)Q

=
Q(P - AVC)
Q[Q(P - AVC) - TFC]
Q(P - AVC) - TFC

(4) LEARNING CURVE

Workers improve with practice so per unit cost of

additional O/P declines

Measures % decrease in additional labor cost

each time O/P doubles

An 80 percent learning curve implies that each

time O/P doubles, L costs associated with
incremental output decrease to 80% of previous
level

UTILITY OF LEARNING CURVES

To forecast needs of

personnel

machinery

raw materials

Scheduling production

Determining Selling price of product

(5) ECONOMIES OF SCOPE

The reduction of a firms unit cost by producing two or

more goods or services jointly rather than separately
Degree of economies of scope =
TC(Q1) + TC(Q2) TC(Q1 + Q2)
TC(Q1 + Q2)

EXAMPLE
Firm A produces 100 units of X & 500 units of Y per
month at the TC of Rs 1,00,000. If X & Y are
produced separately by firms B & C then the TC to
firm B of producing 100 X is Rs 25000 & firm C of
producing 500 Y is Rs 90,000.
Check whether firm A is experiencing economies or
diseconomies of scope

Answer: 0.15 so economies of scope

NOTE:
Positive: economies of scope
Negative: diseconomies of scope