Costs concepts

Study of behavior of cost in relation to

production, size of output, scale of
operations, prices of factors of
production.
 Determinants of costs
1. Laws of returns ie incase of incresing returns
the cost is less and incase of decresing returns
it is incresing.
2. Costs is effected by the size of plant.
3. Time period longer the time period costs would
rise slowly whereas in case of short run
production the initial cost would be high.
4. Technology.
5. Size of plant ,incase of bigger lot the cost per
unit would be less.
 Types of costs
1. Accounting costs
2. Opportunity costs
3. Fixed cost and the variable costs
4. Business costs -all costs incurred to carry the business, whereas
the full costs includes business ,opportunity, and the normal
profit.
5. Incremental costs are the total additional costs needed to expand
the production.
6. Sunk costs are the costs which have already been incurred and
cannot be recovered, nor altered ,increased or decreased by
varying the rate of output.
7. Private costs which are actually borne by the firm for the
production process whereas
8. Social costs are the costs which the society has to bear while the
production process takes place eg effluents into the river by the
rifineries.
 Costs in the Short Run
• The short run is a period of time
for which two conditions hold:
1. The firm is operating under a fixed
scale (fixed factor) of production, and
2. Firms can neither enter nor exit an
industry.
• In the short run, all firms have
costs that they must bear
regardless of their output. These
kinds of costs are called fixed
costs.
 Costs in the Short Run
• Fixed cost is any cost that does not
depend on the firm’s level of output.
These costs are incurred even if the firm is
producing nothing.
• Variable cost is a cost that depends on
the level of production chosen.

TC  TFC  TVC
Total Cost = Total Fixed + Total Variable
Cost Cost
 Fixed Costs
• Firms have no control over fixed costs
in the short run. For this reason, fixed
costs are sometimes called sunk
costs.
• Average fixed cost (AFC) is the total
fixed cost (TFC) divided by the
number of units of output (q):

TFC
AFC 
q
 Short-Run Fixed Cost (Total and
Average) of a Hypothetical Firm
(1) (2) (3)
q TFC AFC (TFC/q)
0 $1,000 $ 
1 1,000 1,000
2 1,000 500
3 1,000 333
4 1,000 250
5 1,000 200

• AFC falls as output

rises; a phenomenon
sometimes called
spreading overhead.
 Variable Costs
• The total variable cost curve is a
graph that shows the relationship
between total variable cost and the
level of a firm’s output.
• The total variable
cost is derived from
production
requirements and
input prices.
 Marginal Cost
• Marginal cost (MC) is the increase in total cost that
results from producing one more unit of output.
• Marginal cost reflects changes in variable costs.
• Change in fixed cost is zero in the short run.

TC TFC TVC

M C   
Q Q Q
Derivation of Marginal Cost from
Total Variable Cost
UNITS OF TOTAL VARIABLE MARGINAL
OUTPUT COSTS ($) COSTS ($)
0 0 0
1 10 10
2 18 8
3 24 6
• Marginal cost measures the additional
cost of inputs required to produce each
successive unit of output.
The Shape of the Marginal Cost
Curve in the Short Run
• The fact that in the short run every
firm is controlled by some fixed input
means that:
1. The firm faces diminishing returns to
variable inputs, and
2. The firm has limited capacity to produce
output.
• As a firm approaches that capacity, it
becomes increasingly costly to
produce successively higher levels of
output.
The Shape of the Marginal Cost
Curve in the Short Run
• Marginal costs ultimately increase with
output in the short run.
Graphing Total Variable Costs
and Marginal
•
Costs
Total variable costs
always increase with
output. The marginal
cost curve shows how
total variable cost
changes with single unit
increases in total output.
• Below 100 units of output,
TVC increases at a
decreasing rate. Beyond 100
units of output, TVC increases
at an increasing rate.
 Average Variable Cost
• Average variable cost (AVC) is the
total variable cost divided by the
number of units of output.
• Marginal cost is the cost of one
additional unit. Average variable
cost is the average variable cost per
unit of all the units being produced.
• Average variable cost follows
marginal cost, but lags behind.
 Total Costs
• the total cost curve has
the same shape as the
total variable cost
curve; it is simply
higher by an amount
equal to TFC.

TC  TFC  TVC
Average Total Cost
• Average total cost (ATC) is
total cost divided by the
number of units of output (q).

ATC  AFC  AVC

TC TFC TVC
ATC   
q q q
• Because AFC falls with
output, an ever-declining
amount is added to AVC.
Relationship Between Average
Total Cost and Marginal Cost
1. ATC is the summation
of AVC and AFC.
2.In the biggning AVCand
AFC falls hence the
ATC falls sharply.
3.MC also falls and is
below than AVC in the
initial stage,reches
minimum and then
rises.
4.ATC falls reaches
minimum and then
rises.
Output Decisions: Revenues,
Costs, and Profit Maximization
• In the short run, a competitive firm faces a demand
curve that is simply a horizontal line at the market
equilibrium price.
 Total Revenue (TR) and
Marginal Revenue (MR)
• Total revenue (TR) is the total amount that
a firm takes in from the sale of its output.
TR  P  q
• Marginal revenue (MR) is the additional revenue
that a firm takes in when it increases output by
one additional unit.
• In perfect competition, P = MR.

TR P (q )
M R    P
q q
 Comparing Costs and
Revenues to Maximize Profit
• The profit-maximizing level of output for
all firms is the output level where MR =
MC.
• In perfect competition, MR = P, therefore,
the profit-maximizing perfectly competitive
firm will produce up to the point where the
price of its output is just equal to short-run
marginal cost.
• The key idea here is that firms will
produce as long as marginal revenue
exceeds marginal cost.
Profit Analysis for a Simple Firm
(6) (7) (8)
(1) (2) (3) (4) (5) TR TC PROFIT
q TFC TVC MC P = MR (P x q) (TFC + TVC) (TR  TC)
0 $ 10 $ 0 $  $ 15 $ 0 $ 10 $ -10
1 10 10 10 15 15 20 -5
2 10 15 5 15 30 25 5
3 10 20 5 15 45 30 15
4 10 30 10 15 60 40 20
5 10 50 20 15 75 60 15
6 10 80 30 15 90 90 0
 The Short-Run Supply Curve

• At any market price, the marginal cost curve shows the output level
that maximizes profit. Thus, the marginal cost curve of a perfectly
competitive profit-maximizing firm is the firm’s short-run supply curve.