Theory of Costs

Maximization of profit is an
important business objective for
the firm
Profit = Revenue- Cost
Thus to know the profitability of
any decision we need to
understand the costs

DTA- Managerial Economics

Total cost(TC) =Total Fixed Cost(TFC)

+Total variable costs (TVC)
Total Fixed costs are the costs that do not vary
with the level of output.
For eg., Cost incurred on account of fixed plant
and equipment, rent charges, advertisement
expenses, salaries of administrative staff
Total fixed cost is the total cost of all the fixed
inputs employed in a production process( it
remains unchanged at all levels of output)

DTA- Managerial Economics

Variable costs
Variable costs represent those costs that
change directly with the change in output.
Examples are cost of raw materials, Direct
labour, electricity charges, fuel charges
etc.

DTA- Managerial Economics

Total Fixed, Variable and Total Cost Curves

Cost
Total Cost Curve
Total Variable
Cost Curve

TFC

Total Fixed Cost Curve

TFC

DTA- Managerial Economics

Quantity

TVC- Inverse S- shape

Total Variable Cost has an inverse S-shapereflecting the law of variable proportions( Law of
diminishing marginal returns)
As per the law, at the initial stages of production
in a particular plant as more of the variable
factor (labour)is employed its productivity
increases initially( MP increases ) and the
average variable cost falls.

DTA- Managerial Economics

Short run costs

Inputs
Output
Capital
Labour
10
1
43
10
2
160
10
3
351
10
4
600
10
5
875
10
6
1152
10
7
1372
10
8
1536
10
9
1656
10
10
1750
10
11
1815
10
12
1860

TFC
100
100
100
100
100
100
100
100
100
100
100
100

Total Cost
TVC
20
40
60
80
100
120
140
160
180
200
220
240

TC
120
140
160
180
200
220
240
260
280
300
320
340

100

DTA- Managerial Economics

Short run average Costs

Cost per unit or average costs are more
important for businessmen and economists.
Average Fixed Costs(AFC):
AFC is the total fixed cost divided by the number
of units of output produced.
AFC= TFC/Output
It is always falling as output increases, as fixed
costs are being spread over larger units of
output.
DTA- Managerial Economics

Average Costs
Average Total Costs is calculated as total
cost divided by the number of units
produced.

DTA- Managerial Economics

Average and marginal costs

Output
43
160
351
600
875
1152
1372
1536
1656
1750
1815
1860

Average Cost
AFC
AVC
ATC
2.326
0.465
2.791
0.625
0.250
0.875
0.285
0.171
0.456
0.167
0.133
0.300
0.114
0.114
0.228
0.087
0.104
0.191
0.073
0.102
0.175
0.065
0.104
0.169
0.060
0.109
0.169
0.057
0.114
0.171
0.055
0.121
0.176
0.054
0.129
0.183

DTA Managerial Economics

Marginal Cost
MC
0.465
0.171
0.105
0.080
0.073
0.072
0.091
0.122
0.167
0.213
0.308
0.444

Average fixed costs

0.8

COST

0.6
AFC

0.4
0.2
0
0

500

1000

OUTPUT
DTA Managerial Economics

10

1500

2000

Average total Cost (ATC) and

Average variable costs(AVC)
0.8

COST

0.6
AVC
ATC

0.4
0.2
0
0

400

800

1200

OUTPUT
DTA-Managerial Economics

11

1600

2000

Marginal costs
0.8

COST

0.6
AVC
ATC
MC

0.4
0.2
0
0

500

1000

OUTPUT
DTA Managerial Economics

12

1500

2000

The supply schedule

The firms supply schedule shows the quantities that
the firm is willing to offer at each market price
Since a firm is presumed to operate for profits, then it
will only offer output when the market price is greater
than the cost of producing the last unit offered.
Therefore, the firms supply schedule is also the
firms marginal cost curve, above the average
variable cost(when MC > AVC)
DTA Managerial Economics

13

Shut down of production

AC/AR
MC

ATC

A (Rs.150)

AVC

BE (Rs.51)
B (Rs.45)
C (Rs.34)

Shut down
point

AFC

OUTPUT

DTA- Managerial Economics

14

Shut down Analysis of graph

A(Rs.150); B (Rs.45); C(Rs.34) are the price/Average

revenue earned by the firm when the market price is
A, B or C.
The minimum ATC is (Rs.51) and the minimum AVC
is (Rs.34) the firm is able to achieve (at a production
level of 180 units).
The firm can cover its variable and fixed costs (that is
the total costs) if price is Rs.51; This is when
AR/Price is at least equal to the Average Total
Cost(ATC curve)
The AR/Price should at least cover the Average
Variable Cost(AVC) for the firm to continue supply
in the short-run. If Price falls below AVC then the firm
will Shut-down. Hence if price is below Rs.34, firm
will not produce.
DTA- Managerial Economics

15

Productivity and costs in the long

run
In the long run both capital and labour are variable
Firms can change the amount of machines or office
space that they use
Therefore, the law of diminishing returns does not
determine the productivity of a firm in the long run
In the long run productivity and costs are driven by
returns to scale

DTA-Managerial Economics

16

Implications of factor substitution

(1)
COST
SRATC1
SRATC2

AC1
AC2
AC3
Q1

Q2

DTA- Managerial Economics

OUTPUT

17

 When a firm substitutes labour with

machinery, and the investment makes the
firm more efficient, then the average cost
curve would move down to the right as in
the previous slide.
If investment does not increase
productivity and does not change average
costs then the cost curve does not
change.

Implications of factor substitution

(2)
COST
SRATC1

SRATC2

AC1

Q1

Q2

DTA- Managerial Economics

OUTPUT

19

Long run average cost curve

The long run average cost curve is simply
a collection of short run average cost
curves, illustrating how average costs
change as fixed inputs (plant size, type
and number of machines etc) change.

The long run average cost curve

COST
PER UNIT
ATC3
ATC2

ATC1

LRAC

x1

x2

x3

DTA- Managerial Economics

OUTPUT
21

LAC/ Envelope Curve

The LAC is also called the planning curve
because it is a guide to the entrepreneur
for planning the future expansion of the
firm and choosing the optimal scale or
plant size for the production.

Long run averagre cost curves

COST PER
UNIT
LRAC

attainable

c1
c2

unattainable

Q1

OUTPUT
DTA- Managerial Economics

23

Returns to scale
Returns to scale measures the change in output for a
given change in inputs
Increasing returns to scale exist when output grows
at a faster rate than inputs
Decreasing returns exist when inputs grow at a faster
rate than outputs
Constant returns to scale exist when inputs and
outputs grow at the same rate
DTA- Managerial Economics

24

Returns to scale
COST
PER UNIT

sin
rea

de
cre
asi

inc

ng

LRAC

constant
MES

Qm
DTA- Managerial Economics

OUTPUT

25

Importance of minimum efficient

scale (MES)
MES is the size of operation with the lowest average
cost. If a factory operate at an output size where it is not
achieving MES, it would be incurring higher average
costs which would finally make it uncompetitive.
MES is the size beyond which no significant economies
of scale can be achieved
Cost advantage over rivals
Firms may merge to achieve MES
Managerial Economics
Firms may diversifyDTAto avoid low cost competition

26

Examples of economies of
scale
Production techniques:
Maruthi Suzuki and Rolls Royce
Indivisibilities: huge machinery
Specialisation and division of labour
By-products

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27

Costs in the Long Run

All inputs that are under the firms
control can be varied there are no
fixed costs ( all inputs are flexible)
Long run is best thought of as a planning
horizon
Firms plan for the long run, but they
produce in the short run
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Long-Run Planning Curve

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29

Firms Long-Run Planning Curve

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Economies of Scale
Notice that the long-run average curve is
U-shaped, a result of economies and
diseconomies of scale
Economies of scale imply that long-run
average costs decline as output expands
while diseconomies of scale imply that
long-run average costs increase as output
increases
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DTA- Managerial Economics

Economies of Scale
A larger size often allows for larger, more
efficient machines and allows workers a greater
degree of specialization Production
techniques such as the assembly line can be
utilized only if the rate of output is large
enough
Typically, as the scale of the firm increases,
capital substitutes for labor and complex
machines substitute for simpler machines
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Diseconomies of Scale
As a firm expands, diseconomies of scale,
eventually take over: long-run average
cost increase as output expands
Additional layers of management are
needed to monitor production
The more levels of management in an
organization, the more difficult it is for top
management to communicate with those
that perform most of the production tasks
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33

A Firms Long-Run Average Cost Curve

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34