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Managerial Economics Cost Concepts

MANAGERIAL ECONOMICS

Cost Concept

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Managerial Economics Cost Concepts

ACKNOWLEDGEMENT
We the members of the group would like
to thank Prof. Pandey for helping us to
prepare this project. It is because of your
guidance and support we could get the
required information and compile it into a
project form and hereby submit this work.
Thank you for your valuable time and effort.

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Managerial Economics Cost Concepts

GROUP MEMBERS
Swati Tikku 95
Pooja Patil 71
Hardik Gohel 114
Riten Sakhiya 117
Sagar Sangani 110
Rajdeep Pandere 102
Aftab Khan 113
Jaiveer Duggal 128

Presented By the students of


F.Y.B.M.S. (B)
College -Bhavan’s College

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Managerial Economics Cost Concepts

Professor - Prof. Pandey

INTRODUCTION

A) MEANING OF COST: For layman, cost of production


means money expenses incurred by a firm on production
of a commodity but in economics sum of explicit costs
and implicit costs constitutes total cost of production of a
commodity. We have seen that human are satisfied by
way of goods and services which are produced by firms.
For producing a commodity, a firm requires factor inputs
and non factor inputs. The money spent by the firm on
both factor inputs and non factor inputs is called money
cost. In economics money expenses alone do not
constitute cost of production because it does not include
the imputed cost of self owned factors supplied by the
firm itself. For an economist this hidden cost of self
supplied factors also forms a part of cost of production.
Thus in economics sum of explicit cost and implicit cost
constitutes total cost of production of a commodity.
Different concepts relating to cost are shown in the
following chart and discussed thereafter.
TYPES OF COST

EXPLICIT IMPLICIT MONEY REAL OPPORTUNITY


PRIVATE SOCIAL

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Managerial Economics Cost Concepts

B) EXPLICIT COST AND IMPLICIT COST:


“EXPLICIT COSTS AND THOSE CASH PAYMENTS
WHICH FIRMS MAKE TO OUTSIDERS FOR THEIR
SERVICES AND GOODS” - LEFTWITCH.
These costs are recorded in firm’s account
book. we know that for producing a commodity, a firm
incurs expenses on hiring factor inputs (like services of
land, labour , capital) and on buying non-factor inputs
(like raw material, power etc).
For e.g. a firm gets land on lease and pays rent. It hires
labour and pays them wages .it borrows money and pays
interest. Similarly it spends money on transportation,
raw material, insurance premium, fuels, advertising and
on making up depreciation of machinery. All these
money expenses are known as explicit costs of
production. Mind, these costs include payments made to
others and not to the owner himself for self-owned, self-
supplied resources.
“IMPLICIT COSTS ARE COSTS OF SELF-
OWNED OR SELF-EMPLOYED RESOURES” –
LEFTWITCH.
These are estimated value of inputs supplied
by the owner of the production unit himself. For
instance, an entrepreneur may utilize his own building
or his own capital or may act as a manager of his firm
himself. for these productive services, he does not pay
rent or interest or salary to himself although the
payments accrue to him. These are, in a way, implicit
rewards or imputed costs of various factors owned and
supplied by the owner himself.
Main difference between the two costs is that in
explicit cost payment is made to others whereas in
implicit cost, payment becomes due to his own factors of
production.
IN ECONOMICS SUM OF EXPLICIT COSTS AND
IMPLICIT COSTS CONSTITUTE THE TOTAL COST OF
PRODUCTION OF A COMMODITY.

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Managerial Economics Cost Concepts

C) MONEY COST AND REAL COST

Money cost of production refers to the money


expenditure incurred on hiring and buying of inputs for
producing a given amount of commodity.

According to MARSHALL ,”Money cost measures the


amount of money which a producer spends on producing
a particular commodity”. For example, all money
expenditure in the form of rent, wages, etc. and money
spent on non factors inputs like raw materials ,transport,
advertising, insurance charges, power, fuel etc. are
included in money cost . If a producer spends Rs. one
lakh in manufacturing 100 transformers, then its money
cost will be taken as Rs. One lakh.

Money cost is further subdivided into two parts namely


fixed cost and variable cost.

Real cost refers to the sacrifice, discomfort, toil and pain


involved in supplying the factors of production by their
owners . money paid for hiring a factor or its owner in
producing a commodity is real cost. Since elements like
sacrifice, pain and discomfort are subjectives. It is
therefore difficult to measure the real cost for instance,
abstinence and sacrifice involved in saving and
accumulation of capital or pain and discomfort felt by
the labourers in the production of goods abd indicators
of real cost which cannot be measured.

D) OPPORTUNITY COST

The opportunity cost of an activity is equal to the value


of next best alternative foregone.

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Managerial Economics Cost Concepts

Alternatively, it is the cost in terms of the alternative


foregone. We know resources are not only scarce but
have alternative uses also. Therefore a particular
resource can be put to different uses simultaneously. For
instance, suppose an economy has a limited stock of
coal which can be used either for running railways steam
engines or for generation of electricity called thermal
power. In other words, we can say that cost of running
railways steam engines is so many kilowatt of thermal
power which could have been generated instead with
the same quantity of coal.

In the context of factor income, opportunity cost


indicates what a factor could earn in the next best use.
One has to forgo something for getting something and
what is given up for getting something Is called the
opportunity cost of that thing. For example, a clerk gets
Rs. 800 per month for giving private tuition after office
hours but for that he forgoes Rs.500 which he would
have got for working overtime after office hours.

IMPORTANCE-

The concept of opportunity cost is very important in the


context of factors of production. Since supply of factors
is scarce and can be put to alternative uses, therefore a
factor can be utilized in one use sacrificing its use for
other purposes. Further it helps economists to know how
limited resources get allocated in different branches of
production.

E)Private Cost and Social Cost

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Managerial Economics Cost Concepts

Private costs refer to the cost incurred by an individual


firm in producing a commodity. It is infact the money
cost which a firm incurs on hiring and purchasing inputs
for producing a commodity. This cost has nothing to do
with the society.

Social cost refers to the disadvantages of producing


a commodity suffered by the society as a whole. It does
not take into consideration money cost but something
like cost in the form of disadvantages which are borne
by the society directly or indirectly. For instance, the
society pays social cost in the shape of health hazards
connected with air pollution when buses and cars emits
smoke while plying in the interior of big cities.

F)Short Run Cost

There is a difference between short run costs and long


run costs of production. In short run some factors (like
machinery, building, technical labour) are fixed which
cannot be changed due to insufficiency of time while
others (like ordinary labor, raw material, power etc.) are
variable which can be changed according to the output
to be produced. Accordingly, costs are divided into fixed
cost and variable cost.

G) Fixed Cost

Fixed costs are the cost which do not change with the
change of level of output. Production may come down to
zero or be doubled, fixed cost remains the same. These
have to be borne even if no output is produced. For
instance, a sugar mill will usually remains closed for
about three months during a year for want of raw

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Managerial Economics Cost Concepts

material but still the mill owner has to incur certain cost
like rent of factory building, interest in past borrowing,
salaries of permanent employees, municipal taxes, etc.
These are also called supplementary cost or overhead
cost.

Since total fixed cost remains the same at all levels of


output TFC curve is a straight line parallel to X axis.

H) Variable Cost

These are the costs which vary directly with the change in
the level of output. Such cost increase when output
increases and decreases when

output falls. That is why they are direct cost since they vary
directly with the change in the level of output. The cost
incurred on raw material, fuel, wages of temporary labor,

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Managerial Economics Cost Concepts

wear and tear of machinery etc. are examples of variable


cost. It is also called as prime cost or direct cost.

The TVC curve is upward sloping which indicates that total


variable cost go on increasing with increase in output.

Importance – The significance of distinction in cost lies in


the fact that when a firm in incurring losses, it still
continues its production if the market price covers at least
its variable costs during short period. In other words, the
firm will be ready to incur losses equal to fixed cost rather
than stop production in the short period. However, in the
long period, market price must cover firm’s fixed and
variable cost otherwise firm will stop production.

Distinction between Fixed Costs and Variable Costs

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Managerial Economics Cost Concepts

1. FC do not increase
1. VC change with
or decrease with increase or
changes in the level of output.
decrease in level of output.
2. VC are related with
2. FC are related with
variable factors capable of
fixed factors which cannot be
being changed during short
changed during short period.
period.
3. FC can never be zero 3. VC is zero (nil) when
even when production is production only when VC are
stopped. met.
4. Production may 4. A firm continues
continue even at the loss of FC production only when VC are
during short period. met.
5. FC curve is parallel 5. VC curve moves up
to X-axis. from left to the right.
6. FC are present only 6. In the long run, ail
in short period. costs are the variable costs.
Fixed costs and variable costs constitute total cost of
production. These are formally called total fixed costs, total
variable costs and total costs respectively.
Explain the following:

• Total fixed cost (TFC), Total variable cost (TVC),


Total cost (TC).

• TFC, TVC & TC Curves.

Ans.There is difference between short period cost and long


period cost of production. Short-run production is governed
by law of variable proportion because plant of a firm being
fixed, production can be changed by changing variable
factors like labour, raw material, etc. Short period cost
basically consists of fixed cost and variable cost whereas
long period cost refers to average cost (AC) and marginal
cost (MC) because there is no distinction

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Managerial Economics Cost Concepts

between fixed cost and variable cost in the long run. Again in
short period TFC remains the same but AFC falls with every
increase in volume of output. On the other hand, TVC
changes according to volume of output affecting AVC.

(a) TFC , TVC , TC

(i) Total fixed costs are the costs which remain the same
at different levels of production. Since TFC Remains
constant irrespective of the size of output, TFC curve
is parallel to X-axis.

(ii) Total variable costs are sum of the cost of which vary
directly with the size of output produced. Such costs
change with change in level of output. In other words,
total variable costs go up as output is increased and
fall as output in decreased. TVC is zero at output.
Remember, rate of increase in TVC depends upo
which phase of ‘law of returns to a variable factor’ is
in operation. Briefly TVC increases at a decreasing
rate in the beginning, then at a constant rate and
finally at an increasing rate making TVC curve
concave in its shape.

(iii)Total cost of production. It is the cost of production of


all the units of a commodity produced by a firm. TC is
sum of TFC and TVC,

TC = TFC

The following imaginary schedule of a firm indicates TC, TFC,


TVC and their relationship. Mind, at zero level of output TC =
TFC because TVC is zero.

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Managerial Economics Cost Concepts

Quantity of TVC TC
Output (units) TFC (Rs.) (Rs.) (Rs.)
0 100 0 100
1 100 50 150
2 100 70 170
3 100 80 180
4 100 105 205
5 100 135 235
6 100 170 270

TFC
TV
Cos

C
t

TFC

Quantity of
Output

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Managerial Economics Cost Concepts

It can be seen from the table that TFC is constant at Rs. 100
whether output is zero or 6 units. On the other hand, TVC is
zero output and increases. Since TFC is constant, TC exceeds
TVC by amount of TFC.

(b) Relationship between TFC, TVC, TC curves

TFC, TVC, TC curves. Remember, an increase in TC


indicates an increase in TVC only since TFC remains same
irrespective of quantity of output produced.

(i) TFC curve is horizontal and parallel to X-axis. The reason


is that TFC is fixed or constant and remains the same
(Rs. 100) at all levels of output.

(ii) TVC curve and TC curve are upward sloping because


TVC and TC increase with increase in output.

(iii) Total cost curve is vertical summation of total fixed


cost curve and total variable cost curve.

(iv) Again at zero level of output, TC is equal to TFC


because there is no variable cost.
After that, change in TC is entirely due to change inn TVC.
Consequently TC curve and TVC curve have similar shape
except that TVC curve starts from zero level of output
whereas TC curve starts on Y-axis from a point having
distance equal to FC. As the vertical distance between
curves remain parallel to each other. Graphically TC
curve is vertical summation of TFC and TVC curves.

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Managerial Economics Cost Concepts

1) Average Fixed Cost – It is the per unit cost of


producing a commodity. It is calculated by dividing the
total fixed cost by the number of units of commodity
produced. For example, if total fixed cost of manufacturing
fans is Rs. 7,500, then:

AFC = Total
Fixed Cost

AFC = 7500 = Rs. 75


100

Beware that fixed cost (i.e., total fixed cost) remains fixed or
same at different levels of production.

2) Average Variable Cost – It is the per unit variable


cost of producing a commodity. It is worked out by
dividing the total variable cost by the number of units
produced. For instance if total variable cost of manufacturing
100 fans is Rs. 12,500, then:

AVC = Total
AFC = 12,500
Variable Cost = Rs. 125
100
No. of units
It should be kept in mind that in the beginning AVC
decreases but after reaching the stage of minimum cost, it

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Managerial Economics Cost Concepts

starts increasing, AVC curve is a dish shaped (U-shaped)


curve.

3) Average Total Cost – It is per unit cost of production


of a commodity. It is worked out by dividing the total cost
(fixed cost + variable cost) by the number of units produced.
Continuing the above example if total cost of manufacturing
100 fans is Rs. 20,000 (fixed cost 7,500 + variable cost
12,500), then:

ATC = Total
Cost

AFC = 20,000 = Rs. 200


100

Like total cost which is the sum of total fixed cost and total
variable cost, ATC is also the sum of AFC and AVC.
Symbolically:

ATC = AFC + AVC

For instance, in the above example AFC = Rs. 75 and


AVC = Rs. 125 whereas ATC = Rs. 200 (75 + 125). In
order to find out profit (or loss) of a firm, it is necessary to
know the average of both fixed and variable costs combined.
It is average of total cost of a firm.

Again short period costs are further illustrated on the


next page with the help of the following cost schedule of any
imaginary firm. (Mind, at zero level of output, TC is equal to
TFC)

Cost Schedule of an Imaginary Firm


Quanti TFC TVC TC AFC AVC ATC MC

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Managerial Economics Cost Concepts

ty
(units) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
0 120 0 120 - - - -
1 120 60 180 120 60 180 60
2 120 80 200 60 40 100 20
3 120 90 210 40 30 70 10
4 120 110 230 30 27.5 57.5 20
5 120 150 270 24 30 54 40
6 120 240 360 20 40 60 90
4) AFC, AVC and ATC curves
All the three average costs have been depicted below.
AVC and ATC curves do not intersect because difference
between the two is AFC which can never be zero. Thus
positive value of AFC keeps the AVC and ATC curves apart.

Y AT

AV
Cost

AF

Output
O X

5) Nature of Shape of TFC Curve and AFC Curve


i. As far as shape of Total Fixed Cost (TFC) curve is
concerned, it is always parallel to X-axis because TFC

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Managerial Economics Cost Concepts

remains the same whether production is doubled or


brought to zero.
ii. Shape of AFC curve is downward sloping curve from left to
the right. Its reason is that average fixed cost goes on
falling with every increase in output. Again AFC always
remain positive nor touches Y-axis because AFC curve
neither touches X-axis because AFC approaches infinity
when production is zero. Thus AFC curve assumes the
shape of rectangular hyperbola with its area defined by
total fixed cost.

6) Relationship between ATC, AVC and MC Curves.


Let it be reminded that both MC and AVC are derived
from total variable cost (TVC). The point to be kept in mind is
that during short period, since fixed costs do not change, it is
only variable costs which vary (change) with output.
Therefore marginal costs are in fact due to changes in
variable costs. It also means changes in fixed costs do not
affect MC
The figure below depicts the relationship between ATC,
AVC and MC curves.

AT
Cost

AV

O
X
Output

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Y X
Managerial Economics Cost Concepts

We know that it is production function which determines ATC,


AVC, and MC. From the above figure, it is clear that AVC,
ATC, and MC curves fall up to a point and then start rising. In
other words, they are U-shaped which is explained by three
stages of operation of law of variable proportion. (i)MC curve
falls faster than AVC curve and also rises faster than AVC
curve. (ii) MC curve intersects AVC and ATC curves at their
minimum points. (iii) Vertical distance between AVC and ATC
curves is declining continuously. ATC and AVC curves do not
intersect each other because the difference between ATC and
ATC is AFC which is always positive (more than zero). Thus
positive value of AFC keeps the ATC and AVC curves apart.

7) Relationship between AVC and MC Curves


i. When AVC is falling, MC is less than AVC
(Diagrammatically when AC curve falls, MC curve falls,
and MC curve lies below AVC curve till their intersection
at point in the above diagram).
ii. When AVC is minimum, MC is equal to AC
(Diagrammatically the point where MC curve intersects
AVC curve, is the minimum point of AVC).
iii. When AVC is rising, MC is more than AVC. (Graphically
MC curve lies above AVC curve after point of
intersection.)
Relationship between AVC and MC with the help of a diagram is shown
in the above diagram.

8) Area under MC curve = TVC


We have seen that MC is addition to the total variable
cost when an additional unit is produced. This means that
total variable cost (TVC) is the sum of marginal costs because
total fixed costs remain the same in short period. This is
provided in the below figure. Assuming output perfectly

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Managerial Economics Cost Concepts

divisible, a hypothetical smooth MC curve is drawn in the


below figure. We know that TVC is simply the sum of
marginal costs of number units produced. Thus under the
assumption of smooth marginal costs curve, total variable
cost (TVC) is equal to the area under marginal cost curve. For
instance at OQ units of output, TVC is equal to the shaded
area OABQ in the diagram.
Y

B
MC/TVC (RS.)

MC

TVC

O
Q
OUTPUT (UNITS)

9) Rising portion of MC curve is the supply curve itself.


How? Recall that the basis of law of supply or supply
curve is increasing marginal cost. In the figure on the next
page, MC curve is U-shaped and P1 is the price line under
perfect competition. At the price P1, the price line cuts MC
curve at two points – at Qa1 and Qb1, i.e., it satisfies profit
maximizing condition P = MC at two places. But total profit at
output level of Qb1 is higher. Therefore at price P1, the firm
produces the amount Qb1. It means that if price is OP1, the
firm will supply OQb1 level of output. Similarly if price is OP2,
the firm will supply (produce) OQ2, level of output and at
price OP3, it would supply (produce) OQ3, level of output; and
so on. We see clearly that all price-output combinations are
simply the points on the rising portion of MC curve. Hence it
is concluded that the rising portion of MC curve is the
supply curve itself.

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Managerial Economics Cost Concepts

MC

P3

P2
PRICE

P1

X
O
Qb1 Q2 Q3
Qa1 OUTPUT

10) Average Cost – It is per unit cost of production of a


commodity. According to Ferguson, “Average cost is total
cost divided by output”. AC is calculated by dividing the total
cost by the number of units produced. Suppose the total cost
of production of 25 chairs is Rs. 2,500. In this case cost per
chair or average chair would be as follow:

Average Cost =
Total Cost
AC = 2,500 = Rs. 100
25

11) Reason for AC curve being U-shaped?


AC curve in short is a U-shaped curve due to operation
of law of returns (i.e., law of variable proportion). Remember,
increasing returns imply diminishing costs, constant returns
mean constant costs and diminishing returns imply

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Managerial Economics Cost Concepts

increasing costs. As output is increased, AC first falls, reaches


its minimum and then rises. Hence, AC curve becomes U-
shaped. Minimum point of AC curve indicates lowest per unit
cost or production. The point of output is also the point of
optimum capacity of firm. It is being showed in the figure on
the next page.

12) Marginal Cost (MC) AC

Marginal cost is the addition to the total variable


COST

cost when an additional (extra) unit of a commodity is


produced or when output is increased by one unit. In
economics, marginal means additional whether it is used in
the context of cost or revenue or product or even utility. Thus
MC is the additional cost of producing an additional unit of a
commodity.OIt is attributable to the addition of one more X unit

to the output. Continuing the above


OUTPUTexample, suppose it
costs Rs. 2500 to manufacture 25 chairs and Rs. 2620 to
manufacture 26 chairs. In this case MC will be Rs. 120 (2620
– 2500) which is addition to the total cost (Rs. 2500) when an
additional unit (26th chair) is produced. Again remember,
since MC is the additional cost, it is in fact addition to
variable cost and not to fixed cost because the latter (FC)
remains same in short period.

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Managerial Economics Cost Concepts

13) Reason for MC curve U-shaped?


It is due to operation of law of returns. The figure below
depicts behavior of MC graphically. MC curve is also U-shaped
which indicates that MC falls in the beginning, then remain
constant and ultimately it rises. The reason behind U-shape
of MC curve is operation of law of returns. Initially
production is subject to law of increasing return (i.e.,
decreasing cost), the law of constant return (i.e., constant
cost) and ultimately to law of diminishing returns (i.e.,
increasing cost). Once we understand why MC curve is U-
shaped. More, MC curve cuts AVC and ATC curves at their
minimum points.
Y
MC
COST

O
X
OUTPUT
14) Relationship between Average Cost and Marginal
Cost
There is an apparent relationship between AC and MC
since both have been derived from total cost. It needs to be
remembered that between AC and MC, it is MC which brings
about changes (rise or fall) in AC and not the rises, it pulls AC
up. Conversely we can also say that when average increases,
marginal is more than average and when average falls,
marginal is less that average. Relationship between AC and
MC is summed up with the help of following imaginary cost
schedule.

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Managerial Economics Cost Concepts

i. When MC is less than AC, AC falls because MC


pulls AC down.
ii. When MC = AC, AC is constant and at its
minimum.
iii. When MC is more than AC, AC rises because MC
pulls AC up.

The above relationship can be expressed conversely also in


the following way:
i. When AC falls, MC is less than AC. (This is clear from first
three units.)
ii. When AC minimum, MC is equal to AC. (This is proved
from the 4th unit.)
iii. When AC rises, MC is more than AC. (This is clear from
5th and 6th unit.)

Output TC AC MC
(Units) (Rs.) (Rs.) (Rs.)
1 20 20 20
2 38 19 18
3 54 18 16
4 72 18 18
5 100 20 28
6 150 25 50

15) Relationship between AC and MC curves


The below diagram represents the relationship
diagrammatically.
i. As long as MC is less than AC, AC curve falls and MC
curve lies below AC curve till their intersection at point
B.

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Managerial Economics Cost Concepts

ii. When MC curve comes to falling, it falls more rapidly and


reaches its minimum point E earlier than AC curve
reaches its minimum point B. Thereafter MC curve starts
rising from E to B even when AC curve is still falling from
D to B. (Hence AC can fall when MC is rising.)
iii. While rising, MC curve cuts AC curve at AC’s minimum
point B. Thereafter, AC curve rises because MC curve lies
above AC curve.

Importance – Both the concepts of AC and MC are very


significant for a firm. A firm aims at maximization of its profit
which is broadly the difference between total cost and total
revenue. And for calculating total cost, we multiply AC with
number of units produced. On the other hand, MC is
important since it helps the firm to determine whether
production of an additional unit be undertaken or not.

A
MC

AC

D
COST

O
25 X
OUTPUT
Managerial Economics Cost Concepts

16) Relationship between Total Cost (TC) and Marginal


Cost (MC)
Remember, MC is the increase in TC when output is
increased by a unit.
i. When TC rises at a diminishing rate, MC is declining.
ii. When rate of increase in TC stops diminishing, MC is at
its minimum.
iii. When TC rises at an increasing rate, MC is increasing.

17) Long Run Costs (Average Cost and Marginal Cost)


Briefly long-run is a time period during which quantities
of the entire factor inputs can be varied (changed). In other
words, in the long-run all factor inputs are variable. Hence
there is no distinction between fixed costs and variable costs.
Therefore only long-run average costs (LAC) and long-run
marginal costs (LMC) curve are mostly discussed. Following
implications are noteworthy.
i. Distinction between total costs and total variable costs
disappears. Simply the term ‘total costs’ is used.
ii. There is distinction between average total costs and
average variable costs because of absence of fixed
costs. Instead only the term ‘Long-run Average Cost
(LAC)’ is used.
iii. Marginal cost is denoted by ‘Long-run Marginal Cost
(LMC)’.

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18) Shapes of LAC and LMC curves


From the below figure, it is clear that the long-run
average cost (LAC) curve and the corresponding LMC curve
are approximately U-shaped. This indicates that LAC curve
declines initially, then remains constant for a while and finally
rises. In the adjoining figure, LAC curve is declining up to OQ
output. LMC curve cuts the LAC curve at the latter’s
minimum point. At the output OQ, the average cost is lowest
which indicates that OQ output is the optimum output which
is being produced at the lowest average cost. Constant
returns prevails for a while which is indicated by flat portion
in the middle of LAC curve. Production is considered most
efficient at this level. Beyond OQ, as output increases, AC
starts rising.
Difference – The nature of curves in the long-run and
short-run is different. In the long-run, U-shape of LAC curve
implies the U-shape of LMC curve whereas in short-run U-
shape of Marginal Cost curve implies the U-shape of Average
Cost curve. Again in the long run, U-shaped average cost
curve is flatter than average variable cost curve of short-run.

LMC
Y
COST (Rs.)

LAC

Lowest AC

F
Optimum output

O X
Q
27
OUTPUT (UNITS)
Managerial Economics Cost Concepts

19) Why is LAC Curve U-Shaped?


Simply put, the U-shape of the LAC curve is the
result of operation of returns to scale, i.e., a firm
experiences increasing returns to scale (i.e., diminishing cost)
in the beginning followed by constant returns to scale and
then by diminishing returns to scale (i.e. increasing cost). It is
explained below. Remember that increasing returns and
diminishing costs broadly go together and that is why law of
diminishing returns is called as law of increasing costs.
Similarly law of diminishing returns is called as law of
increasing costs.
i. It is because of increasing returns to scale that LAC
curve declines initially when a firm expands production
from small scale to large scale. And increasing returns to
scale occur because the firm reaps economies of scale
on expansion of output. Two most important economies
are (i) division of labour, and (ii) volume discounts.
Division of labour broadly means allocation of task
according to specialisation of workers. Alternatively it is
also defined as specialisation of person in particular
activities. Division of labour increases efficiency, saves
time and tools, enables greater machinery which
reduces firm’s cost of production. Volume discounts
refers to the discount (or rebate) on price which a firm
gets on purchase of large quantities (volume) of raw
material. That is bulk purchases of raw material can be
made at lower prices. It leads to cost saving of a firm.
Other economies are technical economies, managerial
economies, financial economies etc.
ii. When AC becomes lowest as a result of increasing
returns, a firm experiences constant returns for a while
since production is considered most efficient at this
level. Thus most efficient level of production is on at
which LAC is minimum or where constant returns to
scale prevail.

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Managerial Economics Cost Concepts

iii. A further increase in the scale of output beyond a certain


point results in diseconomies of scale such as difficulty
in management and coordination, non-availability of
inputs like fuel, power and raw material, crowding and
congestions etc. this leads to decreasing returns (i.e.,
increasing costs). It is because of decreasing returns to
scale that LAC curve starts rising.
In short, LAC curve first declines due to economies of
scale and then rises due to diseconomies of scale. This
briefly explains the U-shape of LAC curve. U-shape of
LAC curve, in turn, implies U-shape of LMC curve.

20) Time element and costs.


Production has its own time dimension. Therefore role of
time element in determining the costs of a firm is significant.
Broadly, the following three time periods are distinguished in
production or supply. This distinction is based on the basis of
possibilities of making adjustments in supply.
(i) Very Short Period (Market Period). It is the period
which is so short that the supply cannot be adjusted
to change in demand (or price). During very short
period supply is price inelastic, i.e., supply does not
respond to change in price. Since supply remains
almost fixed, therefore, costs have little or no
influence on supply.
(ii) Short Period. It is the period during which supply
can be increased only up to the maximum capacity
of existing plant by using more quantities of
variable factors (labour, raw material, power). In
other words supply is inelastic beyond that point.
Since supply can be increased by using the existing
fixed factors, variable cost of the firm must be met
during short period.
(iii) Long period. It is the period which is long enough
to change the supply by changing the quantities of
all types of factor inputs (fixed and variable factors).
New firms can enter and old can leave the industry.
Thus supply is more or less elastic. Therefore during

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Managerial Economics Cost Concepts

long period all costs (fixed cost and variable cost)


must be met otherwise the firm will stop producing.

BIBLIOGRAPHY
Introductory Micro Economics – C. B.
Sachdeva
Managerial Economics – Vipul Publications

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