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6. Sunk Cost
In economics, a sunk cost is any past cost that has already been paid and cannot be
recovered.
Examples
Marketing study. A company spends $50,000 on a marketing study to see if its new
product will succeed in the marketplace. The study concludes that the product will not
be profitable. At this point, the $50,000 is a sunk cost. The company should not
continue with further investments in the project, despite the size of the earlier
investment.
Research and development. A company invests $2,000,000 over several years to
develop a particular product. Once created, the market is indifferent, and buys no
units. The $2,000,000 development cost is a sunk cost, and so should not be
considered in any decision to continue or terminate the product.
Total Cost(TC)
Total Variable
Costs(TVC)
Average Fixed
Short Run Costs
Cost(AFC)
Average Cost(AC)
Average Variable
Cost(AVC)
Marginal Costs(MC)
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• Total Variable Cost: Expenditure incurred on variable factors. Changes with level of
output.
• TC = TFC + TVC
• TVC = TC – TFC
• TFC = TC-TVC
Total Cost Curves
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Average Costs
AVC Curve
• Declines in the initial stages as output expands, reaches the minimum when optimum
factor combination is reached and increases when the output exceeds the optimum
combination.
• Represents different stages in the law of variable proportion.
AC Curve
• U’ Shaped curve
• AC = AFC + AVC
• Behaviour of AC is determined by the behaviour of AFC &AVC.
• Initially both AFC &AVC decline and as result AC also declines.
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• AC reaches the minimum when the optimum combination between fixed and variable
factor is reached.
• After the minimum point AC starts rising, as the rise in AVC is greater than the fall in
AFC.
MC Curve
• U’ Shaped curve.
• As fixed cost remains the same in short run,MC can be calculated using TC or TVC.
• According to the LVP,the MP of an input rises at low levels of output and then falls
with expansion of output. The opposite happens in the case of MC.
• Declines with increase in outpt,reaches the minimum and then starts increasing.
MC & AC Relationship
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Derivation of LAC
LAC derived from Short Run Average Cost Curves(SACs).Each SAC shows different plant
capacity.
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Why LAC remain constant or falling?
• Improvement in technology helps in reducing average cost.
• Learning curve effect: The more experience a person attains, he learns to do things in
a better way than before.
• Development of Appropriate management techniques will reduce the managerial
diseconomies of scale associated with an expansion of the firm.
• If at all there are managerial diseconomies,it will be more than offsetted by the
technical and production economies.