Cost Analysis

Meaning of Short-Run and Short-Run Cost: Short-run is a period of time within which the firm can vary its
output by varying only the amount of variable factors, such as labor and raw materials. In the short-run the fixed
factors such as capital equipment, administrative staff etc cannot be varied. In the short-run the production can be
increased by overworking the existing plant, by hiring more workers and buying more raw materials, but not by
building the new plant. The cost which is needed for production in the short-run is called the short-run costs.
Meaning of Long-Run and Long-Run Cost: Long-run is a period of time within which the quantities of all
factors vary. There is no fixed factor of production. Thus in the long-run the production can be increased by
increasing capital equipment or by increasing the size of the existing plant or by building a new plant of a greater
productive capacity. Thus the cost which is needed for production in the long-run is called the long-run cost.
Short-Run Fixed Costs : In traditional theory, the total costs are split into two groups, one is total fixed costs and
another one is total variable costs. That is;
Total Costs = Total Fixed Costs + Total Variable Costs. Short run fixed costs are those costs which are needed for
fixed factors of production whose amount can not be altered in the short-run. The fixed costs are known as the over
head costs.
Example: (1) salaries of administrative staffs. (2) Depreciation of machinery, (3) Expenses for land maintenance
Short-Run Variable Costs : Short-run variable costs are those costs which are need for variable factors of
production, whose amount can be altered in the short-run. Variable costs are also known as the prime costs or direct
costs. The total variable costs change with change in output in the short-run, means that the variable costs increase
or decrease with output rises or falls. Thus we can say that the variable costs is a function of output. That is TVC =
f(q)
Example : (1) The costs for raw materials, (2) The cost of direct labour, and (3) The transportation costs etc.
Short-Run Total Costs : Short-run total costs is defined as the summation of short-run total variable costs and
short-run total fixed costs which is given by;
STC = STVC + STFC
= f(q) + b
Total cost is a function of total output. The greater the output the greater will be total costs
Short-Run Total Cost Curve : The short-run total costs vary with the level of output. The curve which is obtained
by representing the output level along the horizontal axis and their corresponding short-run total cost along the
vertical axis is called the short-run total cost curve.
Short-Run Variable Cost Curve : The short-run variable costs vary with the level of output. The curve which is
obtained by representing the output level along the horizontal axis and their corresponding short-run variable cost
along the vertical axis is called the short-run variable cost curve.
Short-Run Average Fixed Costs : Short-run average fixed costs is the total fixed costs divided by the numbers of
units of output produced. Thus the average fixed costs is given by;
SAFC = Short-Run Total Fixed Costs/No. of Units of Output Produced
b

q
Short-Run Average Fixed Costs Curve : The short-run average fixed costs vary with the level of output. The
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curve which is obtained by representing the output level along the horizontal axis and their corresponding short-run
average fixed cost along the vertical axis is called the short-run average fixed cost curve.

Fixed Cost

Output

Figure 1: Short-run fixed cost curve

Properties or Characteristics of SAFC :
(1) SAFC is monotonic decreasing function of production, when the output became very large , then the AFC
approaches to zero.
(2) SAFC approaches both axes asymptotically
Short-Run Average Variable Costs: Short-run average variable cost is the total variable costs divided by the
number of units of output produced: The average variable cost is given by,
AVC = Total Variable Costs/No. of Units of Output Produced.
= f(q)/q
Thus the average viable costs is the per unit variable costs of output. AVC first falls, reaches at a minimum level
and then again rises.
Short-Run Average Variable Costs Curve : The short-run average variable costs vary with the level of output.
The curve which is obtained by representing the output level along the horizontal axis and their corresponding
short-run average variable cost along the vertical axis is called the short-run average variable cost curve.

SRAVC

Output

Figure 2: Short-run average variable cost curve

Short-Run Average Total Costs : Short-run average total cost is the total costs divided by the number of units of
output produced. The average total cost are given by,
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ATC = Total Costs/No. of Units of Output Produced.
= (f(q) + b)/q.
= f(q)/q + b/q
= AVC + AFC
Thus the average total cost is the sum of AVC and AFC. ATC is known as the per unit cost of output. ATC first falls
after reaching a minimum level and then again to rise. ATC curve will be the U-shaped curve.
Short-Run Average Total Costs Curve : The short-run average total costs vary with the level of output. The curve
which is obtained by representing the output level along the horizontal axis and their corresponding short-run
average total cost along the vertical axis is called the short-run average variable cost curve.
SRAC

Output

Figure 3: Short-run average total cost curve

Short-Run Marginal Costs : Short-run marginal cost is defined as the change in short-run total cost to produce an
additional unit of output. Thus the short-run marginal cost is the extra costs needed to get an extra unit of output.
The short-run marginal cost is the derivative of the total cost with respect to output.
dC dQ(q) db
C  Q(q)  b     Q(q)
dq dq dq
Short-Run Marginal Costs Curve : The short-run marginal costs vary with the level of output. The curve which is
obtained by representing the output level along the horizontal axis and their corresponding short-run marginal cost
along the vertical axis is called the short-run marginal cost curve.
MC

Level

Figure 4: Marginal cost curve

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No. of Units of Total Fixed Costs Total Variable Costs Total Costs Marginal Costs
Output
1 50 20 70 70
2 50 35 85 15
3 50 45 95 10
4 50 60 110 15
5 50 90 140 30

Cost Function : The functional relationship between the costs and number of units of output produced is called the
costs function. The Costs function is given by;
C  f (q ) .
where q is the output level. Thus we can say that the costs function of a firm depends upon the production function
and the prices of the factors used for production.
There are two types of cost function. One is the short-run costs function and another one is long-run cost function.
Short-Run Costs Function : Short-run costs function is a function which states that cost will be a function of the
output level and input prices plus the cost of fixed inputs which is given by;
C  f (q, p1 , p2 )  b
where q is the output level, p1 , p2 are the prices of raw materials and b is costs of fixed input.
Long-Run Costs Function : Long-run costs function is a function which states that cost will be a function of the
output level and the plant size which is given by;
C  f ( q, k )  h( k )
where q is the output level, k is the plant size, f and h are the symbols of functional relationship.
Profit : Profit is define as the difference between total revenue and total costs. So the profit is given by:
Profit = Total Revenue – Total Costs.
Let a firm produce q amount of a commodity Q, and p is the price per unit of Q. So the total revenue is pq. So the
profit is given by;
Profit = pq-[Q(q)+b], where Q(q) is the variable cost and b is the fixed costs.
Profit Maximization : The profit  of a firm is given by;
 = pq-[Q(q)+b]
The first order condition for profit maximization is that the partial derivative of  with respect to q is zero. That
is;
  Q(q)
0 p 0
q q
 p  Q(q )  0
 Q(q )  p
Marginal Cost = Price
The first order condition for profit maximization in a short-run cost function states that the marginal cost must be
equal to the constant selling price of output.
The second order condition is that

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 2
0
 q2
 2Q ( q )
 0
 q2
 2Q ( q )
 0
 q2
The second order condition implies that the partial derivative of the marginal cost with respect to q must be
positive.
Problem : Suppose the cost function is given by; C  q 3  10q 2  17q  66 , where q is the level of output. Find
the value of q for profit maximization if p = 5.
Iso-cost line : Iso-cost line is defined as the locus of all input combination that a producer or entrepreneur may be
purchased by a specified total cost. Let the producer/entrepreneur purchases two inputs X 1 and X 2 . Let p1 is
the price per unit of input X 1 and p2 is the price per unit of input X 2 and the producer buys x1 units of
input X 1 and x2 units of input X 2 . So, the total cost is given by;
C  p1 x1  p2 x2  b
where b is the fixed cost. Now for a specified cost C  C 0 , the cost function is given by;

C 0  p1 x1  p2 x2  b . .(1).

Since (1) is a linear equation in ( x1 , x2 ) , so it is satisfied a infinite numbers of input combinations of x1 and x2 .
The line which is obtained by representing these combinations is called a iso-cost line. The iso-cost line is given
by;

A(0, C0 -b)/p 2

Input X 2

Input X 1 B(C0 -b)/p1 , 0)

Figure 5: Iso-cost line
Properties of iso-cost line :
(1) Iso-cost line shows all those possible combinations of two inputs which a producer buys at the same level of
cost.
(2) Iso-cost lines are parallel to each other.
(3) The higher iso-cost line gives the higher level of cost
(4) Slope of iso-cost line is given by the negative of the input price ratio
Find the Slope of the Iso-cost line :
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 C 0  p1 x1  b C 0 p1 b
C 0  p1 x1  p2 x2  b  x2   x2   x1 
p2 p2 p2 p2
The slope of the equation is given by;
dx2 p dx1 p
  1 . Similarly we have,  2
dx1 p2 dx2 p1

Obtaining Short-Run Cost Function : The short-run cost function can be obtained from the following system of
equations,
q  f ( x1 , x2 ).................(1)
C  p1 x1  p2 x2  b........(2)
g ( x1 , x2 )  0..................(3)
where, q is the amount of output commodity Q, x1 and x2 are the amounts of input commodity X 1 and X 2 , C
is the total cost, p1 is the price per unit of input X 1 and p2 is the price per unit of input X 2 , and equation (3)
is the expansion path. The short-run cost function can be obtained by reducing these system of equation in a single
equation which states that cost will be a function of level of output, input prices, plus the cost of fixed inputs. To
obtain the short-run cost function the following steps are involved.
Step 1 : At first we have to select a point on the expansion path in which either x1 will be a function of x2 or
x2 will be a function of x1 .
Step 2 : At the second step, we will put the value of x1 or x2 in the production function. If we put the value of
x2 in the production function we will find that x1 will be a function of q.
Step 3 : If we put the value of x1 in step 1, then we will find that x2 will be a function of level of output.
Step 4 : If we put the value of x1 and x2 to the equation (2), then we find that cost will be a function of level of
output, input prices plus fixed cost, which is given by;
C  f (q, p1 , p2 )  b . Assuming that the input prices are invariant, so the general form of the cost function is given
by; C  f (q )  b
Obtaining Short-Run Cost Function : The short-run cost function can be obtained from the following system of
equations,
q  f ( x1 , x2 ).................(1)
C  p1 x1  p2 x2  b........(2)
g ( x1 , x2 )  0..................(3)
where, q is the amount of output commodity Q, x1 and x2 are the amounts of input commodity X 1 and X 2 , C
is the total cost, p1 is the price per unit of input X 1 and p2 is the price per unit of input X 2 , and equation (3)
is the expansion path. The short-run cost function can be obtained by reducing these system of equation in a single
equation which states that cost will be a function of level of output, input prices, plus the cost of fixed inputs. To
obtain the short-run cost function the following steps are involved.
Step 1 : At first we have to select a point on the expansion path in which either x1 will be a function of x2 or
x2 will be a function of x1 i.e. x1  f ( x2 ) or x2  f ( x1 )
Step 2 : At the second step, we will put the value of x1 or x2 in the production function. If we put the value of
x2 in the production function we will find that x1 will be a function of q or if we put the value of x1 we will
find that x2 will be a function of q. i.e. x1  f (q) or x2  f (q)
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Step 3 : If we put the value of x1 or x2 in step 1, then we will find that x2 or x1 will be a function of level of
output.
Step 4 : If we put the value of x1 and x2 to the equation (2), then we find that cost will be a function of level of
output, input prices plus fixed cost, which is given by;
C  f (q, p1 , p2 )  b . Assuming that the input prices are invariant, so the general form of the cost function is given
by; C  f (q )  b
Obtaining Long-Run Cost Function : In the short-run the optimum utilization of a plant size is given. In the
long-run he is free to vary the plant size k, and select a plant of optimum size. Assuming that k is a variable and
introduce explicitly into the production function, cost function and expansion path function. And the long-run cost
function can be obtained from the following system of equations,
q  f ( x1 , x2 , k )...................(1)
C  p1 x1  p2 x2  h(k )........(2)
g ( x1 , x2 , k )  0....................(3)
where, q is the amount of output commodity Q, x1 and x2 are the amounts of input commodity X 1 and X 2 , C
is the total cost, p1 is the price per unit of input X 1 and p2 is the price per unit of input X 2 , and equation (3)
is the expansion path. The Long-run cost function can be obtained by reducing these system of equation in a single
equation which states that cost will be a function of level of output, and plant size. To obtain the long-run cost
function the following steps are involved.
Step 1 : At first we have to select a point on the expansion path in which either x1 will be a function of x2 and k,
or x2 will be a function of x1 and k
i.e. x1  f ( x2 , k ) or x2  f ( x1 , k )
Step 2 : At the second step, we will put the value of x1 or x2 in the production function. If we put the value of
x2 in the production function we will find that x1 will be a function of q and k, or if we put the value of x1 we
will find that x2 will be a function of q and k. i.e. x1  f (q, k ) or x2  f (q, k )
Step 3 : If we put the value of x1 or x2 in step 1, then we will find that x2 or x1 will be a function of level of
output and k.
Step 4 : If we put the value of x1 and x2 to the equation (2), then we find that cost will be a function of level of
output, and k, which is given by;
C  f ( q, k )  h( k ) .
For a given level of output the producer computes the total cost for each possible plant size and select the plant size
for which the cost will be minimum.
Economies and Diseconomies of Scale
Economies of scale are features of a firm’s technology that lead to falling long-run average cost as output
increases.
Diseconomies of scale are features of a firm’s technology that lead to rising long-run average cost as output
increases.
Constant returns to scale are features of a firm’s technology that lead to constant long-run average cost as
output increases.
A firm experiences economies of scale up to some output level.
Beyond that output level, it moves into constant returns to scale or diseconomies of scale.
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Minimum efficient scale is the smallest quantity of output at which the long-run average cost reaches its
lowest level.
If the long-run average cost curve is U-shaped, the minimum point identifies the minimum efficient scale
output level.
Expansion Path: In economics, an expansion path (also called a scale line) is a curve in a graph with
quantities of two inputs, typically capital and labor, plotted on the axes. The path connects optimal
input combinations as the scale of production expands.

Cost Minimization : The producer may desire to minimize the cost of production for a given level of output.
Suppose a producer use two inputs X 1 and X 2 to produce a single output commodity Q. Let the producer uses
x1 units of input X 1 and x2 units of input X 2 to produce q units of output commodity Q. Let p1 is the price
per unit of input X 1 and p2 is the price per unit of input X 2 . So the cost function is given by;
C  p1 x1  p2 x2  b where, b is the fixed cost.
And the production function will be q  f ( x1 , x2 ) . Now we will minimize the cost C  p1 x1  p2 x2  b for a

given level of output q  q0  f ( x1 , x2 )

Now using the Lagrange’s Multiplier method

V = p1 x1  p2 x2  b    q 0  f ( x1 , x2 )  ;where  is undetermined Lagrange multiplier.

Now dividing (4) by (5) we have

f1 p1

f 2 p2
This is the first order condition for cost minimization, which implies that the ratio of marginal products of X 1 and

f11 p22  2 f12 p1 p2  f 22 p12  0

This is the second order condition for cost minimization.

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 2
Problem 1 : The total cost C for the output level q is given by; C  q  17.5
3
Find (i) total cost when output is 4 units; (ii) Average cost of output 10 units and (iii) marginal cost when output is
3 units.
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Problem 2 : The average cost function (AC) for a commodity is given by; AC  q  5  in terms of output
q
level q.
Find the value of q for increasing and decreasing level of AC. Also find the total cost and marginal cost.
Problem 3 : The total cost function is given by; C  0.04q3  0.9q 2  10q  10 .
Find (i) Average cost (AC), (ii) Marginal cost (MC), (iii) Slope of AC and (iv) Value of q at which average variable
cost is minimum,
1 3
Problem 4 : Let the cost function is given by; C  x  300 x  10 x 2  20 , where C is the cost and x is the level
3
of output. Find the value of x (i) at which the average cost is minimum, (ii) at which the marginal cost is minimum
and (iii) the MC is equal to AC
Problem 5 . The total variable cost of a monthly output x tones by a firm producing a variable metal is given by,
1 3
x  3x 2  5 x Taka, and the fixed cost is 300 Taka per month. Draw the average cost curve when only variable
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cost includes .
Problem 6. Find the profit maximization output given the following revenue and cost function.

R(q)  1000q  2q 2
C (q)  q 3  59q 2  1315q  2000

Problem 7. The BTV produces x programs per week at a total cost is TK x 2  78 x  2500 . Let the BTV is
600  p
monopoly and the demand function is given by; x  , where p is the price per program. Find the value of
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x for profit maximization. What is the profit and the price level in the monopoly market.
Problem 8 : The total revenue function of a firm is given by R  21x  x 2 and its total cost is given
1 3
by; C  x  3x 2  7 x  16 , where x is the output level.
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(i) Find output at which the total revenue is maximum (ii) the output at which the total cost is minimum and (iii)
output level at which the profit will be maximum.
1
Problem 9 : The demand function of output commodity X is given by; x  (25  2 p ) , where x is the number
3
of units of commodity X, p is the price per unit of commodity X. Let the average cost per unit of X is TK 40. Find
(i) the revenue function R(x) in terms of p, (ii) the cost function C, (iii) the price per unit that maximize the profit
function, (iv) the level of output for profit maximization and (v) the maximum profit.
Problem 10 . The demand function of a firm is given by; p = 500-0.2x and its cost function is given by; C = 25x +
10,000 , where p is the price, x is the output level and C is cost. Find the output level at which the firm can
maximize its profit. Also, find the price it will change. (ii) Find the output level at the perfect competitive market
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and monopoly market.

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