Theory of Cost: -

Meaning: - Cost of production refers to all the payments required (incurred) to obtain the
4 factors of production i.e., land, labour, capital, and management(entrepreneur).
∴ C = f(Q) [ Implies that cost is a function of output]

→ Types of Cost: -
(i) Explicit Cost: - The costs incurred by the firm to him its factors of production. They
are clearly stated by the firm. E.g.: wages, salaries, rent etc.
(ii) Implicit Cost: The cost of own resources (factors of production or services) is known
as implicit cost. It is also called imputed cost. E.g.: Own building rent. This cost is
included in the average cost.
(iii) Opportunity Cost: The cost of the next best alternative.
(iv) Accounting Cost: It considers explicit cost and historical cost. It does not account for
implicit costs.
(v) Economic Costs: It includes both implicit as well as explicit costs. It is also a
measures of opportunity costs.

(vi) Sunk Cost: The cost (or expenditure) that has been incurred but cannot be recovered.
The opportunity cost of sunk cost is zero as it does not have any other alternative.
E.g.:- expenditure or R & D.
(vii) Fixed Costs: - The costs which are independent of the level of output. It is incurred
even at the level of zero output.
(viii) Variable Costs: - The costs which depend upon the level of output. It is equal to zero
if there is not production/output.
(ix) Total cost: - It is the sum total of both fixed and variable costs.
(x) Marginal Cost (Incremental Cost):- The cost incurred to hire additional variable
factor (say labour). It is the change in total cost/total variable cost due to a change in

variable factor.
(xi) Average Cost: - It is the cost per unit of output.

(1) Traditional Theory of Cost: -

(i) Short run Costs: Traditional Theory: -
 → A/C to the theory, the total costs can be divided into total fixed cost and total variable costs.

→ TFC includes salary of staff, depreciation on machinery, expenses for land maintenance etc.
→ TVC includes cost of raw material, labour etc.

→ Shape of TC, TFC, TVC curves:

● Panel A: TFC is a horizontal curve parallel to ‘x’ axis. It does not depend on the output and
hence does not start from origin. The intercept ‘OC’ shows that there is some fixed cost even
when the output is zero.
● Panel B: TVC is an inverse S-shaped curve. It reflects the law of variable proportions (i.e.,
variable cost initially increases at decreasing rate owing to increasing returns, thereafter it
increases at an increasing rate due to diminishing returns). TVC = 0 when O/P = O. It
depends upon O/P and ↑ is with the increasing O/P.
● Panel C: It shows all the three curves TC, TFC and TVC. TC is also an inverse S shaped
curve. It starts from the intercept OC because TC has an element of TFC and hence there will
always be some cost at zero output. Thereafter, it is influenced by TVC.
 Note: Vertical distance between TC and TVC remains constant throughout due to TFC.
Short Run AC and MC curves: -
● Average Cost = AFC + AVC

● AFC =

● AFC curve is a rectangular hyperbola.

● AFC approaches both the axes asymptotically. [i.e., gets near to axis but never will touch either
of the axis → AFC ≠ 0]
● AFC is never equal to zero as there is always some amount of TFC even if the O/P = 0.
● It falls continuously with the expansion of output.

Average Variable Cost-:

→ AVC, curve is a ‘u’ shaped curve

→ AVC curve initially falls due to increasing returns, attains its minimum point, and then starts rising
steeply owing to decreasing returns.
 ● AC = AFC + AVC
o AC is a ‘u’ – shaped curve’. Why AC is u – shaped?
⇓
→ Law of Variable proportions
→ Economics of scale up to minimum point & then dis-economies of scale.
→ Also, AC = AFC + AVC [ AVC pulls up AC after a certain point]
→ As O/P rises, the vertical difference/distance between AC and AVC decreases due to AFC
which falls continuously.

Relationship b/w ATC and AVC.

→ Both ATC and AVC are u-shaped.

→ AVC reaches its minimum point before AC.

● or TCn – TCn-1 or

→ It is a u- shaped curve [Reason: Law of variable proportions]

→ It falls initially, reaches its minimum point and then starts rising.
 Previous Year Question

Q. 1Among normal cost curves which one of the following curves does
not have a minimum point? (Dec,2019)
Average cost
Marginal cost
Average variable cost
Average fixed cost
Q. 2Which amongst the following statements is correct? (Nov 2017)
The minimum point of AVC and marginal cost are at same level of
output.
Minimum of AVC is at lesser output than the minimum of marginal.
Minimum of AVC is at larger output than the minimum of marginal.
Any of the above is possible depending upon operating the law of
returns.

Relationship b/w MC and AC

→ MC cuts AC at its minimum point [‘b’]

→ When MC ∠ AC, AC is falling
→ When MC > AC, is rising.
→ The rate of rise in MC > Rate of rise in AC i.e., MC falls at a steep rate and rises at a steep
rate as compared to AC.
→ When AC is falling, MC may either be falling or rising. After point ‘a’, MC is rising while
AC is still falling.
(ii) Long Run Costs: Traditional Theory: -

→ The long run costs engulf all possible short-run situations among which a firm must choose an O/P
target.

→ It primarily represents a planning horizon.

Long run Average Cost (LAC):

→ LAC curve can be derived with the help of short run average cost curves (SAC).

→ SAC1, SAC2, SAC3, SAC4, & SAC5 represent different plant sizes.

→ When LAC is falling, it is tangent to SAC at its falling portion. However, when LAC is rising, it is
tangent to rising portion of SAC.

→ When LAC reaches its minimum point ‘a’, it is known as minimum efficient scale/ optimal plant
size.
Min efficient scale = min point of LAC.

→ All the points before ‘a’ show under – utilization of resources, whereas all the points after ‘a’ show
over utilization of resources.

→ LAC is a u-shaped curve. Alternatively known as envelope curve or planning curve.

→ LAC = SAC only at the minimum point

Long Run Marginal Cost (LMC)

→ We can derive LMC by extending and joining tangency points of SAC and LAC.

→ LMC cuts LAC at its minimum point

→ When LAC is minimum, LAC = LMC = SMC = SAC.

 Note: -
→ When LAC is minimum, slope of AC = O
→ When slope of AC = O, MC = AC
→ When LAC is falling, slope of LAC < O, then LAC > LMC
→ When LAC is rising, slope of LAC > O, then LMC > LAC

Note: - Why LAC is ‘u’ shaped?

Reason: - Law of returns to scale

Economics of Scope: -
→ The term ‘economies of scope’ refers to a situation when cost per unit of production decreases due
to the production decreases due to the production of wise variety or range of goods or services.
→ In short, AC falls due to production of more than one product (wide product range).

(2) Modern Theory of Cost: -

→ The modern theory of cost discusses about distinct shape of cost curves. It makes a departure from
the Traditional cost theory on the ground of ‘u’ – shaped curves. George Stigler is a supporter of
modern cost theory stating that cost curves can acquire shapes other than u – shape.

(i) Short Run Costs: -

(a) Average fixed costs (SAFC)

 → AFC is continuously falling
→ Boundary line A: Absolute limit of expansion for small machinery units.
→ Boundary line B: Absolute limit of expansion for large capacity machinery units.
→ A firm can expand O/P from ‘A’ up to ‘B’ by paying overtime to labour to work for long
hours.
→ Another option to expand O/P is to buy smaller units’ machinery. In this case AFC curve
shifts upwards (shown by dotted line ‘ab’ and starts falling again.
(b) Short run average Variable cost (SAVC) & (SMC): -

→ Empirical evidence shows that SAVC 8 SMC are Saucer shaped.

→ There exists a flat stretch over a range of O/P [b/w Q1, & Q2]
→ This flat stretch is due to reserve capacity which is built to impart flexibility.
→ Over the range of reserve capacity [Q1, Q2], the O/P can be expanded without an increase in
the unit cost of factor.
→ When SAVC is falling, SMC < SAVC
→ When SAVC is rising, SMC > SAVC
→ SMC = SAVC during the range of reserve capacity. This shows there are multiple optimal
points b/w Q, & Q2.

(c) Short run Average cost (SAC):

 → SAC is obtained by adding SAVC & SAFC
→ It is continuously falling up to its minimum O/P point.
→ SAC rises after the complete exhaustion of reserve capacity, SMC cuts SAC at its minimum
point.

(ii) Long Run Costs:

→ All costs are variable in the long run, so there is no fixed cost; LAC = LAVC

(a) Long run Average cost (LAC): L -shaped.

→ LAC is L-shaped.
→ LAC falls until the minimum optimal scale [all the economics of scale have exhausted up to
OQ]
→ Thereafter (post the minimum point of LAC), LAC remains constant.
→ LMC is below LAC up to minimum optimal scale.
→ LMC coincides with LAC (LMC = LAC) after minimum point.

Reason for L-shaped LAC:

● Technical Progress
● Learning by Doing
● Economics of scale

→ The concept of learning curve was given by Arrow.

→ He states that per unit cost keeps on falling with O/P expansion because of increased
efficiency arising out of learning process.
Conclusion:
→ Modern cost theory suggests more realistic cost curves in contrast to traditional approach.
Iso-cost line:
→ The Iso-cost line is the locus of all factor combinations that the firm can purchase with a
given monetary cost outlay.
Or
→ Iso-cost line represents all the combinations of factors that can be purchased by a firm with a
specific (given) outlay.
→ The Iso-cost line can be expressed in cost equations as:
C = r(K) + w(L)
→ Where w = wage rate, r = price of capital services/user cost of capital/rate of interest on
capital.

→ It can be said that slope of iso cost line is ratio of wages to user cost of capital.
→ It also represents prices of factors.

→ Every point lying on AB satisfies the eq.

Or
 → Equilibrium is achieved at pt. E where MRTS (L, K) = i.e., slope of iso-quant = slope of
iso- cost line.

Production Equilibrium: Combining production and cost.

→ A producer equilibrium can be studied after considering both the production and cost.

A producer can achieve equilibrium either by cost minimization or output maximization.

Conditions for Producer Equilibrium
(i) Isoquant curve should be convex to origin.
(ii) Isoquant must be tangent to iso-cost line

Let us study the 2 cases of producer equilibrium mentioned above: -

Case-1: Maximization of output subject to a cost constraint (financial constraint)

→ The firm here achieves equilibrium by maximization of output given a specific cost outlay
and prices of factors (‘w’ and ‘r’)
→ AB is the iso-cost line defining the cost constraint.
→ Any combinations outside AB are unattainable.

→ Eq at ‘E’ where MRTSLK =

→ Q3 denotes higher O/P but cannot be achieved with given outlay.
Case: -2: Cost minimization for a given level of output

→ The firm can attain equilibrium by minimization of cost, given a desired level of output.
→ In this case, we have a set of iso-cost line but a single isoquant.
→ Iso-cost lines closer to origin denotes lower cost-outlay.
→ Equilibrium is achieved at point ‘E’ as here Isoquant (IQ) is tangent to iso-cost line & also IQ
is convex to origin.

→ No equilibrium at point ‘a’ and point ‘b’ as here [i.e.., does not satisfy the
condition of tangency]

Numerical:
● Remember: - (1) marginal cost shows the rate of change in total cost due to changes in
output/variable factors.

We can calculate MC by differentiating TC functions with respect to output.

Further, TC can be calculated by the integration of MC function [TC is anti-derivative of MC]

(1)

(2) TC = Q(AC)

(3)

(4)
 (5)
[Note: we do not add C when there are limits given for integration]

(6)

Q.1 A firm faces a cost function of C = 8 + 4q2 + q3. Find

(i) Firm’s fixed cost
(ii) average variable cost
(iii) Marginal cost
When q = 10 units
Solution: -
C = 8 + 4q2 + q3
(I) Fixed cost = cost at q = 0
Put value of q = 0 in the cost functions
C = 8 + 4(0)2 + (0)3
C=8

(i) AVC =?

We know ATC = AFC + AVC

AVC = ATC – AFC
 (ii) C = 8 + 4q2 + q3

To find MC, we must differentiate ‘C’ with respect to ‘q’.

Since q = 10

∴ MC = 8(10) + 3(10)2
= 80 + 300

Previous Year Question

13 2
TC  q  3q  50q  300
10
Practice Question:
Q−1: Firm A has the following variable cost function:
TVC = 200Q – 9Q2 – 0.25Q3
If the firm’s fixed costs are equal to Rs. 200, find out:
(i) TC function
(ii) Marginal cost [When Q = 5]
Ans: (i) TC = 200 + 200Q – 9Q2 – 0.25Q3
(ii) MC = 91.25
Solution:
(i) TC = TFC + TVC
TFC = 200 Given
TC = 200 + (200Q – 9Q2 – 0.25Q3)
TC = 200 + 200Q – 9Q2 – 0.25Q3

(ii)
TC = 200 + 200Q – 9Q2 – 0.25Q3

= 0 + 200 - 18Q – 3(0.25) Q2

= 200 – 18Q – 0.75Q2
= 200 – 18(5) – 0.75 (.5)2

= 200 – 980 – 0.75 (250)

= 200 – 980 – 78.75

Q-2 If MC = 150 + 200Q – 9Q2, find TC function

Ans: 150Q + 100Q2 – 3Q3 [Hint: use integration]
Solution:
We know TC is anti-derivative of MC,

So,
Integrating MC function would take us to TC function.

Using properties

(i)

(ii)
Eco-trivia