Course Title: Economics

Course Code: Econ 2181

Chapter: Theory of Cost and Revenue

Conducted by:
Md. Mehedi Hasan
Lecturer
Economics Discipline, Khulna University

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Cost Related Content

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Concept of Cost

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Watch the Given video

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 Long Run Cost
Long Run Cost is the minimum cost at which a certain level of output
can be achieved in the long run when all factors of production are
variable.
These costs enable a business to understand its asset value and make
necessary improvements in the production cycle. As a result, this helps
organisations analyse their factors of production and expand or reduce
their operational costs accordingly.

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 Types of Long Run Costs
Long Run Cost (LRC) can be divided into three primary types:

1. Long Run Total Cost (LTC): The minimum cost required to produce a
particular quantity of commodity with variable factors of production is LTC.

2. Long Run Average Cost (LAC): LAC can be described as the average cost
to produce a particular quantity of commodity when all factors of production
are variable. It is the LTC divided by output level, which derives a per-piece
cost of the total output.

3. Long Run Marginal Cost (LMC): It depicts the additional costs a company
incurs to expand its factors of production when all units are variable. LMC is
the extra cost of expanding a plant or facility.

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 Long Run Total Cost Curve
A long run total cost curve
(LRTC) is a graph representing
the total cost of production of a
certain unit and its relation with
the average cost. It is an S-
shaped curve with total cost on
one axis and the produced
quantity on the other axis.

In the image below, you can see

the representation of an LTC
Curve.

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 Long Run Average Cost Curve
Long run average cost curve (LRAC) is
a graph representing a company’s
average cost with an increase in the
number of units for a fixed output. It
is a U-shaped curve determining the
relation between the output and the
average cost incurred. As the LAC first
decreases and then increases, the graph
forms a U-shape.
Example:
Here is an example that illustrates the
LRAC:

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 Long Run Marginal Cost Curve
Long run marginal cost curve (LRMC) is
a graph representing the increase in
marginal cost with an expansion of
production scale. It helps to determine
the changes in the cost of production of a
company. Similar to LRAC, it is also a
U-shaped curve.

Example:
Here is an example of a Long Run
Marginal Cost Curve:
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 Cost related Terminologies
What are Short Run Costs?: It is the cost incurred in production during a fixed period of time when all
the factors and inputs vary, except one. Assessing the short run costs of an organisation or an economy
helps us to study how it behaves in response to sudden environment changes.
What are the Types of Short Run Costs?: There are primarily three types of short run costs. It should
be kept in mind that these costs are crucial to determine the long run costs of a company.
1. Short Run Total Cost (STC): Short run total cost is a company’s total cost of production for a given
output. It is further divided into two types which are total fixed and variable costs. The total sum of
these two elements determines the STC.
Total variable costs: (TVC) are costs that change when the output changes in the short run, like cost of
raw materials.
Total fixed costs (TFC) are costs that remain the same with an increase in production in the short run,
like the cost of machinery.
2. Short Run Average Cost (SAC): SAC is the average cost of a given production of a company in the
short run. It is the average cost per unit when all inputs are variable except one. Short run total cost
divided by output equals SAC.
3. Short Run Marginal Cost (SMC): It is the additional cost incurred to produce a certain output. SMC
is incurred when there is a change in total cost due to a change in production input costs. It is calculated
by dividing the total cost by change in total output.

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Relationship Between Long Run and Short Run Costs

Both short run and long run cost curves are essential economic tools to
assess the cost of production of an organisation. This, in turn, helps to
develop a more efficient production process and improve profitability.
Although these two costs are quite closely dependent on each other, they
have their own share of differences.
LRCs are calculated for an extended period of time, and hence all
factors of production are variable. However, SRC affects the long run
production costs as it is the average cost that gets added to the LRC of a
production unit.
In the long run, the fixed factors of SRC also turn into variables that
affect the SAC individually.
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Fixed Cost vs Variable Cost

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 Some terminologies
Fixed costs (FC) are expenses to that do not vary with the quantity of output produced (Q).
Examples of fixed costs include rent and annual salaries.
Variable costs (VC) are expenses which increase with the quantity of output produced (Q).
Examples of variable costs include hourly and piece-rate wages, and raw materials used in
manufacturing.
Total cost (TC) is the sum of the fixed costs and variable costs, so TC = FC + VC.
The graph below shows four costs curves for a firm operating in a perfectly competitive market:
Average fixed cost (AFC) refers to fixed costs divided by the total quantity of output produced, AFC
= FCQ.
Average variable cost (AVC) refers to variable costs divided by the total quantity of output
produced, AVC = VCQ.
Average total cost (ATC) refers to total cost divided by the total quantity of output produced, ATC =
TCQ.
Marginal cost (MC) refers to the additional cost incurred by producing one additional unit of output,
MC = ΔTCΔQ.

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 Envelope Curve/ Long-run Average Cost (LAC)
The long-run average cost (LAC) curve shows the least costly
combination of producing any particular quantity. The graph
below shows short-run average costs (SATC) and the LAC.
The LAC forms a tangent with the SATC and it is therefore the
lowest possible average cost for each level of output where the
factors of production are all variable – it is formed from a
series of SATC curves. The diagram shows:
From the diagram A is the least-cost way to make output Q1 in
the short run. B is the least-cost way to make an output Q2. It
must be more costly to make Q2 using the wrong combination
of factors of production, for example the quantity
corresponding to point E. For the combination of factors of
production at A, SATC1 shows the cost of producing each
output, including Q2. Hence SATC1 must lie above LAC at
every point except A, the output level for which the
combination of factors of production is best

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 Envelope Curve/ Long-run Average Cost (LAC)

The LAC is a flatter U-shape than the SATC curves and can be
explained by economies of scale and diseconomies of scale.
However it is really important to note that the firm does not
necessarily produce at the minimum point on each of its SATC
curves. Thus the LAC curve shows the minimum average cost
way to produce a given output when all factors can be varied, not
the minimum average cost at which a given plant can produce.
Note: This LAC is also know as the envelope curve (looks
similar to the back of an old style envelope)

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 Relationship Between Revenue and Costs
importance:
•Shows the amount of goods which need to be sold in
Break even analysis order to make a profit.
A business’s break even point is •Level of costs which can be survived.
where its total costs equal the total •Price which needs to be charged for goods.
of its sales income. •How price change would affect profits (‘WHAT IF’
ANALYSIS).
The break even point is the
minimum point at which the
business can survive – it is neither
making a profit nor a loss, it is
simply covering its costs (i.e.
breaking even). If it can sell more
goods than its break even level
then the business will be making a
profit. If sales are below the break
even level, then the business will
be making a loss.

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