Cost curve and their relationship

By T Bhandari
Cost of firm

Types of cost

Opportunity
Real cost Implicit cost Explicit cost Money cost
cost
 Cost concept
Opportunity cost: Foregone opportunity is also taken
as cost.
• A/o Leftwitch, opportunity cost of the particular
products is the value of the foregone alternative
products that resources used in its production could
have produced : If resources were not used in that
firm in the production process, these resources
would have alternative use.
Money cost: Money outlays of a firm on the process
of production of its outputs. The cost which enters
the records of the accounts of the company.
Cost concepts (cont..)
• Explicit cost: (or called direct or cash cost) It is
incurred when money is spent to hire labour, repair
machinery, buy seed, fuel, or other things for which cash
expenditures are made. These expenditure have been
made to enhance product output but a simple totaling of
all such money spent is inadequate when trying to
determine the cost of production since these costs are
1/3rd or 2/3rd of all costs.
• Implicit cost (Indirect or noncash cost): are incurred in using
any resources for which there was no cash outlay during the period
that the resource was being used, and it is necessary to determine
that type of resource cost.
E.g 1. Tractor cost: use many years means use cost accordingly but not
count cost just of beginning year of buying.
• Example 2: Operators own labour and management
Types of cost
Fixed cost: Are those costs that
do not vary with the size of
output.
• Salaries of administrative
staffs;
• Insurance premia;
• Property taxes;
• Depreciation of machinery,
• Permanent labour wage;
• Machine/tractor etc;
• Building or rented building;
• Land or land rent;
• Fixed amounts: Like fixed bill,
principle installments bill
Variable cost: Vary in short
period
• The raw materials (short
use expenses: seed,
fertilizer, manure,
pesticides, etc;)
• Cost of direct labour;
• Running expenses of fixed
capital (fuel, ordinary
repairs, routine
maintenance)
• Marketing expenses
(packaging, labeling and
wrapping, and selling
Short-run to long-run cost/function
Short-run: Costs over the period of production during which
some factors of production (usually capital equipment and
management) are fixed;
Production can be increased or decreased by changing variable
costs only but can not change fixed factors;
• Short-run cost function: C=∫(X, T, Pf, K)
Where, X: Output, T: technology, pf: Price of factors, K : fixed
factors)
Long-run cost/ function: The long-run costs are cost over the
period long enough to permit the change of all factors of
production. All factors of production become variable.
It is the time-period in which new plant can be installed and
new firm can enter/exit the market;
Long-run cost function : C=∫(X, T, Pf).
 Cost function
• Thus, both the short-run and in the long-run, total cost
is the multivariable function. i.e. total cost is
determined by many factors;
• Cost function can be linear or curve-linear depending
upon the cost behaviour and response to the
dependent variable studied :
• Short-run total cost (TC): sum of total fixed cost and
total variable cost for each output level.
• i.e TC=> TFC + TVC.
• C= 100+10x
• C= 100+10x+2x2
• Where, 100 is fixed cost and x is the variable cost
Graphically
TVC: inverse S-shape: so follow law of variable proportion.
It means at the initial stage of production, productivity
increases as more variable factors used and average variable cost falls

TFC: Straight line parallel

To the output axis
 Cost concepts
• Average total cost (ATC) or Average cost - total cost
per unit of output (AC=TC/ y= AFC+AVC).
• Total fixed cost (TFC): Cost which don’t change with
changes in the quantity of output. These costs are
buying tractor, irrigation pipe or simple plough having
durable use. TFC= Unit of fixed factors X price of the
factor
• Average fixed cost (AFC): Total fixed cost/quantity of
output (Kg or quintal) i.e. AFC=TFC/y
• Total variable cost (TVC): Sum of amounts spent for
each of the variable inputs used.
• Average variable cost (AVC): Total variable cost by
dividing quantity of output ( i.e. AVC=TVC/y)
Graphically, AFC, SAVC, SATC
 Marginal cost
• Important concept in short-run cost analysis;
• Addition made to the total cost by the production of
one more unit of output
• A/o Dooley, MC is the change in total cost associated
with change in output;
• i.e MC= Change in total costs or ∆TC/ ∆Q
Change in output
Mathematically, TC is the first derivative of the TC
function: MC=δC/ δX
Graphically, MC is the slope of the TC curve. MC curve
follow U shape.
Relation: When AC falls, MC is less than AC, AC rises, MC
is greater than AC, MC cut AC at its lowest point.
Calculation method

Unit of
output TFC AFC TVC AVC SAC TC MC TR MR

0 100 0 0 0 0 100 0 0

1 100 100.00 50 50 150.00 150 50 80 80

2 100 50.00 90 45 95.00 190 40 160 80

3 100 33.33 120 40 73.33 220 30 240 80

4 100 25.00 140 35 60.00 240 20 320 80

5 100 20.00 175 35 55.00 275 35 400 80

6 100 16.67 230 38 55.00 330 55 480 80

7 100 14.29 310 44 58.57 410 80 560 80

8 100 12.50 400 50 62.50 500 90 640 80

Example: calculation
Outpu Total Inpu Total Total Total Profit
t (Y - revenu t Variabl Fixe Cost (TR-
AVC AFC ATC MC MR (
Kg) e (TR)= (X1) e Cost d (TC) TC)
(TVC/Y (TFC/Y (TC/Y (ΔTC/ΔY (ΔTR/
Y*Nr (TVC) Cost
) ) ) ) ΔY)
1.5 (TFC
)
0 0 0 0 150 150 -150
0.00 0.00 0.00
100 150 11.6 58 150 208 -58
0.58 1.50 2.08 0.580 1.5
200 300 17.6 88 150 238 62
0.44 0.75 1.19 0.300 1.5
300 450 22.8 114 150 264 186
0.38 0.50 0.88 0.260 1.5
400 600 28 140 150 290 310
0.35 0.38 0.73 0.260 1.5
500 750 34.5 172 150 322 428
0.34 0.30 0.64 0.320 1.5
600 900 43.9 219 150 369 531
0.37 0.25 0.62 0.470 1.5
700 1050 57.8 289 150 439 611
0.41 0.21 0.63 0.700 1.5
800 1200 90 450 150 600 600
0.56 0.19 0.75 1.610 1.5
850 1275 100 500 150 650 625
0.65 0.18 0.82 2.000 1.5
Relationship of SMC and SAC
160.00

140.00

120.00

100.00

80.00 SAC
MC

60.00

40.00

20.00

0.00
0 1 2 3 4 5 6 7 8

When AC falls, MC is less than AC, AC rises, MC is greater than AC, MC cut AC at
its lowest point.
Total Revenue / Marginal revenue
• Total revenue: The firm gets from the sale of its
products
• Revenue = price X output
• Average revenue: Total revenue
total output
• i.e AR = Price
• Marginal revenue: it is an addition made to total
revenue by the sale of an additional unit of the
product in the market
TR Y  Py
  Py
Y Y
Profit and loss

700
600
500
TFC
400
TVC
300
TC
200
TR
100
0
0 2 4 6 8 10
Efficient production
• The MC=MR is optimising rule force adjustments
in output because of inequalities in cost and
returns at the margin. If MR is at any level of
output is exceeds MC, that inequality simply tells
the operator that an additional surplus can be
captured and added to profit by increasing
outputs. The opposite signal is forceful when MC
exceeds MR.
• What happened if input price rises or output price
rises?
Graphical show
 Relationship of different cost concepts
160.00

140.00

120.00

100.00
AFC
80.00 AVC
SAC
60.00
MC
40.00

20.00

0.00
0 1 2 3 4 5 6 7 8
Profit: TR-TC
800

600

400 TC
TR
200

0
0 5 10 15
π= TR-TC
 Determinants of cost
• Cost follow law of diminishing return: The cost will shows a
tendency to rise, reverse case when the law of increasing
returns operates;
• Bigger the size of the firm/plant, fixed cost higher in the
beginning, variable cost tends to lower in comparison to
small size plant;
• Cost curve in short-period rise steeply than long-run cost
curve;
• Higher capacity utilization of the plant, lower is the fixed
cost/unit output;
• Most technological innovations, if used, makes low cost;
• Efficiency of using inputs and choice of relatively cheaper
inputs;
• When output stable, cost low
Importance of fixed and variable cost
• Decision to shut down the firm: If price of the
output falls, it is not possible to recover FC and VC;
• S/he decides whether to continue of shutdown
business: looks FC and VC; means
• If less production or shut down: no VC but need to
pay FC. Firm decide to shut down if the prices of the
products are less than the AVCs. If the prices> AVC
firm covers parts of fixed cost also.
Importance of fixed and variable cost (cont…)
SR and LR differences in equilibrium conditions of
the firm
• SMC= SMR
Only the proportion of fixed cost and variable costs
taken into account. Only MC is affected by variable
cost only.
• LMC= LMR
It covers both fixed and variable costs.