How costs vary with output in the short

run and in the long run

Elasticity of supply depends to a great
extent on how costs change as output is
varied.
If unit costs rise rapidly as output rises,
then the stimulus to expand production in
response to a price rise will quickly be
choked-off by those increases in costs that
occur as output increases.
In this case, supply will rather be inelastic.
If, on the other hand, unit costs rise only
slowly as production increases, a rise in
price that raises profits will call forth a large
increase in quantity supplied before the rise
in costs puts a halt to the expansion in output.
 In this case, supply will tend to be rather
elastic.
Cost Function
The cost function measures the
minimum cost of producing a given
level of output for some fixed factor
prices.
Topics
Types of cost : total cost, average cost,
marginal cost
Link between production and costs
Short run and long run Cost curves
Costs and benefits
Break-even analysis and Plant Sizing
Sunk Costs
 Accounting costs & Economic Costs
Suppose, I run a firm named Reenu Ltd. at
my own building (I’m the owner of the
building).
In this case, I need not to pay any rent for
the office space( because I’m the owner).
Now the question arises,
Will I consider the cost of the office space in
my records to be zero?
Accountant’s point of view- Yes, the cost
will be zero because there is no actual
expenditure incurred.
Economist’s point of view- No, the cost
won’t be zero because had I not used it for
my business, I would have earned rent on
the office space by leasing it to another
company.
This forgone rent should be thus included
as part of the economic cost of doing
business.
ACCOUNTING COST account only for
the explicit cost (actual money expenditure
on inputs or payment made to outsiders for
hiring their factor services).
ECONOMIC COST account for both
the explicit as well as implicit cost (imputed
value of the inputs supplied by the owner).
In a nutshell, ECONOMIC COST includes
not only the ACCOUNTING COST(explicit
cost) but also the implicit cost.
Explicit and Implicit
Explicit cost are the costs paid to external
factors of production &
Implicit cost are the costs paid to internal
factors of production
Fixed and Variable Costs

 Fixed costs are those costs that do not

vary with the quantity of output produced.
 Variable costs are those costs that do
change as the firm alters the quantity of
output produced.
 Fixed Costs Variable Costs
Meaning In accounting, fixed costs are expenses
that remain constant for a period of time
irrespective of the level of outputs.
Incurred when Even if the output is nil, fixed costs are
incurred
Also known as Fixed costs are also known as overhead
costs, period costs or supplementary
costs.
Nature Fixed costs are time-related i.e. they
remain constant for a period of time.
Examples Depreciation, interest paid on capital,
rent, salary, property taxes, insurance
premium, etc.
Variable costs are expenses that change
directly and proportionally to the
changes in business activity level or
volume.
The cost increases/decreases based on
the output
Variable costs are also referred to as
prime costs or direct costs as it directly
affects the output levels.
Variable costs are volume-related and
change with the changes in output level.
Commission on sales, credit card fees,
wages of part-time staff, etc.
 
Costs
Total fixed costs (TFC)
Average fixed costs (AFC)
Total variable costs (TVC)
Average variable cost (AVC)
Total cost (TC)
Average total cost (ATC)
Marginal cost (MC)
Average & Marginal Cost Curves
Short-run cost curves
Short-run total cost
Short-run average cost
Short-run marginal cost
 Fixed Costs
Result from owning a fixed input or resource.
Incurred even if the resource isn’t used.
Don’t change as the level of production changes
(in the short run).
Exist only in the short run.
Not under the control of the manager in the short
run.
The only way to avoid fixed costs is to sell the
item.
 Fixed Costs
1. Depreciation
2. Interest
3. Rent
4. Taxes (property)
5. Insurance
Average Fixed Costs
Average fixed cost per unit of output:
AFC = TFC/Output
Variable Costs
Can be increased or decreased by the manager.
Variable costs will increase as production
increases.
Total Variable cost (TVC) is the summation of
the individual variable costs.
VC = (the quantity of the input) X (the input’s
price).
Variable Costs
Variable costs exist in the short-
run and long-run
In fact, all costs are considered to be
variable costs in the long run.
Average Variable Costs
Average variable cost per unit of
output:
AVC = TVC/Output
Total Cost
The sum of total fixed costs and
total variable costs:

TC = TFC + TVC

In the short run TC will only

increase as TVC increases.
Family of Total Costs
Average Total Cost
Average total cost per unit of output:
ATC = TC/Output
Average Costs

 The average cost is the cost of each

typical unit of product.
Family of Average Costs

 Average Fixed Costs (AFC)

 Average Variable Costs (AVC)
 Average Total Costs (ATC)

ATC = AFC + AVC

Marginal Cost

 Marginal cost (MC) measures the amount

total cost rises when the firm increases
production by one unit.
 Marginal cost helps answer the following
question:
 How much does it cost to produce an additional
unit of output?
Marginal Cost
The additional cost incurred from producing
an additional unit of output:
MC =  TC/ Output
MC =  TVC/ Output
Average & Marginal Cost Curves
Typical Average & Marginal Cost Curves
(selected attributes)
 AFC is always  MC is generally
declining at a increasing.
decreasing rate.  MC crosses ATC and
 ATC and AVC decline AVC at their minimum
at first, reach a point.
minimum, then  If MC is below the average
increase at higher value:
levels of output. ◦ Average value will be
 The difference between decreasing.
ATC and AVC is equal
 If MC is above the average
value:
to AFC.
◦ Average value will be
increasing.
Explain the relationship between average
cost and the marginal cost. How is it
possible that the marginal cost continues
to rise while average cost declines?
• As long as AC curve is falling, MC is less than AC, i.e.,
MC pulls AC downwards.
• However, MC falls more rapidly and reaches its
minimum point ‘A’ earlier than AC reaches its own
minimum point ‘B’.
• Therefore, MC starts rising from point ‘A’ to point ‘B’.
AC is still falling upto point ‘B’.
Further, beyond point ‘B’ both MC and
AC rise, but, the former rises more
sharply.
When MC rises above AC, it pulls the
latter upwards.
Similar relationship holds between MC
and AVC too.
MC intersects both AVC and AC (from
below) at their respective minimum
points in that order.
Long- run cost
 Long-run total cost
 Long-run average cost
 Long-run marginal cost
Long run total cost
Least possible cost of production when all
the inputs are variable.
Relation between STC and
LTC Curves
LTC≤ STC
Long run Average Cost or
Envelope curve
Minimum possible per unit cost of
producing different quantities of output of
a good in the long period.
Plant sizing
A plant as may reduce average cost to the
minimum.
With change in demand for output,
producer will go on changing the size of
the product.
Each plant has its SAC with whose help
producer can estimate LAC
 The newly formed Bangladesh Automobile Corporation plans to
produce and export an expensive sports car and has asked your
consulting firm for advice on the size of plant to construct.
 Because of the union contract and technical features of
automobile production, labour must be paid the equivalent of
$12,000 per person per annum, and each incremental change in
plant size involves $900,000 in annual expenses for
depreciation, interest, and other fixed costs.
 The maximum the firm will have available for expenditure on
capital and labour is $9 million per annum. BAC has supplied
the following details of its production function, meticulously
derived by its chief engineer. (The data in the body of the table
represent automobiles produced, in units.)
 Labour can be varied virtually continuously; the table shows
units of fifty persons for convenience. All other variable
expenses are constant at $2,500 per vehicle produced.
Planning curve/Envelope curve
Long run marginal cost
Relation between LMC and SMC

If output is less than optimum level,

SMC<LMC
If output is more than optimum level,
SMC>LMC
Cost volume profit analysis /
Break even analysis

The point where the total cost equals the

total revenue is known as the break-even
point
Contribution margin
Margin of safety
In break-even analysis, the term margin
of safety indicates the amount of sales
 that are above the break-even point.
In other words, the margin of safety
indicates the amount by which a
company's sales could decrease before the
company will have no profit
Example of Margin of Safety

Let's assume that a company currently

sells 3,000 units of its only product. The
company has estimated that its break-even
point is 2,800 units.
Therefore, the company's margin of safety
is 200 units
Importance of Break-Even
Analysis:
• Manages the Size of Units to be Sold- 
• With the help of break-even analysis, the
company or the owner comes to know how
much units need to be sold to cover the cost.
• The variable cost and the selling price of an
individual product and the total cost are required
to evaluate the break-even analysis.
• Budgeting and Setting Targets
• Since a company or the owner know at
which point a company can break-even, it
makes it easy for them to fix a goal and
set a budget for the firm accordingly.
• This analysis can also be practised in
establishing a realistic target for a
company.
• Manage the Margin of Safety- 
• In financial breakdown, the sales of a
company tends to decrease.
• The break-even analysis helps the
company to decide the least number of
sales required to make profits.
• With the margin of safety report, the
management can execute a high business
decision.
• Monitors and Controls Cost
• Companies profit margin can be affected
by the fixed and variable cost; therefore,
with break-even analysis, the management
can detect if any effects are changing the
cost.
Helps Design Pricing Strategy
Break-even point can be affected if there
is any change in the pricing of a product.
For example, if the selling price is raised,
the quantity of the product to be sold to
break -even will be reduced. Similarly, if
the selling price is reduced, a company
needs to sell extra to break-even.