Cost Concepts

in Economics
Dr Monika Jain

1
 Definition of Cost
A cost is relevant if it is affected by a management
decision.
Historical cost is incurred at the time of procurement
Replacement cost is necessary to replace inventory

2
 Definition of Cost
There are two types of cost associated with economic
analysis
Opportunity cost is the value that is forgone in
choosing one activity over the next best alternative
Out-of-pocket cost is actual transfer of value that occur

3
 Opportunity Cost
The income that would have been received if
the input had been used in its most profitable
alternative use.
The value of the product not produced because
an input was used for another purpose.
An “economic concept” not an “accounting
concept.”
As economic decision-makers, we assume costs
include opportunity costs.

4
 Accounting versus Economic Cost
An accountant’s notion of costs involves only the firm’s
explicit costs:
Explicit costs: the firm’s actual cash payments for its inputs or the
Accounting cost
An economist includes the firm’s implicit costs:
Implicit costs: the opportunity costs of nonpurchased inputs.
 Economic cost: the sum of explicit and implicit costs.

5
Accounting versus Economic Cost
Accounting versus Economic Cost
Accounting Economic
Approach Approach
Explicit Cost (purchased inputs) $60,000 $60,000
Implicit: opportunity cost of
30,000
entrepreneur’s time
Implicit: opportunity cost of funds 10,000
______ ______
Total Cost $60,000 $100,000

6
 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)

7
 Short-run versus Long-run Decisions
Short run: a period of time during which at least one
factor of production remains fixed. In the short run, a
firm decides how much output to produce in the
current facility.
Long run: the time it takes for a firm to build a
production facility and start producing output. In the
long run, a firm decides what size and type of facility
to build.

8
 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.

9
 Fixed Costs

1. Depreciation
2. Interest
3. Rent
4. Taxes (property)
5. Insurance

10
 Important Fixed Costs
Total fixed cost (TFC):
All costs associated with the fixed input.
Average fixed cost per unit of output:

AFC = TFC
Output

11
 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).

12
 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.
 Variable versus Fixed, some examples:
Fertilizer is a variable cost until it has been
purchased and applied.
Labor and cash rent contracts have to be considered
fixed costs during the duration of the contract.
Irrigation water is generally variable, but can have a
fixed component.

13
 Important Variable Costs
Total variable cost (TVC):
All costs associated with the variable input.
Average variable cost per unit of output:

AVC = TVC
Output

14
 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.

15
 Output TFC
100
(Q) (£)
Total costs for firm X
0 12
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40

20

0
0fig 1 2 3 4 5 6 7 8
 Output TFC
100
(Q) (£)
Total costs for firm X
0 12
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Output TFC TVC
100
(Q) (£) (£)
Total costs for firm X
0 12 0
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Output TFC TVC
100
(Q) (£) (£)
Total costs for firm X
0 12 0 TVC
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
100 Total costs for firm X
TVC
80

Diminishing marginal
60
returns set in here

40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Output TFC TVC
100
(Q) (£) (£)
Total costs for firm X
0 12 0 TVC
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Output TFC TVC TC
100
(Q) (£) (£)
Total costs for firm X
(£)

0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Output TFC TVC TC
100
(Q) (£) (£)
Total costs for firm
(£) TC X
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
100 Total costs for firm
TC X
TVC
80

Diminishing marginal
60
returns set in here

40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Typical Total Cost Curves

25
 Average Total Cost
Average total cost per unit of output:

AFC + AVC

ATC = TC
Output

26
 Short-run Average Total Cost
 Short-run average total cost measures total cost per unit of output
produced.

TFC TVC
SA T C  
Q Q
Short-
run Fixed Variable
Average = Cost + Cost per
Total per Unit Unit
SA T C  A F C  SA V C
Cost

27
 Short-run Average Total Cost
 Short-run average total cost measures total cost per unit of output
produced.

TFC TVC
SA T C  
Q Q
Short-
run Fixed Variable
Average = Cost + Cost per
Total per Unit Unit
SA T C  A F C  SA V C
Cost

28
 Marginal Cost
The additional cost incurred from producing an
additional unit of output:

MC =  TC
 Output
MC =  TVC
 Output

29
Costs (£) Q TVC AVC
35 0 0 -
1 10 10
30 2 16 8
3 21 7
25 4 28 7
5 40 8
20 6 60 10
7 91 13
15

10

5
AFC
0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TVC AVC
35 0 0 -
1 10 10
30 2 16 8
3 21 7
25 4 28 7
5 40 8
20 6 60 10
3 13
7 91
15

10 AVC

5
AFC
0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TC AC
35 0 12
1 22 22
30 2 28 14
3 33 11
25 4 40 10
5 52 10.4
20 6 72 12
7 103 14.7
15

10 AVC

5
AFC
0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TC AC
35 0 12
1 22 22
30 2 28 14
3 33 11
25 4 40 10
5 52 10.4
20 6 72 12
7 103 14.7
15
AC

10 AVC

5
AFC
0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TC MC
35 0 12
10
1 22
6
30 2 28
5
3 33
7
25 4 40
12
5 52
20
20 6 72
31
7 103
15

10

0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TC MC
35 0 12
10 MC
1 22
6
30 2 28
5
3 33
7
25 4 40
12
5 52
20
20 6 72
31
7 103
15

10

0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TC MC AC
35 0 12 -
10 MC
1 22 22
6
30 2 28 14
5
3 33 11
7
25 4 40 10
12
5 52 10.4
20
20 6 72 12
31
7 103 14.7
15

10

0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TC MC AC
35 0 12 -
10 MC
1 22 22
6
30 2 28 14
5
3 33 11
7
25 4 40 10
12
5 52 10.4
20
20 6 72 12
31
7 103 14.7
15
AC

10

0
0 1 2 3 4 5 6 7
Q
 Average and marginal costs
MC
AC

AVC
Costs (£)

x
AFC

fig
Output (Q)
 Typical Average & Marginal Cost
Curves

39
 Short-run Average Total Cost (SATC)
 The AC curve is U-shaped
because of the behavior of its
two components as output
produced increases.
AFC decreases as output
increases.
AVC increases as output
increases.

40
 Relationship between Short-run
Marginal and Average Cost Curves
As long as AC is declining,
marginal cost lies below it.

 When AC rises, SMC

is greater than SATC.

 At point m, AC=MC.

41
 Farm Size in the Short-Run

42
 Long-run Average Cost
Long-run average cost (LAC) is total cost divided by
the quantity of output when the firm can choose a
production facility of any size.
The LAC curve describes the behavior of average cost
as the plant size expands. Initially, the curve is
negatively sloped, then beyond some point, it becomes
horizontal.

43
 Alternative long-run average cost curves

Economies of Scale
Costs

LRAC

O Output
fig
 Alternative long-run average cost curves

LRAC
Diseconomies of Scale
Costs

O Output
fig
 Alternative long-run average cost curves

Constant costs
Costs

LRAC

O Output
fig
 A typical long-run average cost curve

LRAC
Costs

O Output
fig
 A typical long-run average cost curve

Economies Constant Diseconomies LRAC

of scale costs of scale
Costs

O Output
fig
 Possible Size-Cost Relations

49
 Economies of Size
 Increasing returns to size.
 LRAC curve is decreasing.
 Economies of size result from:
Full utilization of labor, machinery, buildings.
Ability to afford specialized labor and machinery and
new technology.
Price discounts for volume purchasing of inputs.
Price advantages when selling large amounts of output.

50
 Long-Run Average Cost Curve
(Economies of Size)

51
 Diseconomies of Size
Decreasing returns to size.
LRAC curve begins to increase.
Diseconomies of size result from:
Lack of sufficient managerial skill.
Need to hire, train, supervise, and coordinate larger
labor force.
Dispersion over a larger geographical area.
Disease control, waste disposal.

52
 Long-Run Average Cost Curve
(Diseconomies of size)

53
 Reduction in costs when the scale of
production increases is called

ECONOMIES
OF SCALE

INTERNAL EXTERNAL
ECONOMIES ECONOMIES

54
 INTERNAL ECONOMIES

Technological Large scale production provides

opportunities for technological
advances
Advantages
Economies in
Production
Large scale production workers of
Advantages of varying skills & qualifications are
divisions employed which facilitates division of
of labour labour as per specialization
&
Specialization
.. Large scale selling of
firms own products

.. Large scale purchase

of raw materials & Improves the overall
Economies in performance of the firm
other inputs
Marketing
.. Advertising cost
.. Large
scale distribution
55
 .. Specialization in
managerial activities

Managerial .. Improves managerial

Economies efficiency
.. Mechanization of
managerial functions

.. Efficient management
of the transport
function
.. Helps in reducing
Transport
transportation and
&
storage costs
Storage
Economies
.. Proper utilization of
storage facilities

56
 CAUSES OF EXTERNAL ECONOMIES
Advantages Common Pool of
Knowledge
CONCENTRATION of of locality
locality Reduced transportation
cost

The benefits which

companies derive from
trade publications and
Knowledge technical journals
INFORMATION
sharing By virtue of location,
common pool of research
can be created and
benefits can be shared

Breaking up of processes
Breaking up which can be handled by
DISINTEGRATIO
N specialist firms
57 processes
 ADVANTAGES AND DISADVANTAGES OF LARGE SCALE
PRODUCTION

Specialization Rent

Economy of Overhead
labour charges

Economics of
buying and
selling

58
 Economies of Scale
 Economies of scale: a situation in which an increase in the
quantity produced decreases the long-run average cost of
production.
 Economies of scale refer to cost savings associated with spreading
the cost of indivisible inputs and input specialization.
 When economies of scale are present, the LAC curve will be
negatively sloped.

59
 Economies of Scale
 Economies of scale are said to exist if by increasing your
output of a single good by one more unit, your average cost
deceases.
The opposite of economies of scale is diseconomies of
scale.
This comes from initially spreading fixed costs across
more units of output.

60
 Minimum Efficient Scale

 The minimum efficient scale describes the output at which

economies of scale are exhausted and the long-run average
cost curve becomes horizontal.
 Once the minimum efficient scale has been reached, an
increase in output no longer decreases the long-run average
cost.

61
 Diseconomies of Scale

 A firm experiences diseconomies of scale when an

increase in output leads to an increase in long-run average
cost—the LAC curve becomes positively sloped.
 Diseconomies of scale may arise for two reasons:
Coordination problems
Increasing input costs

62
 Economies of scope
 Economies of scope is a term that refers to the reduction of
per-unit costs through the production of a wider variety of
goods or services
 Economies of scope are said to exist if when the firm
increases the variety of goods it sells, it achieves a savings
in total cost in comparison to two firms producing the two
variety of goods separately.

63
 Economies of Scope
 Economies of Scope Concept
Scope economies are cost advantages that stem from
producing multiple outputs.
Big scope economies explain the popularity of multi-
product firms.
Without scope economies, firms specialize.
 Exploiting Scope Economies
Scope economics often shape competitive strategy for
new products.

64
 Economies of Scope

 Economies of scope are comparable to economies of scale

but imply efficiency gains resulting from expansion of
scope, or number of different output types, rather than from
an increase in the volume of total output.

65
 How It Works/Example
 
Let's assume Company XYZ strictly manufactures vacuum cleaners.
 if the company decided to branch out into brooms? Adding brooms to
the product line would allow XYZ to spread certain fixed costs over a
larger number of units.
 Thus, the company could reach more customers with its advertising
budget, its sales force could be used to sell both products, brooms
could be stored and shipped from the firm's existing vacuum
warehouse, and the company's factory could turn leftover broom
bristles into cleaning brushes for its vacuums.
 Furthermore, XYZ could then market itself as a "cleaning products"
company rather than just a "vacuum" company.

66
 How It Works/Example
 In this example, XYZ increased the variety of items
produced rather than increasing the number of vacuum
cleaners produced.
 As a result, the company's advertising, selling, and
distribution costs may generally remain the same, but its
number of products sold will increase.
 The cost of producing multiple products simultaneously is
often less than the costs associated with producing each
product line independently.

67
 Why It Matters
 Similar to economies of scale, economies of scope provide companies
with a means to generate operational efficiencies.
 However, economies of scope are often obtained by producing small
batches of many items (as opposed to producing large batches of just a
few items).
 Because they frequently involve marketing and distribution
efficiencies, economies of scope are more dependent upon demand
than economies of scale.
 This is often what motivates manufacturers to bundle products or to
create a whole line of products under one brand.

68
 Diseconomies of scope.
Although economies of scope are often an
incentive to expand product lines, the
creation of new products is often less
efficient than expected.
 The need for additional managerial
expertise or personnel, higher raw materials
costs, a reduction in competitive focus, and
the need for additional facilities can actually
increase a company's per-unit costs. When
this happens, it is often referred to as
diseconomies of scope.
69
 Conclusion
Nevertheless, when done correctly,
economies of scope can help companies
gain a significant competitive advantage.
Not only do they trim expenses on a per-unit
basis and improve profitability, but they can
also force less cost-efficient competitors out
of the industry or discourage would-be
rivals from even entering the market

70