Analysis of Costs

Definition

• Economic analysis of cost is tightly

bound to economic analysis of
production

• Cost function used in economic analysis is

simply the production function expressed in
monetary rather than physical units
 Cost Function
• Remember production function
Q = f(L, K, Land, Raw material, efficiency,…)

• Cost function can be expressed as

C = f(Q, T, Pi )
Where C = cost, Q = output, T =
Technology and P = Price of inputs
 Cost Function

• All the limiting assumptions used in

specifying SR production function are
apply to SR cost function as well

• The only additional assumption needed

to determine SR cost function pertains
to the price of the inputs used in
production process
 Short run
• A period of time so short that the
firm cannot alter the quantity of
some of its inputs
Typically some inputs are fixed inputs in the
short run, e.g. plant and equipment.
equipment
Output has to be increased by using
additional units of variable input like
unskilled labour and raw materials
Fixed inputs determine/restrict the scale of
the firm’s operation (output)
 Short-Run Cost Functions

• Fixed Cost
• Variable Cost
• Total Cost
• Average Costs
– Fixed Cost
– Variable Cost
– Total Cost
• Marginal Cost
Short-Run Cost Functions: Fixed Cost

• Costs that do not vary with output

– Firm has to bear those costs even there is no

output

– Also called plant cost as they determined

plant size in the SR

– Shape of Fixed Cost (FC) curve is a straight line

parallel to quantity axis
 Total costs for firm X
Output FC VC TC
100 (Q) (Rs) (Rs) (Rs)

0 12 0 12
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 CCC

40

20
FC

0
0 1 2 3 4 5 6 7 8
 Fixed Cost
• Examples: Rent, Insurance Premiums, Loan
Payment, Depreciation, Interest expense, Property
Tax, Salaries, Utilities.....
– High Fixed Cost: Airlines, Auto manufacturers, Drilling
operations, solar & wind power plants
– Low Fixed Cost: Website Design, Insurance, e Marketing ..

• For a firm with large fixed cost component, profit

margins get squeezed when sales fall

• High fixed costs can create economies of scale

(reductions in per-unit costs through an increase in
production volume) and may create a barrier to entry
 Fixed Cost
• Some fixed costs change in a stepwise manner
as output changes and therefore may not be
totally fixed

• Many cost items have both fixed and variable

components
– For example, management salaries typically do not
vary with the number of units produced
– However, if production falls dramatically or reaches
zero, layoffs may occur
• Economically, all costs are variable in the
end
Short-Run Cost Functions: Variable Costs
• Costs that vary with output
– Equal to zero if there is no output
– Total Variable Cost (TVC) curve is an inverse
S shaped upward slopping curve starting
from origin
– As more and more units of variable factor are
added in production, its productivity goes on
increasing
– This leads to fall in per unit cost in the
beginning
 Total costs for firm X
Output FC TVC TC
100 (Q) (Rs) (Rs) (Rs)

0 12 0 12 VC
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 CCC

40

20
FC

0
0 1 2 3 4 5 6 7 8
 Variable Cost
• When total product (Q) increases at an
increasing rate, total variable cost (TVC)
increases at a decreasing rate

• When total product (Q) increases at a

decreasing rate, total variable cost (TVC)
increases at an increasing rate

• A company with a large number of variable

costs (compared to fixed costs) may exhibit
more consistent per-unit costs and hence
more predictable per-unit profit margins than
a company with fewer variable costs
 Caselet

• Renewable energy has a tariff

problem. Here’s how to fix it

https://indianexpress.com/article/opinion/columns/
renewable-energy-has-a-tariff-problem-heres-how-t
o-fix-it-7851296/
 Short-Run Cost Functions: Total Cost
• Sum of TFC & TVC
Short-Run Average Cost Functions
•Average Fixed Cost (AFC)= FC/Q
•When output becomes very large, average fixed cost
approaches zero.

•Average Variable Cost (AVC)= TVC/Q

•The average variable cost falls as output increases
from zero to the normal capacity due to the occurrence
of increasing returns.
•But beyond the normal capacity output average
variable cost will rise steeply because of the operation
of diminishing returns

•AC = AFC + AVC

Costs (Rs)
35 TC AC Q VC AVC
12 0 0 -
30 22 22 1 10 10
28 14 2 16 8
25 33 11 3 21 7
40 10 4 28 7
20 52 10.4 5 40 8
72 12 6 60 10
15 103 14.7 7 91 13 AC
AVC
10

0 AFC
0 1 2 3 4 5 6 7

Q
 AC, AFC, AVC
• As Q increased, FC remaining same, AFC falls steeply at
first and then gently
• AVC and AC curves are both U shaped

• AC being sum of AFC & AVC, lies above both AFC &
AVC
• With both AFC & AVC fall, AC also falls

• AVC soon reaches its minimum and start rising, while

AFC continues to fall
• However, a sharp rise in AVC compensates the fall in
AFC and AVC pulls AC up after the later reaches a
minimum
Costs (Rs)
35 TC AC Q TVC AVC
12 0 0 -
30 22 22 1 10 10
28 14 2 16 8
25 33 11 3 21 7
40 10 4 28 7
20 52 10.4 5 40 8
72 12 6 60 10
15 103 14.7 7 91 13 AC
AVC
10

0 AFC
0 1 2 3 4 5 6 7

Q
 Marginal Cost
• Marginal Cost = TC/Q =  TVC/Q as
fixed cost cannot be altered
• MC first decreases then increases
• Changes in marginal coat reflect changes
in marginal productivity
– At the beginning because of increasing
marginal returns marginal cost falls

– When firm experiences diminishing

marginal returns, marginal cost of output
increases
Remember average and marginal output!!
Costs (Rs) Q TC MC AC
35 - MC
0 12
10
1 22 22
30 6
2 28 14
5
3 33 11
25 7
4 40 10
12
5 52 10.4
20 20
6 72 12
31
7 103 14.7
15 AC

10

AFC
0
0 1 2 3 4 5 6 7
Q
Relationship between Marginal Cost &
Average cost
Term Grade Grade point average
1 3.4 4
2 2.8 3.1
3 2.2 2.8
4 2.4 2.7
5 2.7 2.7
6 3.3 2.8

• When term grades are below GPA, GPA falls

• When term performance improves, GPA does not
improve until term grades exceed GPA
• Term grades first pull down GPA and then eventually pull it
up
• At term grade 2.7, GPA would not change
Relationship between Marginal Cost &
Average cost
• When AC decline, MC lies below AC
– Because MC is below AC, MC pulls down AC

• When AC rises, MC lies above them

– MC pulls up AC

• Average cost will be neither decreasing nor

increasing when marginal cost at a given
quantity is equal to average cost at that
quantity.
– MC=AC, MC passes through the minimum points of
AC curve
The Relationship Between Marginal and Average
Cost

25 of 42
Costs (Rs) Q TC MC AC
35 - MC
0 12
10
1 22 22
30 6
2 28 14
5
3 33 11
25 7
4 40 10
12
5 52 10.4
20 20
6 72 12
31
7 103 14.7
15 AC
AVC
10

AFC
0
0 1 2 3 4 5 6 7
Q
 Summary of Relationship
• Over the output range for which TVC is
increasing at a decreasing rate, both AVC
and MC decrease but MC is less than AVC

• MC reaches its minimum point at output at

which TVC reaches its inflection point; at its
minimum, MC is less than AVC

• For all output levels beyond the minimum of

AVC, both AVC and MC increase with MC
rising at a faster rate (MC lies above AVC)

• MC is equal to AC when AC is minimum

 Short-Run Cost Functions
Q TFC TVC TC AFC AVC ATC MC
0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
 Fixed, variable, and total costs: Media Corp.
OUTPUT FC
TFC VC
TVC TC
0 2000 0 2000
1 2000 100 2100
2 2000 180 2180
3 2000 280 2280
4 2000 392 2392
5 2000 510 2510
6 2000 650 2650
7 2000 800 2800
8 2000 960 2960
9 2000 1140 3140
10 2000 1340 3340
11 2000 1560 3560
12 2000 2160 4160
 Average and marginal costs: Media Corp.
OUTPUT AFC AVC ATC MC
0
1 2000.0 100.0 2100.0 100
2 1000.0 90.0 1090.0 80
3 666.7 93.3 760.0 100
4 500.0 98.0 598.0 112
5 400.0 102.0 502.0 118
6 333.3 108.3 441.7 140
7 285.7 114.3 400.0 150
8 250.0 120.0 370.0 160
9 222.2 126.7 348.9 180
10 200.0 134.0 334.0 200
11 181.8 141.8 323.6 220
12 166.7 180.0 346.7 600
 Problem
• Popo Cola’s TVC function is as follows
TVC = 50Q – 10Q2 + Q3 ; Q is output
A. Find the level of output when MC is minimum
B. What is the level of output where AVC is minimum
C. What is the value of AVC & MC at output of ‘B’

Ans.
A. MC = 50 – 20Q + 3Q2 ; for min. MC, d(MC)/dQ=0
- 20 + 6Q = 0  Q = 20/6; SOC; d2 (MC)/dQ2 = 6 > 0
B. AVC = 50 – 10Q + Q2 ; FOC d(AVC)/dQ = 0; Q = 5
SOC d2 (AVC)/dQ2 = 2 > 0
C. At Q = 5; AVC = MC = 25
 Long-run cost functions
• In LR, all costs are variable

• Often considered to be the firm’s planning

horizon

• Firm’s LR cost curve is derived from firm’s

expansion path and shows the minimum
long-run total costs of producing various
levels of output
 Long-run Total Cost
• The long run total cost curve shows
the total cost of a firm's optimal choice
combinations for labour and capital as the
firm's total output increases.
– Note that the total cost curve will always be
zero when Q=0 because in the long run a firm
is free to vary all of its inputs

• LR consists of many SRs

• So. LR curve is the composite of many
SR curves
 Long-run
Long-run costs
costs

Relationship
Relationship between
between short-run
short-run
and
and long-run
long-run AC
AC curves
curves
 Short & long-run AC curves
• Like short-run average cost curve, firm’s
long-run average cost curve is U-shaped

• Recall that the shape of short-run

average cost curve is determined
primarily by increasing and diminishing
marginal returns of the variable inputs

• A different principle shapes the long-run

cost curve
 Relationship between short-run and
long-run AC curves
• When plant size and other inputs
increases in LR, SR curves shift to the
right
• Let us assume that in LR, firm operates
with five different plant sizes and can
switch over to a different plant size
depending upon cost considerations

• Thus, SAC1 , SAC2, SAC3 …. relate AVC

in respective plant size
 Deriving long-run average cost curves

SRAC1
Costs

1st factory

O
Output
 Deriving long-run average cost curves

SRAC1
SRAC2
Costs

2nd factory

O
Output
 Deriving long-run average cost curves

SRAC1
SRAC2 SRAC3
Costs

3rd factory

O
q0 q1 Output
• As output increases from q0 to q1 in SR, the firm can
continue to produce along SRAC1 utilizing its
installed capacity of I

• At output level q1 the capacity is overworked and it

would be cost effective for the firm to shift to a higher
plant size say II and so on

• The shifting from SRAC1 to SRAC2 would lower AVC

of the firm

• LRAC curve envelopes SRAC curves

• LRAC curve is a sequence of points,

each of which lies on different AC curve
 Deriving long-run average cost curves

SRAC1 SRAC5
SRAC4
SRAC2 SRAC3
Costs

5th factory
4th factory

O
Output
 Deriving long-run average cost curves

SRAC1 SRAC5
SRAC4
SRAC2 SRAC3

LRAC
Costs

O
Output
Deriving a long-run average cost curve: choice of factory size

LRAC
Costs

LRAC curve:
is envelope of the SRAC curves
O
Output
Different shapes of long-run average cost curves

• LRAC curve is an idealized

representation of production condition
in LR
• LRAC curve showing the lowest cost at
which the firm is able to produce a
given quantity of output in the LR, when
no inputs are fixed
• Economics of scale exists when a firm’s
average costs falls as it increases
output
 A typical long-run average cost curve

LRAC
Costs

O Output
Different shapes of long-run average cost curves
(a) Economies of scale: Decreasing Cost Industry
Costs

LRAC

O Output
Different shapes of long-run average cost curves

(b) Diseconomies of scale: Increasing Cost Industry

LRAC
Costs

O Output
Different shapes of long-run average cost curves

(c) Constant costs: Constant Cost Industry

Costs

LRAC

O Output
 A typical long-run average cost curve

LRAC
Costs

O Output
 A typical long-run average cost curve

Economies Constant Diseconomies LRAC

of scale costs of scale
Costs

O
Output
Different shapes of long-run average cost curves

• Firms may encounter Economics of

scale for several reasons
– Technology may make it possible to
increase production with a smaller
proportional increase in at least one input
– Both worker and managers can become
more specialized , enabling them to become
more productive, as output expands
– Large firms like Wal-Mart may be able to
purchase inputs at a lower cost than smaller
companies (more bargaining power)
 Economy of Scale - Examples

• https://www.youtube.com/watch?v=6ihehRMt
RWc

• Why Chicken Sandwiches Don't Cost $1500

https://www.youtube.com/watch?v=_rk2hPrEnk8&t=41s
Different shapes of long-run average cost curves

• Economics of scale do not continue forever

• LRAC curve in most industries has a flat

segment that often stretches over a substantial
range of output called constant returns of scale
• Finally, very large firms will experience
increasing average costs as managers begin to
have difficulty coordinating the operation

• Under such circumstances, firm will experience

dis-economics of scale
 Long-Run Cost Curves
Long-Run Total Cost (LTC) = f(Q)
Long-Run Average Cost (LAC) =

LTC/Q
Long-Run Marginal Cost (LMC) =

 LTC/Q
 LEMC
• The long-run marginal cost curve can be
directly derived from the long-run total cost
curve
– since the long-run marginal cost at a level of output is
given by the slope of the total cost curve at the point
corresponding to that level of output.

• Be­sides, the long-ran marginal cost curve can be

derived from the long-run average cost curve,
because the long-ran marginal cost curve is
related to the long-run average cost curve in the
same way as the short-ran mar­ginal cost curve is
related to short-run aver­age cost curve
 Long-run average and marginal costs

LRMC

LRAC
Costs

O Output
 Lessens Learnt

• If the SR marginal cost (MC) of

producing the current output is greater
than the LRMC, then the firm should
build a larger plant
 Profit Maximization: MR=MC
Magnitude of profit/loss depends on the position of
AC curve

35

30

25

20

15

10

0
0 1 2 3 4 5 6 7
 Profit maximising under monopoly
Rs MC
AC

a
PM
Profit
b
AC

D
MR
O Qm Q
Long-run equilibrium of the firm under perfect competition

Rs (SR)MC
(SR)AC

LRAC

DL
AR = MR

O Q