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For eg……Earning more money may require working more hours. which costs more leisure time. . A central economic concept is that getting something requires giving up something else.Cost Theory in Economics Economists use cost theory to provide a framework for understanding how individuals and firms allocate resources in such a way that keeps costs low and benefits high.

OCCURANCE OF COSTS……. Machinery used in the production process  plant workers for production Cost theory offers an approach to understanding the costs of production that allows firms to determine the level of output that reaps the greatest level of profit at the least cost . Opening a manufacturing plant.  Production facilities.  Manufacture goods.

AVERAGE COST iii . MARGINAL COST . Average Total cost and output  IN THE LONG RUN (LR) i. Average Variable Cost & Output iii .COST-OUTPUT RELATIONSHIP HAS 2 ASPECTS: IN THE SHORT RUN (SR) i . Average Fixed Cost & output ii . TOTAL COST ii .

e. building etc) & in the size of the org. . the lower the fixed cost per unit i. the average fixed cost & total fixed costs remain the same & do not change with a change in output.IN THE SHORT RUN (SR) The SR is a period which doesn’t permit alterations in the fixed equipment (machinery . •Average Fixed Cost & output The greater the output.

•Average Variable Cost & Output The avg. if more & more workers are appointed.g. workers may have to be paid higher wages for overtime work. Greater output can be obtained but at much greater avg variable cost. E. Variable factors tend to produce somewhat more efficiently near a firm’s optimum output than at very low levels of output. moreover. . variable costs will first fall & then rise as more & more units are produced in a given plant. it may ultimately lead to overcrowding & bad org.

total cost will show a rise .•Average Total cost and output Average total cost. variable cost declines the Avg. So . would decline first & then rise upwards. variable cost first declines & then rises.C Average fixed cost continues to fall with an increase in output while avg. Average cost = Average F. as Avg. variable cost will rise. When the rise in AVC is more than the drop in Avg. also known as average costs. fixed cost that the Avg.C + Average V. total cost will also decline. But after a point the Avg.


IN THE LONG RUN (LR) The LR is a period in which there is sufficient time to alter the equipment (machinery.) & the size of the org. output can be increased without any limits being placed by the fixed factors of production . land etc. building.

COST IN LONG RUN Total cost (TC) = TFC + TVC. rise as output rises AVERAGE COST (AC) = TC/output MARGINAL COST (MC) = change in TC as a result of changing output by one unit . machinery.long run period enables the producers to change all the factor & he will be able to meet the demand by adjusting supply. Change in Fixed factors like building. managerial staff etc. All factors become variable in the long run.

Demand is less & the plant’s capacity is limited. We can make a LR cost curve by joining the tangency points of all SR curves We use long run costs to decide scale issues. for example mergers.When all the short run situations are combined. When demand rises. it forms the long run industry. the capacity of the plant is expanded. we can derive a long run cost curve out of that.(CONNECTING LINK) . cost curves of all such situations are depicted. During the SR. When SR avg.

it is important to forecast the anticipated demand. Conversely too large a factory results in large fixed costs (e.g. or taxes) and low profitability. and other considerations..In the long run. we can build any size factory we wish. Therefore. we move to the short run. based on anticipated demand. profits. . Too small a factory and marginal costs will be high as the factory is stretched to over produce. Once the plant is built. air conditioning.