Cost Function

Cost
It is payment made to the factors of production which are used in the
production of that commodity.
Cost Function
A cost function shows the functional relationship between output and
cost of production
Time Element is very important in the theory of cost. The time period is
classified into two categories: Short-run and Long-run Costs.
Accordingly, there are two types of cost:
Short-run Costs: It is sum total of fixed cost and variable cost
incurred by the producer in producing the commodity. In the short run,
at least one factor of production is fixed and output can be increased
by adding more variable factors.

Hence we consider both fixed and variable costs

Long-run Costs: The long-run costs are the costs over a period long
enough to permit changes in all factors of production.
Short-run Costs
1. Total Cost
2. Average Cost
3. Marginal Cost
1. Total Cost

(TC = TFC + TVC)

Total Fixed Cost = TC-TVC

Total Fixed Costs are the sum total of expenditure incurred by the
producer on the purchase of fixed factors of production. Total Fixed
Costs are those costs that are invariant to the rate of production. Fixed
costs usually include the following:
1. Rent for building
1

2.
3.
4.
5.

Interest for capital

Insurance premium
Property taxes
Depreciation

Total Variable Cost = TC/Qp

Total Variable Costs are those costs which vary with the quantity of
output produced. It rises when output expands and falls when output
contracts. When output is zero, variable cost becomes zero. Variable
costs usually include the following:
1. Payments for raw materials
2. Wages for labour
3. Fuel and power charges
4. Interest on short term loans
5. Transport costs
(TVC)
(TC)
Total Total Total
Law of
Law of
Total Cost
Output Fixed Variabl
Variable Variable
(4)
Units Cost e Cost
Proportio Proportio
(2 + 3)
(1)
(2)
(3)
n
n
Operates Operates
0
50
0
50
1
50
50
100
50
50
2
50
78
128
28
28
3
50
98
148
20
20
4
50
112
162
14
14
5
50
130
180
18
18
6
50
150
200
20
20
7
50
175
225
25
25
8
50
204
254
29
29
9
50
242
292
38
38
10
50
300
350
58
58
11
50
385
435
85
85
A change in TC is entirely due to change in TVC. TC is above the TVC
curve by the amount of TFC. The reason behind the shape of the TC
and TVC is the law of variable proportion.
Average Cost
AC is the cost of producing per unit of the commodity.
2

AC = AFC + AVC
The average cost is easily obtained as follows:
TC = TFC + TVC --- Eq. (1)
Divide this equation by the level of output(X), we get
TC/X = TFC/X + TVC/X
AC = AFC + AVC --- Eq. (2)
Average Fixed Cost: It is defined as the fixed cost of producing per
unit of the commodity.
AFC = TFC/X
Or
AFC = AC AVC
Average Variable Cost
The average variable cost is the variable cost per unit of output. It is
obtained by dividing the total variable cost by the number of units of
the commodity produced.
Symbolically AVC = TVC/Q
Or
AVC = AC AFC
Average Total Cost or Average Cost
Average cost or average cost is the cost per unit of output. It is
obtained by dividing the total cost by the total number of units of the
commodity produced.
Symbolically, ATC = TC/Q
TC = TFC + TVC
Therefore, ATC = (TFC+TVC)/Q = (TFC/Q) + (TVC/Q)
ATC = AFC + AVC
3

The rise in AVC becomes greater than the fall in the AFC so that AC
starts rising. The U-Shape of AC curve is due to the law of variable
proportion.
Marginal Cost
Marginal Cost is defined as addition made to total variable cost or total
cost when one more unit of output is produced.
MC = TVC/X or TC/X
or
MCn = TCn TCn-1 or TVCn TVCn-1
or
MU = TVC
MC curve is derived from TVC curve is U-shaped. The reason behind
the shape is the law of variable proportion.
Long-run Cost Curves
1. Long-run Average Cost (LAC)
2. Long-run Marginal Cost (LMC)
LAC shows the minimum cost per unit of producing each level of output
in the long-run.
LMC shows addition made to long-run total cost when output is
increased by one more unit.
LAC is U-shaped. The reason behind the U-shape of the LAC is the law
of returns to scale.
NUMERICAL EXERCISES
Average
Total Total
Total
Total Average
Averag
Variable
Margina
Output Fixed Variable Cost
Fixed
e Cost
Cost
l Cost
Units Cost
Cost
(4)
Cost (5)
(7)
(6)
(8)
(1)
(2)
(3)
(2 + 3)
(2/1)
(4/1)
(3/1)
0
50
0
50
----1
50
50
100
50
50
100
50
2
50
78
128
25
39
64
28
3
50
98
148
16.7
32.7
49.3
20
4
50
112
162
12.5
28
40.5
14
4

Average
Total Total
Total
Total Average
Averag
Variable
Margina
Output Fixed Variable Cost
Fixed
e Cost
Cost
l Cost
Units Cost
Cost
(4)
Cost (5)
(7)
(6)
(8)
(1)
(2)
(3)
(2 + 3)
(2/1)
(4/1)
(3/1)
5
50
130
180
10
26
36
18
6
50
150
200
8.3
25
33.5
20
7
50
175
225
7.1
25
32.1
25
8
50
204
254
6.3
25.5
31.8
29
9
50
242
292
5.6
26.9
32.4
38
10
50
300
350
5
30
35
58
11
50
385
435
4.5
35
39.5
85
Calculating Average Variable Cost
The standard method of calculating Average Variable Cost is to divide
Total Variable Cost by the Quantity, illustrated by this equation:
Average variable Cost

Total Variable Cost

Quantity of Output

An alternative specification for Average Variable Cost is found by

subtracting Average Fixed Cost from Average Total Cost:
Average Variable Cost = Average Total Cost - Average Fixed Cost
An alternative equation computes Total Variable Cost from Average
Variable Cost:
Total Variable Cost = Average Variable Cost x Quantity of Output

Calculate TC and AVC

Output
AFC
MC
Output
1
2
3
4
5
6

1
60
32

2
30
30
AFC
60
30
20
15
12
10

3
20
28
MC
32
30
28
30
35
43

4
15
30
TC

5
12
35
AC

6
10
43
AVC