Cost

Rashmi Narayana

T A Pai Management Institute

Managerial Economomics (ECO 5001)
PGDM Batch 201719, Term 1

July 31 & August 2, 2017

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Outline

1. Cost function
2. Derivation of cost function from production function
3. Short run cost function: TFC, TVC, STC; AFC, AVC, ATC;
SMC
4. Relation between average and marginal cost
5. Long run cost function: LTC,LAC and LMC
6. Derivation of LTC from STCs (LAC from SACs): envelope
theorem
7. Economies of scale and scope

Reference: Salvatore, D. and Rastogi, S. K. (2016): Managerial Economics:

Principles and Worldwide Applications (Adopted version). New Delhi: Oxford
University Press. 8th Edition. Ch.8
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Costs

Cost?

Firms cost?

How to measure these costs?

Cost importance in managerial decision making

Firms cost functions are derived from optimal input

combinations

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Implicit vs explicit costs

Explicit costsrefer to actual expenditures of the firm to hire,

rent, or purchase the inputs it requires in production
wages to hire labor
rental price of capital, equipment, and buildings
purchase of raw materials and semi-finished products

Implicit costsrefer to the value of the inputs owned and

used by the firm in its own production activity
highest salary that entrepreneur earn in his best alternative
employment
highest return of the firm could receive from investing its
capital in the most rewarding alternative use
renting land and building to the highest bidder

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Economic vs accounting costs

Economic costsrefer only to the firms actual expenditures

or explicit costs incurred for purchased or rented inputs
Economist thinks of opportunity cost

Accounting costsor historical costs are important for

financial reporting by the firm and for tax purpose
Accountant focuses on actual money payments

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Opportunity costs

Opportunity costis defined as cost associated with opportunities

that are forgone when a firms resources are not put to their best
alternative use

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Fixed vs quasi-fixed costs

Variable costscost that varies as output varies

Fixed coststhey are independent of the level of output, and,

in particular, they must be paid whether the firm produces
output or not

The only way that a firm can eliminate its fixed costs is by
shutting down.

Quas-fixed costsare costs that are also independent of the

level of output, but only need to be paid if the firm produces
a positive amount of output

There are no fixed costs in the long run, by definition.

However, there may easily be quasi-fixed costs in the long run

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Sunk costs

Sunk costs are another kind of fixed costs

Sunk costs are costs that are not recoverable

Monthly rent that you have committed to pay is a fixed cost,

since you are obligated to pay it regardless of the amount of
output you produce.

The cost for paint is a fixed cost, but it is also a sunk cost
since it is a payment that is made and cannot be recovered.

The cost of buying the furniture is not entirely sunk, since you
can resell the furniture when you are done with it. Its only the
difference between the cost of new and used furniture that is
sunk.

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Identify the sunk costs

Suppose that you borrow INR 20,000 at the beginning of the year
at, say, 10 percent interest. You sign a lease to rent an office and
pay INR 12,000 in advance rent for next year. You spend INR 6,000
on office furniture and INR 2,000 to paint the office. At the end of
the year you pay back the INR 20,000 loan plus the INR 2,000
interest payment and sell the used office furniture for INR 5,000.

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Total sunk costs consists of

INR 12,000 rent

INR 2,000 of interest

INR 2,000 of paint

but only INR 1,000 for the furniture

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Cost functions

Cost functionis defined as the minimum cost of achieving a

given level of output

Short run cost functionis defined as the minimum cost to

produce a given level of output, only adjusting the variable
factors of production

Long run cost functiongives the minimum cost of producing

a given level of output, adjusting all of the factors of
production

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Short run cost functions

Total costs (TC)total economic cost of production,

consisting of fixed and variable costs

Total variable costs (TVC)cost that varies as output varies

Total fixed cost (TFC)cost that does not vary with the level
of output and that can be eliminated only by shutting down

TC = TVC + TFC

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Short run cost functions

Average cost function (AC)measures the cost per unit of

output
AC = TC /Q = AFC + AVC

Average variable cost (AVC) functionmeasures the variable

costs per unit of output
AVC = TVC /Q

Average fixed cost (AFC) functionmeasures the fixed costs

per unit output
AFC = TFC /Q

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Average cost curves

A. AFCs decrease as output is increased

B. AVCs eventually increase as output is increased
C. Combination of these two effects produces a U-shaped AC
curve
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Short run cost functions

Marginal cost (MC)measures the cost per unit of output

TC TVC
MC = =
Q Q
TFCs does not change as the firms level of output changes,
MC is equal to the increase in TVC or the increase in TC that
results from an extra unit of output
Diminishing Marginal Returns and Marginal Cost

Diminishing marginal returns means that the marginal product

of labor declines as the quantity of labor employed increases

As a result, when there are diminishing marginal returns,

marginal cost will increase as output increases.

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Average and marginal cost curves

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Short run cost curves

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Costs in long run

User cost of capitalannual cost of owning and using a

capital asset, equal to economic depreciation plus forgone
interest

User cost of capital is given by the sum of the economic

depreciation and the interest (i.e., the financial return) that
could have been earned had the money been invested
elsewhere

User cost of capital =

Economic depriciation + (Interest rate)value of capitaal

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Long run cost curves

Long run total cost (LTC)

Long run average cost(LAC)curve relating average cost of

production to output when all inputs, including capital, are
variable

Long marginal cost(LMC)curve showing the change in

long-run total cost as output is increased incrementally by 1
unit

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Long run cost curves

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Short run and long run AC curves

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Short run and long run AC curves

SAC curves and LAC curve have been drawn as

U-shapedreason for their shapes is quite different

SAC curves decline at first, but eventually rise because of

operation of the law of diminishing returns (resulting from the
existence of fixed inputs in the short run)
In the long run there are no fixed inputs, and the shape of the
LAC curve is determined by economies and dis-economies of
scale
as output expands from very low levels, increasing returns to
scale cause the LAC, curve to decline initially
as output becomes greater and greater, dis-economies of scale
may become prevalent, causing the LAC curve to start rising

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LAC curve

U-shaped LAC curve is based on the assumption that

economies of scale prevail at small levels of output and
dis-economies of scale prevail at larger levels of output

LAC curveis U-shaped and has a flat bottomimplying

CRS over a wide range of outputs

LAC curveis L-shapedindicating that over the observed

levels of outputs there are no dis-economies of scale
E.g.: small firms coexists with much larger firms

LAC curvedeclines continuously as the firm expands output

E.g.: natural monopolies

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Economies of scale and scope

Long run
average cost

LAC curve

Economies of scale Constant returns to scale (CRS) Dis-economies of scale

Output

IRS are depicted in a declining LAC DRS are depicted in a rising LAC
curve curve
Constant input prices leads to lower Constant input prices leads to
cost per unit higher cost per unit

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Economies of scale and scope

Economies of scalerefers to the situation in which output

grows proportionately faster than inputs

Dis-economies of scalerefers to the situation in which output

grows at a proportionately slower rate than the use of inputs

Economies of scoperefer to the lowering of costs that a firm

often experiences when it produces two or more products
together rather than each alone
E.g: Sugar factories produces a secondary product (molasses)
arising from the production of the primary product
(sugar)this increases profitability by extending the product
line to exploit the economies of scope

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Cost-volume-profit analysis (break-even analysis)

Cost-volume-profit analysis (break-even analysis)examines

the relationship among the TR, TC and TPs of the firm at
various levels of outputs

TR = P Q

TC = TFC + TVC = TFC + AVC Q

Break-even volume, TR = TC
TFC
QBE =
P AVC
(P-AVC) is called contribution of margin per unit because it
represents the portion of the selling price that can be applied
to cover the fixed costs of the firm and to provide the profits

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Cost-volume-profit analysis (break-even analysis)

Price of product = $ 10 /unit

TFC = 200 (vertical intercept of TC curve)
AVC = 5 (slope of TC curve)
QBE = break-even output = 40 units
B = Break-even point (TR =TC =$400)

The losses that the firm incurs at smaller output levels and profits at larger output levels.

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Cost-volume-profit analysis (break-even analysis)

Cost-volume-profit analysis or break-even analysis can be used

in determining the target output (QT ) at which a target profit
(T ) can be achieved

TFC + T
QT =
P AVC

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