Theory of Costs

Costs
Hello friends I am an entrepreneur,

producing X goods. I am a land owner.
I use my own land for the production o
but purchased raw materials, recruit w
Loan from bank
Economic Cost of Using Resources
Explicit And Implicit Costs
Firms cost of production involves

Inputs firm purchases from market
Such as additional labor or additional capital equipment
Inputs firm already owns
Such as owners labor, land, or equipment
Explicit (or expenditure) costs

Costs of employing additional inputs not owned by
firm
Includes all cash or out-of-pocket expenses incurred in

production
Accounting cost for purchased inputs whether they are fixed
or variable
Explicit And Implicit Costs
Implicit costs (also called nonexpenditure,

imputed, or entrepreneurial costs)
Costs charged to inputs that are owned

by firm
An opportunity cost of using an input in
production of a commodity
Loss in benefits that could be obtained
by using these inputs in another activity
Owners of firm also have an implicit cost
associated with time devoted to a
particular production activity
A Firms Profit
Profit is the firms total revenue
minus its total cost.
Profit = Total revenue - Total cost
Economic Profit versus Accounting Profit

How an Accountant
Views a Firm
How an Economist
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Explicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
Accounting Profits & Economic Profits

Accounting Profits
= Total Revenue - Accounting Costs
= Total Revenue - Explicit Costs
Economic Profits
= Total Revenue - Economic Costs
= Total Revenue - (Explicit and Implicit
Costs)
Cost Concept
A cost is relevant if it is affected by a management
decision.
Historical cost is incurred at the time of
procurement.
Replacement cost states the cost that the firm
would have to incur if it wants to replace or
acquire the same asset now
For ex, In the year 2000, price of silver was Rs
250/kg & if present price is Rs 400/kg then the
historical cost = Rs 250 & replacement cost = Rs
400.
Out-of-pocket
cost is the cost that

involve immediate payments to
outsiders.
For ex wages and salaries paid to the
employees.
Book
cost is that cost which do not

require current cash expenditure.
For ex Salary of the owner manager, if not
paid, is a book cost
Incremental Cost
Incremental
Cost: Change in
cost caused by a given
managerial decision
For example, cost of adding a
new product line, advertising
campaign, etc
Sunk Cost
Sunk
Cost: Cost that does not vary

across decision alternatives.
Example entered into a bad longterm contract last year that will last
for the next five years
Costs
that have already been

incurred.
Since
they are in the past, they

cannot influence current decisions.
Short-run costs
Total cost
Fixed And Variable Costs
Total cost (TC) of a particular production

activity
Sum of explicit plus implicit costs
Costs can also be classified according to whether

they are
Fixed
Costs that do not vary with changes in output -rent, rates,

insurance costs, admin costs. They can change but not in relation to
output
Variable
Costs associated with variable inputs and do vary with outputRaw materials primarily
Explicit and implicit costs may contain both fixed and

variable costs
Total cost (TC) is sum of fixed and variable costs
100
TFC
Total costs for firm X
Output TFC
(Q) (Rs)
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
40
20
0
0
Output
100
TFC
Output TFC
(Q) (Rs)
0
1
2
3
4
5
6
7
80
60
40
12
12
12
12
12
12
12
12
20
TFC
0
0
Output
Output TFC TVC

(Q) (Rs) (Rs)
TFC
100
0
1
2
3
4
5
6
7
80
60
0
10
16
21
28
40
60
91
12
12
12
12
12
12
12
12
40
20
TFC
0
0
Output
100
TVC,TFC
Output TFC TVC

(Q) (Rs) (Rs)
0
1
2
3
4
5
6
7
80
60
0
10
16
21
28
40
60
91
12
12
12
12
12
12
12
12
TVC
40
20
TFC
0
0
Output

100
TVC
80
Diminishing marginal
returns set in here
60
40
20
TFC
0
0
Output TFC TVC

(Q) (Rs) (Rs)
100
0
1
2
3
4
5
6
7
80
60
0
10
16
21
28
40
60
91
12
12
12
12
12
12
12
12
TVC
40
20
TFC
0
0
Output TFC TVC TC

(Q) (Rs) (Rs) (Rs)
100
0
1
2
3
4
5
6
7
80
60
0
10
16
21
28
40
60
91
12
12
12
12
12
12
12
12
12
22
28
33
40
52
72
103
TVC
40
20
TFC
0
0
100
TC, TVC,TFC
Output TFC TVC TC

(Q) (Rs) (Rs) (Rs)
0
1
2
3
4
5
6
7
80
60
0
10
16
21
28
40
60
91
12
12
12
12
12
12
12
12
TC
12
22
28
33
40
52
72
103
TVC
40
20
TFC
0
0
Output

TC
100
TVC
80
returns set in here
60
40
20
TFC
0
0
Short-run costs
Marginal cost
= TC / Q
Deriving marginal costs
Costs (Rs)
120
Q TC
0 12
1 22
2 28
3 33
4 40
5 52
6 72
7 103
100
80
60
40
MC
10
6
5
7
12
20
31
20
0
0
Costs (Rs)
120
Q TC
0 12
1 22
2 28
3 33
4 40
5 52
6 72
7 103
100
80
60
40
MC
TC
10
6
5
7
12
20
31
20
0
0
Costs (Rs)
120
Q TC MC
0 12
1 22 10
2 28 6
3 33 5
4 40 7
5 52 12
6 72 20
7 103 31
100
80
60
40
TC
TC = 12
Q = 1
20
0
0
Costs (Rs)
120
Q TC MC
0 12
1 22 10
2 28
6
3 33
5
4 40
7
5 52 12
6 72 20
7 103 31
100
80
60
40
TC
Diminishing
returns set
in here
20
MC
0
0
Costs (Rs)
35
MC
30
25
returns set in here
20
15
10
5
0
0
Short-run costs
Average cost
=TC / Q
Average
total cost (ATC) is the

average per-unit cost of using all of
the firms inputs (TC/Q)
Average
variable cost (AVC) is the

average per-unit cost of using the
firms variable inputs (TVC/Q)
Average
fixed cost (AFC) is the

average per-unit cost of using the
firms fixed inputs (TFC/Q)
Costs (Rs)
35
30
25
20
15
10
5
0
0
Costs (Rs)
Q TVC AVC
0
0
1 10 10
2 16
8
3 21
7
4 28
7
5 40
8
6 60 10
7 91 13
35
30
25
20
15
10
5
AFC
0
0
Costs (Rs)
Q TVC AVC
0
0
1 10 10
2 16
8
3 21
7
4 28
7
5 40
8
6 60 10
3 13
7 91
35
30
25
20
15
AVC
10
5
AFC
0
0
Costs (Rs)
Q TC
0 12
1 22
2 28
3 33
4 40
5 52
6 72
7 103
35
30
25
20
AC
22
14
11
10
10.4
12
14.7
15
AVC
10
5
AFC
0
0
Costs (Rs)
Q TC
0 12
1 22
2 28
3 33
4 40
5 52
6 72
7 103
35
30
25
20
AC
22
14
11
10
10.4
12
14.7
15
AC
10
AVC
AFC
0
0
Q TC MC
0 12
10
1 22
6
2 28
5
3 33
7
4 40
12
5 52
20
6 72
31
7 103
Costs (Rs)
35
30
25
20
15
10
5
0
0
Q TC MC
0 12
10
1 22
6
2 28
5
3 33
7
4 40
12
5 52
20
6 72
31
7 103
Costs (Rs)
35
30
25
20
MC
15
10
5
0
0
Q TC MC AC
0 12
1 22 10 22
6 14
2 28
5 11
3 33
7 10
4 40
5 52 12 10.4
6 72 20 12
7 103 31 14.7
Costs (Rs)
35
30
25
20
MC
15
10
5
0
0
Q TC MC AC
0 12
1 22 10 22
2 28
6 14
3 33
5 11
4 40
7 10
5 52 12 10.4
6 72 20 12
7 103 31 14.7
Costs (Rs)
35
30
25
20
MC
AC
15
10
5
0
0
Average and marginal costs

MC
AC
Costs (Rs)
AVC
z
y
x
AFC
Output (Q)
Long-run costs
Long-run average
costs
=LRTC / Q
Costs
Alternative long-run average cost curves
Economies of Scale
LRAC
Output
Costs
LRAC
Diseconomies of Scale
Output
Costs
Constant costs
LRAC
Output
A typical long-run average cost curve
Costs
LRAC
Output
Costs
A typical long-run average cost curve
Economies
of scale
Constant
costs
Output
Diseconomies
of scale
LRAC
Costs
Long-run average and marginal costs
Economies of Scale
LRAC
LRMC
O
Output
Costs
LRMC
Diseconomies of Scale
Output
LRAC
Costs
Constant costs
LRAC = LRMC
Output
Initial economies of scale,

then diseconomies of scale
LRAC
Costs
O
LRMC
Output
Long-run costs
Relationship between
short-run and long-run
AC curves
Deriving long-run average cost curves: factories of fixed size

SRAC1 SRAC
2
SRAC3
Costs
1 factory
2 factories
SRAC5
SRAC4
5 factories
3 factories 4 factories
Output
Deriving long-run average cost curves: factories of fixed size

SRAC1 SRAC
2
SRAC3
SRAC5
SRAC4
Costs
LRAC
Output
Costs
Deriving long-run average cost curves: choice of factory size
Examples of short-run
average cost curves
Output
Deriving long-run average cost curves: choice of factory size
Costs
LRAC
Output
Short-Run & Long-Run Marginal Cost Curves
SRMCs
Costs
LAC
Output
Short-Run & Long-Run Marginal Cost Curves
LMC
Costs
SRMCs
LAC
Output
For
each output > 0, the LRMC equals the

MC for the short-run chosen by the firm.

Theory of Costs

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Theory of Costs

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Costs

Hello friends I am an entrepreneur,

Economic Cost of Using Resources

Explicit And Implicit Costs

Firms cost of production involves

Such as additional labor or additional capital equipment

Inputs firm already owns

Such as owners labor, land, or equipment

Explicit (or expenditure) costs

Includes all cash or out-of-pocket expenses incurred in

Explicit And Implicit Costs

Implicit costs (also called nonexpenditure,

Costs charged to inputs that are owned

Economic Profit versus Accounting Profit

Accounting Profits & Economic Profits

cost is the cost that

cost is that cost which do not

Cost: Cost that does not vary

that have already been

they are in the past, they

Fixed And Variable Costs

Total cost (TC) of a particular production

Costs can also be classified according to whether

Costs that do not vary with changes in output -rent, rates,

Explicit and implicit costs may contain both fixed and

Total costs for firm X

Total costs for firm X

Total costs for firm X

Output TFC TVC

Total costs for firm X

Output TFC TVC

Total costs for firm X

Total costs for firm X

Output TFC TVC

Total costs for firm X

Output TFC TVC TC

Total costs for firm X

Output TFC TVC TC

Total costs for firm X

Deriving marginal costs

Deriving marginal costs

Deriving marginal costs

Deriving marginal costs

Deriving marginal costs

total cost (ATC) is the

variable cost (AVC) is the

fixed cost (AFC) is the

Average and marginal costs

Alternative long-run average cost curves

Alternative long-run average cost curves

Alternative long-run average cost curves

A typical long-run average cost curve

A typical long-run average cost curve

Long-run average and marginal costs

Long-run average and marginal costs

Long-run average and marginal costs

Long-run average and marginal costs

Initial economies of scale,

Deriving long-run average cost curves: factories of fixed size

Deriving long-run average cost curves: factories of fixed size

Deriving long-run average cost curves: choice of factory size

Deriving long-run average cost curves: choice of factory size

Short-Run & Long-Run Marginal Cost Curves