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C= f(X, T, Pf, K)
Where C is total cost
X is the output
T is technology
Pf is price of FOP
K is fixed factor (capital)
Cost Concepts
Opportunity Cost & Actual Concepts
Business Costs & Full Costs
Explicit & Implicit or Imputed Costs
Out-of-Pocket & Book Costs
Fixed & Variable Costs
Total, Average & Marginal Costs
Short-Run and Long-Run Costs
Incremental Costs and Sunk Costs
Historical & Replacement Costs
Private & Social Costs
Opportunity Cost & Actual
Concepts
Opportunity cost refers to the expected returns
from the second best use of resources which
are foregone due to the scarcity of resources.
Actual cost are those which are actually
incurred by the firm in the payment for labour,
material , machinery, equipment etc.
Business cost and full cost
All the expenses which are incurred to carry out a
business. The concept of business cost is similar to
actual cost.
Full cost includes business cost, opportunity cost and
normal profit. Normal profit is the necessary
minimum earning which the firm must receive to
remain in the present occupation.
Explicit & Implicit or Imputed Costs
Total fixed cost: costs that do not vary with output and must be paid
even if output is zero. These types of costs are beyond managerial
control. Examples: Depreciation of machinery, rent, mortgage
payments, interest payments on loans, and monthly connection fees for
utilities. The level of total fixed costs is the same at all levels of output
(even when output equals zero).
Total variable cost: costs that vary as output changes. If a firm uses
more inputs to produce output, total variable costs will rise. These types
of costs are within management control. Examples: labour costs, raw
material costs, and running expenses such as fuel, ordinary repair &
routine maintenance. Variable costs are equal to zero when no output is
produced and increase with the level of output.
Fig. : Total Cost Curves
TC
Cost
TVC
TFC
Output
Explanation for the total cost curve
Total fixed costs are the same at all levels of output, a
graph of the total fixed cost curve is a horizontal line.
ATC
AVC
AFC
Output
Average Costs
Marginal Cost
ATC
Output
Relationship between MC &
ATC
If the MC is less than the ATC, then the ATC must be
falling. This follows from the fact that if you add a
quantity to the average costs that is less than the
average, the average must fall.
If the MC exceeds the ATC, the ATC must be rising.
This follows from the fact that you are adding a
quantity to the average costs that is greater than the
average. Hence the average must rise.
It should also be noted that when MC cuts the ATC
and the AVC at their minimum points.
Fig .: Traditional Theory Cost
Cost
MC
ATC
AVC
AFC
Output
Traditional Theory -Long run
costs/Envelope Curve
The firm plans in the long run, when all inputs
are variable
SRATCl
SRATCs SRATCm
40
30
6 12 Output
The plant size selected in the long-run depends on the expected
level of production
Fig. : The LRAC with unlimited
plant size
Cost
LRAC
LRAC is tangent to
the set of SRACs
Output
Fig. : Scale economies
Cost
Minimum
efficient scale
Output
•LRAC varies from industry to industry
•Usually economies dominate diseconomies
Economies of scale
(a) internal economies
Diseconomies of scale
(a) internal – managerial and labour
inefficiency
(b) external
Reasons for Economies of Scale…
Increasing returns to scale
Specialization in the use of labor and capital
Economies in maintaining inventory
Discounts from bulk purchases
Lower cost of raising capital funds
Spreading promotional and R&D costs
Management efficiencies
Reasons for Diseconomies of Scale…
Decreasing returns to scale
Input market imperfections
Management coordination and control
problems
Long Run Marginal Cost
LRMC is derived from SRMC, but does not
envelope them.
LRMC is formed from points of intersections
of SRMC curves with vertical lines drawn
from point of tangency of corresponding SAC
curve and LRAC curve.
At the minimum point we have
SACB = SMCB = LAC = LMC
LMC
SAC3
SMC3
SMC1 SAC2 LAC
SAC1
SMC2
Break Even Analysis/Profit
Contribution Analysis
Linear Cost & Revenue Function
Break Even Analysis/Profit
Contribution Analysis
Non Linear Cost & Revenue Function
Modern Theory of Cost
Need for Reserve Capacity
To meet seasonal & cyclical fluctuations in demand.
To give flexibility for repair of broken down
machinery.
To increase output as demand increases.
To give flexibility for minor alterations of the product
due to change in taste of customers.
Some reserve capacity on organizational &
administrative level will also be required.
Difference b/w Reserve Capacity &
Excess Capacity
Excess capacity arises from U-shaped costs by
the traditional theory of the firm. While
reserve capacity arises from the saucer shaped
cost of modern theory of firm.
The traditional theory assumes that each plant
is designed to produce optimally only single
level of output. While the reserve capacity
makes it possible to have constant SAVC
within a certain range of output.
Difference b/w Reserve Capacity &
Excess Capacity
The modern theory with change in output cost
does not change while in traditional theory the
cost also changes.
In figure the firm produces an output of X
smaller than XM thus (XM-X )is the excess
capacity which leads to increase in cost. The
range of output X1X2 reflects the plant reserve
capacity which does not leads to increase in
cost.
Difference b/w Excess & Reserve Capacity
C C
A A
V V
C
C
Reserve
Capacity
0 X Excess XM X 0 X1 X2
Capacity
Short – Run Cost Curve under
Modern Theory of Cost
Long Run Cost under Modern
Theory (L-Shaped LAC Curve)