Cost Theory and Analysis

What is Cost

 T h e expenditure incurred to produce an output
or provide service

 T h u s the cost incurred in connection with raw

material, labour, other heads constitute the overall
cost of production
 Types of Cost

 A c c o u n t i n g Cost

 E c o n o m i c Cost

 V a r i a b l e Cost
 Accounting Cost

 A l l those expenses that incurred
during production with adjusted
depreciation is called accounting cost.
 C a s h payments which firms make for
factorand non-factor input depreciation other
book keeping entries.
 Economic Cost

 Economic costs includes the payments such as rent,
wages, interest and profit, which are paid to factors of
production – land, labour, capital and entrepreneur for
their services.

 Economic = Accounting Costs + Implicit Costs

Costs
 Opportunity Cost

 Factors of production or resources, in an economy are
limited and have alternative uses. The cost of sacrifice or
foregone for the next best use of resource is known as
opportunity cost.

Sunk Cost
 A cost that has already been incurred and thus canotbe
recovered.
 Cost Function

 Short Run Cost
Function

 Long Run Cost

Function
 Cost Function
 Costs According to Time Period

Short Run Cost Curve Long Run Cost Curve

Total Cost Average Marginal Long Run Long Run Long Run
(TC) Cost Cost (MC) Total Costs Average Marginal
(AC) (LTC) Costs (LAC) Costs (LMC)

Total Total Averag Averag [TC =TFC+TVC] [AC = AFC+AVC]

Fixed Variabl e Fixed e
Costs e Costs Variabl
(TFC) Costs (AFC) e
(TVC) Costs MC = TCn – TCn-1
(AVC) Or
MC = ΔTC
ΔQ
 Short-Run Cost Functions

 In short-run period, some of the firm’s inputs are fixed and
some are variable, and this leads to fixed and variable costs.
 Fixed Cost
 Variable Cost
 Total Cost
 Average Fixed Cost
 Average Variable Cost
 Average Total Cost
 Marginal Cost
 Short-Run Cost Functions

 Fixed Cost
Fixed costs are those costs which do not change
with the change in level of output.
 Variable Cost
Variable costs are the costs which change with the
change in level of output when output is zero, the variable
cost also zero. It will increase with the increase in level of
output. E.g. electricity changes, telephone charges.
 Short-Run Cost Functions

 Total Cost
Total costs is the cost of all the productive
resources used by the firm.
TC = TFC + TVC
 Average Fixed Cost
Average Fixed Cost, can be calculated by dividing
total fixed cost with the level of output. As the level of output
increases, the average fixed cost decreases.
 AFC = TFC
Q
 Short-Run Cost Functions

 Average Variable Cost
Average Variable Cost is the per unit cost of the variable
factors of production. It can be calculated dividing total variable cost by
output.
AVC = TVC
Q
 Average Total Cost
Average cost is the total cost per unit. It can be found
out as follows
 Short-Run Cost Functions

 Marginal Cost
Marginal Cost is an addition made to total cost by
the production of one more unit of output.

 MC = ∆TC
∆Q
Short-Run Cost Functions
Q TFC TVC AVC ATC MC
TC
0 $60 $0 $60 - - - -
1 60 20 
80 $60 $20 $80 $20
2 60 30 AFC 30
90 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
Average Total Cost = ATC = TC/Q
Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC

Marginal Cost = TC/Q = TVC/Q

Short-Run Cost Functions

 Long-Run Cost Curves


 I n long run all factors of production are

changeable. In long run a firm can increase its
capacity, equipment, machinery, land, employee,
etc. in order increase output.
Long-Run Cost Curves

 Long-Run Total Cost = The minimum total costs of
producing various levels of output when the firm can
build any desired scale of plant: LTC = f(Q)
Long-Run Cost Curves

 Long-Run Average Cost = The minimum per-unit cost of
producing any level of output when the firm can build any
desire scale of plant: LAC = LTC/Q
 Long-Run Marginal Cost = The change in long-run
totalcosts per unit change in output:
LMC = LTC/Q
Long-Run Cost Curves

Long-Run Cost Curves
The slope of the total
revenue TR curve
refers to the product
price of $10 per unit.

 The vertical intercept

of the total cost of (TC)
curve refers TFC of
$200, and the slope of
the TC curve to the
AVC of $5. The break-
even with TR=TC
$400 at the output (Q)
of $40 units per time
period at the point B.