COST THEORY AND

ANALYSIS
NATURE OF COSTS

 Actual cost: cost incurred in production

 Opportunity cost: return from the second best use of

firm’s resources which the firm foregoes in order to
avail the return

 Explicit / Accounting Costs : Actual money spent in

purchasing or hiring services of factor

 Implicit / Imputed cost: Cost of self-owned and self-

employed resources
NATURE OF COSTS

 Fixed costs: Costs which do not change with change

in O/P

 Variable or Prime costs: Costs which change with

change in level of O/P

 Accounting costs: Cost as stated in books of

accounts (explicit cost only)

 Economic Costs: includes both explicit & implicit cost

NATURE OF COSTS

 Marginal cost: Change in total cost

associated with a one-unit change in output

 Incremental Costs: Total additional cost of

implementing a managerial decision
NATURE OF COSTS

 Private cost: Actually incurred or provided for by an

individual for its business activity

 Social cost: Cost to society on account of production

of good

 Original cost: cost incurred originally

 Replacement cost: cost incurred in replacing

EXERCISE
A Carpenter makes 100 chairs per month & sells them at
Rs 150 per piece. His expenses on rent of shop, cost of
wood & other materials are worth Rs 5000. He employs 2
workers whose monthly wage bill stand at Rs 2400 & pays
electricity bill of Rs 500 per month. He has invested Rs
50,000 in the form of machines, tools & inventories of
which Rs 25,000 is from his own fund & remaining 25,000
is a loan from bank at interest rate of 18% p.a. Assuming
imputed cost of his own time, own shop & own savings of
Rs 25000 as Rs 3000, Rs 1000 & Rs 250 respectively,
find:
 Explicit cost
 Implicit cost
 Accounting profit
 Economic profit
ANSWERS
 Explicit cost : Rs 8275
 Implicit cost: Rs 4250
 Accounting profit: Rs 6725
 Economic profit: Rs 2475
COST FUNCTION

C = f (S, O, P, T……)
Where:
 C: Cost of O/P
 S: Size of plant
 O: level of O/P
 P: price of I/Ps used in production
 T: nature of technology
SHORT-RUN COST
FUNCTIONS

Total Cost = TC = f(Q)

TC = TFC + TVC
Total Fixed Cost = TFC
Total Variable Cost = TVC
 SHORT-RUN COST
FUNCTIONS
Average Fixed Cost = AFC = TFC/Q

Average Variable Cost = AVC =TVC/Q

Average Total Cost = ATC = TC/Q

Average Total Cost = AFC + AVC

Marginal Cost = ∆ TC/∆ Q =∆ TVC/∆ Q

SHORT-RUN COST
FUNCTIONS
Q TFC TVC TC AFC AVC ATC MC

0 60 0 60 - - - -

1 60 20 80 60 20 80 20

2 60 30 90 30 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
Cost 250
Total Cost Function

200 TC

150
TVC

100

TFC
50

0 Output
0 1 2 3 4 5 6
Cost
90
80 Per Unit Cost Function
70
60 MC
50
40
AC
30 AVC
20
10 AFC
0 Output
0 1 2 3 4 5 6
SHORT RUN COST FUNCTION:
IMPORTANT OBSERVATIONS

 AFC declines steadily over the range of

production

 In general, AVC, AC, and MC are U shaped

 When MC<AVC, AVC is falling
 When MC>AVC, AVC is rising
 When MC=AVC, AVC is at its minimum

 The distance between AC and AVC

represents AFC
SR RELATIONSHIP BETWEEN
PRODUCTION AND COST

 A firm’s cost structure is intimately related to its

production process

 Costs are determined by the production

technology and input prices
SR RELATIONSHIP BETWEEN
PRODUCTION AND COST
Total
In order to illustrate
Input
the relationship,
(L) Q (TP) MP
consider the
0 0
production process
1 1,000 1,000
described in table
2 3,000 2,000
3 6,000 3,000
4 8,000 2,000
5 9,000 1,000
6 9,500 500
7 9,850 350
8 10,000 150
9 9,850 -150
 SR RELATIONSHIP BETWEEN PRODUCTION
& COST
TOTAL Q (TP) MP TVC (wL) MC
I/P (L) (∆TVC/
 Total variable ∆Q)
cost (TVC) is
the cost 0 0 0
associated with 1 1000 1000 500 0.5
the variable 2 3000 2000 1000 0.25
input, in this
case labor 3 6000 3000 1500 0.16
 Assume that 4 8000 2000 2000 0.25
labor can be 5 9000 1000 2500 0.5
hired at a price 6 9500 500 3000 1
(w) of Rs 500
per unit 7 9850 350 3500 1.4
8 10000 150 4000 3.33
9 9850 -150 4500
SR RELATIONSHIP BETWEEN
PRODUCTION & COST
 TP and TVC are mirror images of each other
 When TP increase at an increasing rate, TVC increase at a
decreasing rate
 RELATION B/W MP & MC
Total
 When MP is Input TVC
(L) Q MP (wL) MC
increasing, MC is 0 0 0
decreasing 1 1,000 1,000 500 0.50
2 3,000 2,000 1,000 0.25
 When MP is 3 6,000 3,000 1,500 0.17
decreasing, MC is 4 8,000 2,000 2,000 0.25
increasing 5 9,000 1,000 2,500 0.50
6 9,500 500 3,000 1.00
 Also when MP= 7 9,850 350 3,500 1.43
8 10,000 150 4,000 3.33
AP at max AP,
9 9,850 -150 4,500
MC = AVC at min
AVC
SHORT-RUN COST
FUNCTIONS

Average Variable Cost

AVC = TVC = w L
Q Q
= w = w
Q/L APL

Marginal Cost
∆ TC/∆ Q = ∆ TVC/∆ Q = ∆ (w L)/∆ Q
= w = w
∆ Q/∆ L MPL
EXERCISE

Given Total Cost function:

TC = 1000 + 10 Q – 0.9 Q 2 + 0.04 Q 3
Find the rate of O/P that result in minimum Average
Variable cost
LR RELATIONSHIP B/W PRODUCTION &
COST
 All I/Ps variable
 No fixed costs
 LR cost structure of firm is related to firm’s long
run production process which is described by
RTS
 Economists hypothesize that a firm’s long-run
production function may exhibit at first IRS then
CRS & finally DRS
LR RELATIONSHIP B/W PRODUCTION &
COST
IRS:
 A proportional increase in all I/Ps increases O/P by a
greater percentage than costs
 Costs increase at a decreasing rate

CRS:
 A proportional increase in all I/Ps increases O/P by same
percentage as costs
 Costs increase at a constant rate

DRS:
 A proportional increase in all I/Ps increases O/P by a
smaller percentage than costs
 Costs increase at an increasing rate
LR RELATIONSHIP B/W PRODUCTION &
COST
LONG-RUN COST CURVES

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = ∆ LTC/∆ Q
DERIVATION OF LONG-RUN COST CURVES
LAC

It shows the lowest average cost of producing each

level of O/P when the firm can build the most
appropriate plant to produce each level of O/P
RELATIONSHIP B/W LONG-RUN & SHORT-RUN
AVERAGE COST CURVES
RELATIONSHIP B/W LONG-RUN & SHORT-RUN
AVERAGE COST CURVES
LONG-RUN COST FUNCTION

 When LAC declines: firm experiences

economies of scale (per-unit costs are
falling)

 When LAC increases: firm experiences

diseconomies of scale (per-unit costs are
rising)
LONG-RUN COST FUNCTION:
GENERAL SHAPE
 ECONOMIES OF SCALE

Internal External

Real economies Pecuniary economies

Quantity discounts
Specialization
Indivisibility Lower cost of capital

Advertising
transportation
Team work
Sales promotion
 DISECONOMIES OF SCALE

Congestion Scarcity of Difficulty in

resources Coordination &
control
MANAGERIAL USES OF COST
FUNCTIONS: DETERMINING OPTIMUM
OUTPUT LEVEL

 O/P level at which AC is minimum

 Necessary condition: ∂(AC) / ∂Q = 0
 Sufficient condition: ∂2(AC) / ∂Q2 > 0
MANAGERIAL USES OF COST
FUNCTIONS: DETERMINING
OPTIMUM SCALE
 Value of plant size (K) at which total cost (C) is
minimum
 Necessary condition: ∂C / ∂K = 0
 Sufficient condition: ∂2C / ∂K2 > 0
SPECIAL TOPICS IN COST THEORY
(1) PROFIT CONTRIBUTION ANALYSIS

Total Revenue = TR = (P)(Q)

Total Cost = TC = TFC + (AVC)(Q)

Profit = TR -TC
Profit = Π = PQ - [TFC + (AVC)(Q)]

Q = TFC + Π
P - (AVC)

Profit contribution = P - AVC

 EXAMPLE
Fixed cost = Rs 10,000
Price = Rs 20
AVC = Rs 15
How much O/P should the firm produce to
have a profit of Rs 20,000?

Answer: 6000 units

(2) BREAKEVEN VOLUME (TR = TC)
(zero economic profit)

Π = TR - TC = 0
TR = TC

(P)(Q) = TFC + (AVC)(Q)

QBE = TFC
(P - AVC)
 EXAMPLE
Fixed cost = Rs 10,000
Price = Rs 20
AVC = Rs 15
How much O/P should the firm produce in order
to break even?

Answer: 2000 units

Also : TR = 20Q
TC = 10,000 + 15Q
TR = TC
LINEAR BREAKEVEN ANALYSIS

P = 10
TFC = 200
AVC = 5
LINEAR BREAKEVEN ANALYSIS:
SHORTCOMINGS
 Assumes constant prices
 Assumes constant average variable costs
 EXCERCISE
 Petersen & Lewis Page # 239: Breaking even on
Microcomputer software
NONLINEAR BREAKEVEN ANALYSIS
TR/TC 350 TC
300

250 TR
200

150

100

50

0
0 1 2 3 4 5 6 Q
Profit 40

30

20

10

0
0 1 2 3 4 5 6 Q
-10

-20

-30
Π
-40

-50
 (3) OPERATING LEVERAGE

Operating Leverage = TFC/TVC

Degree of Operating Leverage (or profit elasticity) = DOL

DOL = %∆ Π = ∆ Π/Π = ∆ Π *Q = EΠ
%∆ Q ∆ Q/Q ∆Q Π
Π = PQ - TFC + (AVC)(Q) ∆ Π = ∆ Q(P - AVC)
= Q(P - AVC) - TFC

DOL = ∆ Q(P - AVC)Q = Q(P - AVC)

∆ Q[Q(P - AVC) - TFC] Q(P - AVC) - TFC
(4) LEARNING CURVE

 Workers improve with practice so per unit cost of

additional O/P declines

 Measures % decrease in additional labor cost

each time O/P doubles

 An “80 percent” learning curve implies that each

time O/P doubles, L costs associated with
incremental output decrease to 80% of previous
level
UTILITY OF LEARNING
CURVES
 To forecast needs of

 personnel
 machinery
 raw materials
 Scheduling production
 Determining Selling price of product
 (5) ECONOMIES OF SCOPE
 The reduction of a firm’s unit cost by producing two or
more goods or services jointly rather than separately
 Degree of economies of scope =
TC(Q1) + TC(Q2) – TC(Q1 + Q2)
TC(Q1 + Q2)
 EXAMPLE
Firm A produces 100 units of X & 500 units of Y per month
at the TC of Rs 1,00,000. If X & Y are produced separately
by firms B & C then the TC to firm B of producing 100 X is
Rs 25000 & firm C of producing 500 Y is Rs 90,000.
Check whether firm A is experiencing economies or
diseconomies of scope

 Answer: 0.15 so economies of scope

NOTE:
 Positive: economies of scope
 Negative: diseconomies of scope