Theory of Cost

 Cost Function – Derived Function

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

 Explicit costs = payments to non-owners of a firm for the

supply of their resources (wages paid to labour, costs of
electricity, the rental charges for plant usage, the cost of
other raw materials used in the production process, etc.)

 Implicit costs = the opportunity costs of using the resources

already owned by the firm, where no payment is made to
outsiders (use of the factory by giving up renting out for the
same purpose, input of the owner / manager to give up the
opportunity to earn a salary at another firm)
 Out of Pocket and Book cost
 The items of expenditure which involves cash
payments or cash transfers are known as out of
pocket cost. All the explicit cost like wages,
rent, interest etc fall in this category.
 Certain cost which do not involve cash
payment but a provision is made while
calculating profit and loss a/c are known as
book cost. Eg. Unpaid interest on the owner’s
own fund
 Short run and Long run cost
 Short run cost are the cost which vary with
variation in the output, the size of the firm
remaining the same.
 Long run cost are the cost incurred on fixed
assets like plant & machinery etc.
Historical and Replacement cost
 Historical cost refers to the cost of the asset
acquired in the past
 Replacement cost refers to the outlay which
has to be made for the replacement of old
asset.
 Incremental cost and sunk cost
 Incremental cost refers to the total additional cost
associated with the decision to expand the output.
 Sunk cost are the cost that cannot be altered ,
increased or decreased by varying the rate of output.
These are the cost that cannot be recovered. For eg.
Amortization of past expenses like depreciation ,
expenditure on a highly specialized equipment
designed to order for a plant that can neither be sold
to any other firm nor can be used for any alternative
purpose.
 Private cost and social cost

 Private cost refers to the cost of production

incurred and provided for by the individual
firm engaged in production of the
commodity. It includes both explicit and
implicit cost.
 Social cost refers to the cost of producing
the commodity to the society as the whole.
It takes into consideration all those cost
borne by the society directly or indirectly.
Traditional Theory – Short Run
Cost
TC = TFC + TVC

 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.

 The total variable cost curve increases as output

increases. Initially, it is expected to increase at a
decreasing rate (since marginal productivity increases
initially, the cost of additional units of output
decline). As the level of output rises, however,
variable costs are expected to increase at an
increasing rate (as a result of the law of diminishing
marginal returns).
 TC, TVC, TFC
 The table below contains a listing
of a hypothetical set of total fixed
cost and total variable cost
schedules. As this table indicates,
total fixed costs are the same at
each possible level of output.
Total variable costs are expected
to rise as the level of output rises.
 As the table below indicates, we
can use the TFC and TVC
schedules to determine the total
cost schedule for this firm. Note
that, at each level of output, TC =
TFC + TVC.
 AC = AFC + AVC

 Average costs: costs per unit of output

 Average fixed cost = TFC divided by quantity
produced.
 AFC = TFC / Q

 as output rises AFC falls continuously (resembles a

rectangular hyperbola)
 Average variable cost = TVC divided by quantity
produced
 AVC = TVC / Q

 usually average variable cost is U-shaped, with

AVC falling initially and then rising as it becomes
more costly to produce additional units of output.
 Average total costs = AFC + AVC = TC/Q
 Fig. : Average costs
Cost

ATC

AVC

AFC

Output
Average Costs
 Marginal Cost

Marginal Cost (MC):

Change in total costs due to a unit change in
output.
TC
MC 
Q

MC is the slope of TC curve. With an inverse

S-shape of TC, MC curve will be U shape.
Fig.: Average and marginal costs
Cost
MC

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

 The LRAC is often called the firm’s planning

curve.

 The long run average cost (LRAC) is derived

from short run cost curves. Each point of
LRAC corresponds to a point on short run cost
curve, which is tangent to LRAC.
 Long-Run Average Costs
 The LRAC is a curve that is tangent to the set
of SRACs. When the LRAC curve falls the
tangency points are to the left of the minimum
points on the SRAC and when the LRAC
curve is rising the tangency points are to the
right of the minimum points of the SRAC
curves.
 With a great variety of plant sizes, the
corresponding short-run average total cost
curves trace a smooth LRAC curve.
Fig. :The LRAC or ‘the firm’s planning
curve’
Cost

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

Economies Constant Diseconomies

of scale returns to of scale
scale

Minimum
efficient scale
Output
•LRAC varies from industry to industry
•Usually economies dominate diseconomies
Economies of scale
 (a) internal economies

 (b) external 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)