COSTS

In order to produce output, the firm needs to employ inputs. But a given level of output,
typically, can be produced in many ways. There can be more than one input combinations with
which a firm can produce a desired level of output. In Table 3.1, we can see that 50 units of
output can be produced by three different input combinations – (x1 = 6, x2 = 3), (x1 = 4, x2 = 4)
and (x1 = 3, x2 = 6). The question is which input combination will the firm choose? With the
input prices given, it will choose that combination of inputs which is least expensive. So, for
every level of output, the firm chooses the least cost input combination. This output-cost
relationship is the cost function of the firm.

Opportunity Cost – Opportunity cost is the next best alternative foregone. When economists
refer to the “opportunity cost” of a resource, they mean the value of the next – highest valued
alternative use of that resource.

A benefit/profit/value of something that must be given up to acquire or achieve something else.

Since every resource can be put to alternative uses, action, choice or decision has an associated
opportunity cost. Opportunity cost are fundamental costs in economics and are used in
computing cost benefit analysis of a project. Such costs however are not recorded in the account
books but are recognized in decision making by computing the cash outlays.

If you invest £1million in developing a cure for pancreatic cancer, the opportunity cost is that
you can’t use that money to invest in developing a cure for skin cancer.

Economic Cost. Economic cost includes both the actual direct costs (accounting costs) plus the
opportunity cost. For example, if you take time off work to a training scheme. You may lose a
weeks pay of £350, plus also have to pay the direct cost of £200. Thus the total economic cost =
£550.

Incremental Costs

Incremental costs are associated with a choice and therefore only ever include forward-looking
costs. Previously made purchases or investments, such as the cost to build a factory, are called
“sunk” costs and are not included. The Incremental cost can include many different direct and
indirect cost inputs depending upon the situation. However, only costs that will change as a
result of the decision are to be included. When a factory production line is at full capacity, the
incremental cost of adding another production line might include cost of the equipment, the
people to staff the line, electricity to run the line and additional human resources and benefits.
An incremental cost is the difference in total costs as the result of a change in some activity.
Incremental costs are also referred to as the differential costs and they may be the relevant
costs for certain short run decisions involving two alternatives.
Note: Incremental costs may include more than the change in variable costs.

Example of Incremental Cost

Let's assume that a company has the following experience:

 Total cost of manufacturing 8,000 units of Product X is $320,000, or $40 per unit
 Total cost of manufacturing 10,000 units of Product X is $360,000, or $36 per unit

From the above information, we see that the incremental cost of manufacturing the additional
2,000 units (10,000 vs. 8,000) is $40,000 ($360,000 vs. $320,000). Therefore, for these 2,000
additional units, the incremental manufacturing cost per unit of product will be an average of $20
($40,000 divided by 2,000 units). The reason for the relatively small incremental cost per unit is
due to the cost behavior of certain costs. For example, when the 2,000 additional units are
manufactured most fixed costs will not change in total although a few fixed costs could increase.

Accounting Costs – This is the monetary outlay for producing a certain good. Accounting costs
will include your variable and fixed costs you have to pay.

Sunk Costs: These are costs that have been incurred and cannot be recouped. If you left the
industry, you could not reclaim sunk costs. For example, if you spend money on advertising to
enter an industry, you can never claim these costs back. If you buy a machine, you might be able
to sell if you leave the industry.

Avoidable Costs: Costs that can be avoided. If you stop producing cars, you don’t have to pay
for extra raw materials and electricity. Sometimes known as an escapable cost.

Short Run Costs

In the short run, some of the factors of production cannot be varied, and therefore, remain fixed.
The cost that a firm incurs to employ these fixed inputs is called the total fixed cost (TFC).
Whatever amount of output the firm produces, this cost remains fixed for the firm. To produce
any required level of output, the firm, in the short run, can adjust only variable inputs.
Accordingly, the cost that a firm incurs to employ these variable inputs is called the total variable
cost (TVC). Adding the fixed and the variable costs, we get the total cost (TC) of a firm
TC = TVC + TFC

In order to increase the production of output, the firm needs to employ more of the variable
inputs. As a result, total variable cost and total cost will increase. Therefore, as output increases,
total variable cost and total cost increase.
 In Table 3.3, we have an example of cost function of a typical firm. The first column shows
different levels of output. For all levels of output, the total fixed cost is Rs 20. Total variable cost
increases as output increases. With output zero, TVC is zero. For 1 unit of output, TVC is Rs 10;
for 2 units of output, TVC is Rs 18 and so on. In the fourth column, we obtain the total cost (TC)
as the sum of the corresponding values in second column (TFC) and third column (TVC). At
zero level of output, TC is just the fixed cost, and hence, equal to Rs 20. For 1 unit of output,
total cost is Rs 30; for 2 units of output, the TC is Rs 38 and so on.

The short run average cost (SAC) incurred by the firm is defined as the total cost per unit of
output. We calculate it as

SAC = TC/ number of output

In Table 3.3, we get the SAC-column by dividing the values of the fourth column by the
corresponding values of the first column. At zero output, SAC is undefined. For the first unit,
SAC is Rs 30; for 2 units of output, SAC is Rs 19 and so on.

Similarly,

The average variable cost (AVC) is defined as the total variable cost per unit of output. We
calculate it as

AVC = TVC / q

q= total number of output

Also, average fixed cost (AFC) is

AFC = TFC/q
Clearly, SAC = AVC + AFC (3.10)

In Table 3.3, we get the AFC-column by dividing the values of the second column by the
corresponding values of the first column. Similarly, we get the AVC-column by dividing the
values of the third column by the corresponding values of the first column. At zero level of
output, both AFC and AVC are undefined. For the first unit of output, AFC is Rs 20 and AVC is
Rs 10. Adding them, we get the SAC equal to Rs 30.

The short run marginal cost (SMC) is defined as the change in total cost per unit of change in
output
SMC = change in total cost / change in output

If output changes in discrete units, we may define the marginal cost in the following way. Let the
cost of production for q1 units and q1 – 1 units of output be Rs 20 and Rs 15 respectively. Then
the marginal cost that the firm incurs for producing q1 th unit of output is

MC = (TC at q1 ) – (TC at q1 – 1)

Just like the case of marginal product, marginal cost also is undefined at zero level of output. It is
important to note here that in the short run, fixed cost cannot be changed. When we change the
level of output, whatever change occurs to total cost is entirely due to the change in total variable
cost. So in the short

Table 3.3: Various Concepts of Costs

Output TFC TVC TC AFC AVC SAC SMC
(units) (Rs) (Rs) (Rs) (Rs) (Rs) (Rs) (Rs)
0 20 0 20 – – – –
1 20 10 30 20 10 30 10
2 20 18 38 10 9 19 8
3 20 24 44 6.67 8 14.67 6
4 20 29 49 5 7.25 12.25 5
5 20 33 53 4 6.6 10.6 4
6 20 39 59 3.33 6.5 9.83 6
7 20 47 67 2.86 6.7 9.57 8
8 20 60 80 2.5 7.5 10 13
9 20 75 95 2.22 8.33 10.55 15
10 20 95 115 2 9.5 11.5 20

marginal cost is the increase in TVC due to increase in production of one extra unit of output.
For any level of output, the sum of marginal costs up to that level gives us the total variable cost
at that level. One may wish to check this from the example represented through Table 3.3.
Average variable cost at some level of output is therefore, the average of all marginal costs up to
that level. In Table 3.3, we see that when the output is zero, SMC is undefined. For the first unit
of output, SMC is Rs 10; for the second unit, the SMC is Rs 8 and so on.
Fixed costs are costs that are independent of output. These remain constant throughout the
relevant range and are usually considered sunk for the relevant range (not relevant to output
decisions). Fixed costs often include rent, buildings, machinery, etc.

Variable costs are costs that vary with output. Generally variable costs increase at a constant
rate relative to labor and capital. Variable costs may include wages, utilities, materials used in
production, etc.

Below is an example of a firm's cost schedule and a graph of the fixed and variable costs.
Noticed that the fixed cost curve is flat and the variable cost curve has a constant upward slope.
Total costs

Average Cost
Average Variable Cost:

In modern economics, the average variable cost includes wages of labour employed, cost of raw-
material, and running expenses of machinery. The short run average variable cost curve in
modern-micro economic theory is saucer-shaped, that is, it is broadly U-shaped but has a flat
stretch over a range of output. This flat stretch represents the built-in reserve capacity of the
plant. Over this flat stretch, the SAVC is equal to the MC, both being constant per unit of output.
To the left of the flat stretch, MC lies below the SAVC, while to the right of the flat stretch;
marginal cost rises above the SAVC.

The falling portion of the SAVC shows reduction in costs due to better utilization of the fixed
factor like machinery and also due to improvement in the skill and efficiency of labour. Better
efficiency of labour helps in reducing wastage of raw-material and achieving better utilization of
the whole plant. On the other hand, rising portion of the SAVC curve indicates declining labour
efficiency due to longer hours of work, rising costs due to payment of over-time wages, frequent
breakdown of machinery, and wastage of raw-materials.

Relation between MC and AC:

There is a close relation between MC and AC. When AC is falling, MC is less than AC.

Cost Elasticity:
On the basis of the relation between MC and AC we can develop a new concept, viz., the
concept of cost elasticity. It measures the responsiveness of total cost to a small change in the
level of output.

AFC declines continuously, approaching both axes asymptomatically (as shown by the de-
creasing distance between ATC and AVC) and is a rectangular hyperbola.

(2) AVC first declines, reaches a minimum at Q2and rises thereafter. When AVC is at its
minimum, MC equals AVC.
(3) ATC first declines, reaches a minimum at Q3, and rises thereafter. When ATC is at its
minimum, MC equals ATC.
(4) MC first declines, reaches a minimum at Q1, and rises thereafter. MC equals both AVC and
ATC when these curves are at their minimum values.

The lowest point of the AVC curve is called the shut (close)- down point and that of the ATC
curve the break-even point. These two concepts will be discussed in the context of market
structure and pricing. Finally, we see that MC lies below both AVC and ATC over the range in
which these curves decline; contrarily, MC lies above them when they are rising.
The relationship between average cost and marginal cost can also be studied in the context of
laws of return.

It can be explained as under:

(i) Law of Increasing Returns or the Law of Diminishing Costs:
When a firm produces under the law of increasing returns, it means that as it employs more and
more factors of production, its output increases at an increasing rate.

In such a situation both the average cost and marginal cost slope downward, but the downward
slope of MC curve is more than that of AC curve.

From Figure 11 it becomes clear that when due to the operation of the law of increasing returns,
average cost falls, marginal cost also falls. The fall in marginal cost is much more than the
average cost, so the marginal cost remains below the average cost.

(ii) Law of Diminishing Returns or Increasing Costs:

If a firm operates under the law of diminishing returns, it means its output increases at
diminishing rate as it employs more and more units of factors of production. In this case, if AC
increases MC also increases. The increase in MC will be much more than the increase in AC. It
can be shown with the help of figure 12. The Figure 12 depicts that as AC increases MC also
increases at a faster rate than the AC. Therefore, the curve MC remains above the curve AC.
(iii) Law of Constant Returns or Constant Costs:
According to the law of constant returns when a firm employs more and more factors, output
increases at a constant rate. Therefore, the average cost curve as well as marginal cost curve
remains parallel to horizontal axis. This can be made clear with the help of diagram 13. In the
diagram 13 output has been measured on OX- axis while costs on OY-axis. Here, we see that AC
= MC and both are parallel to X-axis.

Relationship of Different Cost Curves in Short Period:

In Figure, the relationship between different cost curves can be explained with the help of figure
14. In Fig. 14 AFC is the average fixed cost curve which slopes downward. It indicates that as
production increases, AFC goes on falling. In the beginning, it slopes steeply but later on rate of
fall slows down. AVC is the average variable cost. It falls up to point E and then rises upward.
SAC is the short run average cost curve having U-shape. The minimum point E of AVC occurs
earlier than the minimum point E’ of SAC. MC passes from the minimum points of both AVC
and SAC through the points E and E’ respectively.

Qus 1. At which point does the SMC curve cut the SAC curve? Give reason in support of
your answer

Short run marginal cost (SMC) curve cuts the short run average cost (SAC) curve from below at
the minimum point of SAC curve, where SAC is constant and at its minimum point.

The reason behind it is -

When SMC and SAC fall, the SMC falls at a lower rate than SAC

When SMC and SAC rise, the SMC rises at a greater rate than SAC

Costs in Long Run Period:

Long-run is a period in which there is sufficient time to alter the equipment and the scale or
organization with a view to produce different quantities of output. In other words, if we want to
change output, it can be done by changing all the factors. It is due to the reason that in the long-
run, all the factors are variable.

According to Koutsoyiannis, “In the long-run, all the factors of production are assumed to be
variable.” In the same fashion Leftwich has defined the long-period as, “It will be helpful to
think of the long run situations into any one in which the firm can move.”
Long Run Total Cost:
According to Leibhafasky, “The long run total cost of production is the least possible cost of
producing any given level of output when all inputs are variable.”

Long run total cost is always less than or equal to short run total cost, but it is never more than
short run total cost. Long run total cost curve represents the least cost of different quantities of
output. Therefore, it is tangent to any given point, on short run total cost. As shown in Figure-
10, short run total costs curves; STC1, STC2, and STC3 are shown depicting different plant
sizes. The LTC curve is made by joining the minimum points of short run total cost curves.
Therefore, LTC envelopes the STC curves.

Long-Run Average Cost Curve:

Long-run average cost is the long run total cost divided by the level of output.

LAC = LTC / Q

According to Robert Awh, “The long run average cost curve shows the lowest average cost of
producing output when all inputs can be varied freely.”

Similarly, J.S. Bain has defined the long-run average cost as, “The long-run average cost curve
shows for each possible output, the lowest cost of producing that output in the long run.”
Moreover, in the long-run, each firm can make use of different sizes of plants.

A given level of output can be had from a special plant to which it is appropriated. If, such a
plant is put to operation, goods will be produced at the lowest average cost. Thus, a rational
producer in the long- run will choose to produce with the help of such a plant. Now, the question
is how to find out this long-run average cost curve. The answer is very simple. We can derive the
LAC from the short-run average cost curves.
In Figure 16 long-run average cost has been shown. The long- run average cost curve is tangent
to different short run average cost curves. In order to produce OX0 level of output, the
corresponding point on LAC is K at which it 1S tangent to SAC0. Therefore, if a firm is willing
to produce OX0 level of output, it will construct a plant corresponding to SAC0 and will operate
on this curve at point K.

Different Names of LAC:

LAC is also known by the following names:

(i) Envelope curve:
LAC is also known as envelope curve because it envelopes all the SAC curves. It indicates that
LAC cannot exceed SAC. As in the long-run indivisible factors can be used to their full capacity,
therefore, LAC curve will be surrounding the SAC. It will not cut SAC curves or rise upward.

(ii) Planning curve:

LAC is also known as planning curve. With its help, a firm can plan as to which plant; it should
use to produce different quantities of output so that production is obtained at minimum cost. This
fact can also be explained with the help of fig. 17.
In the Fig. 17, short-run average cost curves of all the three types of plants have been shown. If
the firm has to produce OQ1 output, it will select small plant. If it wants to produce OQ3 level of
output, it will select the large output plant.
If the firm begins production with the small plant and demand for its product rises slowly, it will
produce at minimum cost up to OA quantity of output. After OA amount of output its cost begins
to rise. In case, demand for the product of the firm increases to OB then the firm will produce
either with small or medium plant.

It first falls and then rises, thus it is U- shaped curve. The returns to scale also affect the LTC and
LAC. Returns to scale implies a change in output of an organization with a change in inputs. In
the long run, the output changes with respect to change in all inputs of production. In case of
increasing returns to scale (IRS), organizations can double the output by using less than twice of
inputs. LTC increases less than the increase in the output, thus, LAC falls. In case of constant
returns to scale (CRS), organizations can double the output by using inputs twice. LTC increases
proportionately to the output; therefore, LAC becomes constant. On the other hand, in case of
decreasing returns to scale (DRS), organizations can double the output by using inputs more than
twice. Thus, LTC increases more than the increase in output. As a result, LAC increases.

Long-Run Marginal Cost:

Long-run marginal cost shows the change in total cost due to the production of one more unit of
commodity. According to Robert Awh, “Long-run marginal cost curve is that which shows the
extra cost incurred in producing one more unit of output when all inputs can be changed.”

LMC = ∆LTC / ∆ Q
Where

LMC = Long run Marginal Cost

∆LTC = Change in Long-Run Total Cost

∆Q = Change in Output

Relationship between LAC and SAC:

The relationship between LAC and SAC can be explained with the help of Fig. 18.

(1) Representation:
SAC represents the costs of a single plant, whereas LAC represents the costs of different plants.

(2) Shape:
Like SAC, LAC is also U-shaped but it is relatively flatter. The U-shape of LAC is less
pronounced as compared to SAC. It indicates that in the long run, increase or decrease in costs is
relatively less. It is so because LAC represents the minimum average cost of different quantities
of output so there exists less possibilities of fluctuations.
(3) LAC does not Exceed SAC:
LAC cannot be more than SAC. It is so because LAC is tangent to SAC

(4) LAC Not Tangent to all SAC at their minimum points:

Except to one SAC curve, LAC is not tangent to SAC curve at their minimum point. It will be
tangent to that SAC curve at its minimum point which coincides with the minimum point of
LAC.

Relation between LMC and LAC:

Generally, the relation between long-run marginal cost and long run average cost is similar to
that of what it is in short run AC and MC. But the only difference in LAC and LMC is that long
run marginal and average costs are more flatter than that of SAC and SMC. It is so because in the
long run all factors are variable. It can be shown with the help of a figure 19.
In Figure 19 when LAC is falling, LMC also falls but the fall in LMC is greater than that of
LAC. At a minimum point i.e. E, LMC is equal to LAC. In the same fashion when LAC raises
LMC also rises. But the increase in LMC is more than the increase in LAC.