THEORY OF PRODUCTION AND COST

Chapter 3 :
UNIT 2: THEORY OF COST

COST CONCEPTS
Accounting Costs and Economic costs: An entrepreneur has to pay
price for the factors of production which he employs for
production. He thus pays wages to workers employed, prices for
the raw materials, fuel and power used, rent for the building he
hires and interest on the money borrowed for doing business. All
these are included in his cost of production and are termed as
accounting costs. Accounting costs relate to those costs which
involve cash payments by the entrepreneur of the firm. Thus,
accounting costs are explicit costs and includes all the payments and charges made by the entrepreneur to the
suppliers of various productive factors. Accounting costs are expenses already incurred by the firm.
Accountants record these in the financial statements of the firm.
However, it generally happens that an entrepreneur invests a certain amount of capital in his business. If the
capital invested by the entrepreneur in his business had been invested elsewhere, it would have earned a
certain amount of interest or dividend. Moreover, an entrepreneur may devote his time to his own work of
production and contributes his entrepreneurial and managerial ability to do business. Had he not set up his
own business, he would have sold his services to others for some positive amount of money. Accounting costs
do not include these costs. These costs form part of economic cost. Thus, economic costs include:
(1) the normal return on money capital invested by the entrepreneur himself in his own business;
(2) the wages or salary not paid to the entrepreneur, but could have been earned if the services had been
sold somewhere else. Accounting costs are also called explicit costs whereas the cost of factors owned by the
entrepreneur himself and employed in his own business is called implicit
costs. Thus, economic costs include both accounting costs and implicit
costs. Therefore, economic costs are useful for businessmen while making
decisions.
The concept of economic cost is important because an entrepreneur must cover his economic
cost if he wants to earn normal profits. Normal profit is part of implicit
costs. If the total revenue received by an entrepreneur just covers both
implicit and explicit costs, then he has zero economic profits. Super normal
profits or positive economic profits (abnormal profits) are over and above
these normal profits. In other words, an entrepreneur is said to be
earning positive economic profits (abnormal profits) only when his revenues
are greater than the sum of his explicit costs
and implicit costs.
Outlay costs and Opportunity costs: Outlay costs involve actual
expenditure of funds on, say, wages, materials, rent, interest, etc.
Opportunity cost, on the other hand, is concerned with the cost of
the next best alternative opportunity which was foregone in
order to pursue a certain action. It is the cost of the missed
opportunity and involves a comparison between the policy that was
chosen and the policy that was rejected. For example, the
opportunity cost of using capital is the interest that it can earn in
the next best use with equal risk.
A distinction between outlay costs and opportunity costs can be
drawn on the basis of the nature of the sacrifice. Outlay costs involve
financial expenditure at some point of time and hence are recorded
in the books of account. Opportunity cost is the amount or
PROF AKHILESH DAGA

subjective value that is foregone in choosing one activity over the next best alternative. It relates to sacrificed
alternatives; it is, in general not recorded in the books of account.
The opportunity cost concept is generally very useful for business managers and therefore it has to be
considered whenever resources are scarce and a decision involving choice of one option over other(s) is
involved. e.g., in a cloth mill which spins its own yarn, the opportunity cost of yarn to the weaving department is
the price at which the yarn could be sold. This has to be considered while measuring profitability of the
weaving operations.
Direct or Traceable costs and Indirect or Non-Traceable costs: Direct costs are those which have direct
relationship with a component of operation like manufacturing a product, organizing a process or an activity
etc. Since such costs are directly related to a product, process or machine, they may vary according to the
changes occurring in these. Direct costs are costs that are readily identified and are traceable to a particular
product, operation or plant.
Indirect costs are those which are not easily and definitely identifiable in relation to a plant, product, process or
department. Therefore, such costs are not visibly traceable to specific goods, services, operations, etc.; but are
never the less charged to different jobs or products in standard accounting practice. Examples of such costs are
electric power and common costs incurred for general operation of business benefiting all products jointly.
Incremental costs and Sunk costs: Theoretically,
incremental costs are related to the concept of
marginal cost. Incremental cost refers to the
additional cost incurred by a firm as result of a
business decision. For example, incremental costs will
have to be incurred by a firm when it makes a decision
to change its product line, replace worn out
machinery, buy a new production facility or acquire a
new set of clients.
Sunk costs refer to those costs which are already
incurred once and for all and cannot be recovered.
They are based on past commitments and cannot be
revised or reversed if the firm wishes to do so. Eg: Textile Mill Plant cannot be used for other production.
Historical costs and Replacement costs: Historical cost refers to the cost incurred in the past on the
acquisition of a productive asset such as machinery, building etc.
Replacement cost is the money expenditure that has to be incurred for replacing an old asset. Instability in
prices make these two costs differ. Other things remaining the same, an increase in price will make
replacement costs higher than historical cost.
 THEORY OF PRODUCTION AND COST

Private costs and Social costs: Private costs are costs actually incurred or provided for by firms and are either
explicit or implicit. They normally figure in business decisions as they form part of total cost and are
internalised by the firm.
Social cost, on the other hand, refers to the total cost borne by the society on account of a business activity
and includes private cost and external cost. It includes the cost of resources for which the firm is not required
to pay price such as atmosphere, rivers, roadways etc. and the cost in terms of dis-utility created such as air,
water and environment pollution.
Fixed and Variable costs: Fixed or constant costs
are not a function of output; they do not vary
with output upto a certain level of activity. These
costs require a fixed expenditure of funds
irrespective of the level of output, e.g., rent,
property taxes, interest on loans and
depreciation when taken as a function of time
and not of output. However, these costs vary with
the size of the plant and are a function of capacity.
Therefore, fixed costs do not vary with the
volume of output within a capacity level.
Fixed costs cannot be avoided. These costs are fixed so long as operations are going on. They can be avoided
only when the operations are completely closed down. These are, by their very nature, inescapable or
uncontrollable costs. But, there are some costs which will continue even after the operations are suspended, as
for example, for storing of old machines which cannot be sold in the market. These are called shut down costs.
Variable costs are costs that are a function of output in the production period. For example, wages of casual
labourers and cost of raw materials and cost of all other inputs that vary with output are variable costs.
Variable costs vary directly and sometimes proportionately with output.

COST FUNCTION
Cost function refers to the mathematical relation between cost of a product and the various determinants of
costs. In a cost function, the dependent variable is unit cost or total cost and the independent variables are
the price of a factor, the size of the output or any other relevant phenomenon which has a bearing on cost,
such as technology, level of capacity utilization, efficiency and time period under consideration. Cost function
is a function which is obtained from production function and the market supply of inputs.

SHORT RUN TOTAL COSTS

Total, fixed and variable costs: There are some factors which can be easily adjusted with changes in the
level of output. A firm can readily employ more workers if it has to increase output. Similarly, it can purchase
more raw materials if it has to expand production. Such factors which can be easily varied with a change in the
level of output are called variable factors. On the other hand, there are some factors such as building, capital
equipment, or top management team which cannot be so easily varied. It requires comparatively longer time to
make changes in them. It takes time to install new machinery. Similarly, it takes time to build a new factory. Such
factors which cannot be readily varied and require a longer period to adjust are called fixed factors.

Corresponding to the distinction between variable and fixed factors, we distinguish between short run and
long run periods of time. Short run is a period of time in which output can be increased or decreased by
changing only the amount of variable factors such as, labour, raw materials, etc. In the short run, quantities
of fixed factors cannot be varied in accordance with changes in output. If the firm wants to increase output
in the short run, it can do so only by increasing the variable factors, i.e., by using more labour and/or by
buying more raw materials. Thus, short run is a period of time in which only variable factors can be varied,
while the quantities of fixed factors remain unaltered. On the other hand, long run is a period of time in
which the quantities of all factors may be varied. In other words, all factors become variable in the long run.
PROF AKHILESH DAGA

Fig. 5: Completely Fixed Cost Fig. 6: Completely Variable Cost

Thus, we find that fixed costs are those costs which are independent of output, These costs are a “fixed
amount” which are incurred by a firm in the short run, whether the output is small or large. Even if the firm
closes down for some time in the short run but remains in business, these costs have to be borne by it.
Fixed costs include such charges as contractual rent, insurance fee, maintenance cost, property taxes,
interest on capital employed, managers’ salary, watchman’s wages etc. The fixed cost curve is presented in
figure 5.

Variable costs, on the other hand are those costs which change with changes in output. These costs include
payments such as wages of casual labour employed, prices of raw material, fuel and power used,
transportation cost etc. If a firm shuts down for a short period, it may not use the variable factors of
production and therefore, will not therefore incur any variable cost.

Total Semi-Variable
Cost

Fig. 7: Semi Variable Cost

 THEORY OF PRODUCTION AND COST

There are some costs which are neither perfectly variable, nor absolutely fixed in relation to the changes in the
size of output. They are known as semi-variable costs. Example: Electricity charges include both a fixed charge
and a charge based on consumption.

There are some costs which may increase in a stair-step fashion, i.e., they remain fixed over certain range of
output; but suddenly jump to a new higher level when output goes beyond a given limit. E.g. Costs incurred
towards the salary of foremen will have a sudden jump if another foreman is appointed when the output
crosses a particular limit.

Fig. 8: A Stair-step Variable Cost

Fig. 9: Short run Total Cost Curves

Symbolically TC = TFC + TVC. We may represent total cost, total variable cost and fixed cost
diagrammatically.
Total fixed cost curve (TFC) is a horizontal straight line parallel to X-axis as TFC remains fixed for the whole
range of output. This curve starts from a point on the Y-axis meaning thereby that fixed costs will be incurred
even if the output is zero. The total variable cost curve starts from the origin because variable costs are zero
when the output is zero. It should be noted that the total variable cost initially increases at a decreasing rate
and then at an increasing rate with increases in output. This pattern of change in the TVC occurs due to the
operation of the law of increasing and diminishing returns to the variable inputs. Due to the operation of
diminishing returns, as output increases, larger quantities of variable inputs are required to produce the same
quantity of output. Consequently, variable cost curve is steeper at higher levels of output.
PROF AKHILESH DAGA

Short run average costs

Average fixed cost (AFC) : AFC is obtained by dividing the total fixed cost by the number of units of output
produced. i.e. AFC = TFC / Q, where Q is the number of units produced. Thus, average fixed cost is the fixed
cost per unit of output.
Average variable cost (AVC) : AVC = TVC / Q , Average variable cost normally falls as output increases
from zero to normal capacity output due to occurrence of increasing returns to variable factors. But beyond
the normal capacity output, average variable cost will rise steeply because of the operation of
diminishing returns (the concepts of increasing returns and diminishing returns have already been

discussed earlier). If we draw an average variable cost curve, it will first fall, then reach a minimum and then
rise. (Fig. 10)
Fig. 10: Short run Average and Marginal Cost Curves

Average total cost (ATC): Average total cost is the sum of average variable cost and average fixed cost. i.e.,
ATC = AFC + AVC. It is the total cost divided by the number of units produced, i.e. ATC = TC/Q. The
behaviour of average total cost curve depends upon the behaviour of the average variable cost curve and
the average fixed cost curve. In the beginning, both AVC and AFC curves fall, therefore, the ATC curve will also
fall sharply. When AVC curve begins to rise, but AFC curve still falls steeply, ATC curve continues to fall. This
is because, during this stage, the fall in AFC curve is greater than the rise in the AVC curve, but as output
increases further, there is a sharp rise in AVC which more than ousets the fall in AFC. Therefore, ATC curve
first falls, reaches its minimum and then rises. Thus, the average total cost curve is a “U” shaped curve. (Fig.
10)
Marginal cost: Marginal cost is the addition made to the total cost by the production of an additional
unit of output. In other words, it is the total cost of producing t units instead of t-1 units, where t is any
given number. For example, if we are producing 5 units at a cost of ` 200 and now suppose the 6th unit is
produced and the total cost is ` 250, then the marginal cost is ` 250 - 200 i.e., ` 50. And marginal cost will be
24, if 10 units are produced at a total cost of ` 320 [(320-200) / (10-5)]. It is to be noted that marginal cost is
independent of fixed cost. This is because fixed costs do not change with output. It is only the variable costs
which change with a change in the level of output in the short run. Therefore, marginal cost is in fact due to
the changes in variable costs. Symbolically marginal cost may be written as:
MC = Change in Total Cost / Change in Total Output
Marginal cost curve falls as output increases in the beginning. It starts rising after a certain level of output.
This happens because of the influence of the law of variable proportions. The MC curve becomes minimum
corresponding to the point of inflexion on the total cost curve. The fact that marginal product rises first,
reaches a maximum and then declines ensures that the marginal cost curve of a firm declines first, reaches
its minimum and then rises. In other words marginal cost curve of a firm is “U” shaped (see Figure 10).
The behaviour of these costs has also been shown in Table 2.
 THEORY OF PRODUCTION AND COST

Table 2 : Various Costs

Units of Total Total Total Average Average Average Marginal
output fixed cost variable cost cost fixed cost variable cost total cost cost
0 1000 0 1000 - - - -
1 1000 50 1050 1000.00 50.00 1050.00 50
2 1000 90 1090 500.00 45.00 545.00 40
3 1000 140 1140 333.33 46.67 380.00 50
4 1000 196 1196 250.00 49.00 299.00 56
5 1000 255 1255 200.00 51.00 251.00 59
6 1000 325 1325 166.67 54.17 220.83 70
7 1000 400 1400 142.86 57.14 200.00 75
8 1000 480 1480 125.00 60.00 185.00 80
9 1000 570 1570 111.11 63.33 174.44 90
10 1000 670 1670 100.00 67.00 167.00 100
11 1000 780 1780 90.91 70.91 161.82 110
12 1000 1080 2080 83.33 90.00 173.33 300
The above table shows that:
(i) Fixed costs do not change with increase in output upto a given level. Average fixed cost, therefore,
comes down with every increase in output.
(ii) Variable costs increase, but not necessarily in the same proportion as the increase in output. In the above
case, average variable cost comes down gradually till 4 units are produced. Thereafter it starts increasing.
(iii) Marginal cost is the additional cost divided by the additional units produced. This also comes down first
and then starts increasing.
Relationship between Average Cost and Marginal Cost: The relationship between marginal cost and
average cost is the same as that between any other marginal-average quantities. The following are the
points of relationship between the two.

(1) When average cost falls as a result of an increase in output, marginal cost is less than average cost.
(2) When average cost rises as a result of an increase in output, marginal cost is more than average cost.
(3) When average cost is minimum, marginal cost is equal to the average cost. In other words, marginal cost
curve cuts average cost curve at its minimum point (i.e. optimum point).
Figure 10 confirms the above points of relationship.

LONG RUN AVERAGE COST CURVE

As stated above, long run is a period of time during which the firm can vary all of its inputs; unlike short run in
which some inputs are fixed and others are variable. In other words, whereas in the short run the firm is tied
with a given plant, in the long run the firm can build any size or scale of plant and therefore, can move from
one plant to another; it can acquire a big plant if it wants to increase its output and a small plant if it wants
to reduce its output. The long run being a planning horizon, the firm plans ahead to build the most
appropriate scale of plant to produce the future level of output. It should be kept in mind that once the firm
has built a particular scale of plant, its production takes place in the short run. Briefly put, the firm actually
operates in the short run and plans for the long run. Long run cost of production is the least possible cost of
producing any given level of output when all individual factors are variable. A long run cost curve depicts
the functional relationship between output and the long run cost of production.
In order to understand how the long run average cost curve is derived, we consider three short run average
cost curves as shown in Figure 11. These short run average cost curves (SACs) are also called ‘plant curves’.
In the short run, the firm can be operating on any short run average cost curve, given the size of the plant.
Suppose that there are the only three plants which are technically possible. Given the size of the plant, the
firm will be increasing or decreasing its output by changing the amount of the variable inputs. But in the
PROF AKHILESH DAGA

long run, the firm chooses among the three possible sizes of plants as depicted by short run average curves
(SAC , SAC , and SAC3). In the long run, the firm will examine with which size of plant or on which short run

1 2
average cost curve it should operate to produce a given level of output, so that the total cost is minimum. It
will be seen from the diagram that up to OB amount of output, the firm will operate on the SAC , though it
1
could also produce with SAC . Up to OB amount of output, the production on SAC results in lower cost
2 1
than on SAC . For example, if the level of output OA is produced with SAC , it will cost AL per unit and if it is
2 1
produced w ith SAC it will cost AH and we can see that AH is more than AL. Similarly, if the firm plans to
2
produce an output wh ich is larger than OB but less than OD, then it will not be economical to produce on
SAC. For this, the firm will have to use SAC . Similarly, the firm will use SAC for output larger than OD. It is
1 2 3
thus clear that, in the long run, the firm has a choice in the employment of plant and it will employ that plant
which yields minimum possible unit cost for producing a given output.

Fig. 11 : Short run Average Cost Curves Fig. 12 : Long run Average Cost
Curves
Suppose, the firm has a choice so that a plant can be varied by infinitely small gradations so that there are
infinite number of plants corresponding to which there are numerous average cost curves. In such a case
the long run average cost curve will be a smooth curve enveloping all these short run average cost curves.
As shown in Figure 12, the long run average cost curve is so drawn as to be tangent to each of the short
run average cost curves. Every point on the long run average cost curve will be a tangency point with some
short run AC curve. If a firm desires to produce any particular output, it then builds a corresponding plant
and operates on the corresponding short run average cost curve. As shown in the figure, for producing
OM, the corresponding point on the LAC curve is G and the short run average cost curve SAC 2 is tangent
to the long run AC at this point. Thus, if a firm desires to produce output OM, the firm will construct a plant
corresponding to SAC2 and will operate on this curve at point G. Similarly, the firm will produce other levels of
output choosing the plant which suits its requirements of lowest possible cost of production. It is clear from
the figure that larger output can be produced at the lowest cost with larger plant whereas smaller output can
be produced at the lowest cost with smaller plants. For example, to produce OM, the firm will be using SAC2
only; if it uses SAC3, it will result in higher unit cost than SAC2. But, larger output OV can be produced most
economically with a larger plant represented by the SAC3. If we produce OV with a smaller plant, it will result
in higher cost per unit. Similarly, if we produce larger output with a smaller plant it will involve higher costs
because of its limited capacity.
It is to be noted that LAC curve is not tangent to the minimum points of the SAC curves. For outputs larger
than OQ the firm will construct a plant and operate it beyond its optimum capacity. “OQ” is the optimum
output. This is because “OQ” is being produced at the minimum point of LAC and corresponding SAC i.e.,
SAC4. Other plants are either used at less than their full capacity or more than their full capacity. Only SAC4 is
being operated at the minimum point.
The long run average cost curve is often called as ‘planning curve’ because a firm plans to produce any
output in the long run by choosing a plant on the long run average cost curve corresponding to the given
output. The long run average cost curve helps the firm in the choice of the size of the plant for producing a
specific output at the least possible cost.
Explanation of the “U” shape of the long run average cost curve: As has been seen in the diagram LAC
curve is a “U” shaped curve. This shape of LAC curve has nothing to do with the U shaped SAC which is due
to variable factor ratio because in the long run all factors are variable. U shaped LAC arises due to returns to
 THEORY OF PRODUCTION AND COST

scale. As discussed earlier, when the firm expands, returns to scale increase. After a range of constant returns
to scale, the returns to scale finally decrease. On the same line, the LAC curve first declines and then finally
rises. Increasing returns to scale cause fall in the long run average cost and decreasing returns to scale result
in rise in long run average cost. Falling long run average cost and increasing economies of scale result from
internal and external economies of scale and rising long run average cost and diminishing returns to scale
result from internal and external diseconomies of scale. (Economies of scale will be discussed in the next
section.)
The long run average cost curve initially falls with increase in output and after a certain point it rises making a
boat shape. The long-run average cost (LAC) curve is also called the planning curve of the firm as it helps in
choosing an appropriate a plant on the decided level of output. The long-run average cost curve is also called
“Envelope curve”, because it envelopes or supports a family of short run average cost curves from below.
The above figure depicting long-run average cost curve is arrived at on the basis of traditional economic
analysis. It is flattened ‘U’ shaped. This type of curve could exist only when the state of technology remains
constant. But, empirical evidence shows modern firms face ‘L-shaped’ cost curve over a considerable
quantity of output. The L-shaped long run cost curve implies that initially when the output is increased due
to increase in the size of plant (and associated variable factors), per unit cost falls rapidly due to economies
of scale. The long-run average cost curve does not increase even after a sufficiently large scale of output as
it continues to enjoy economies of scale.

ECONOMIES AND DISECONOMIES OF SCALE

The Scale of Production
Production on a large scale is a very important feature of modern industrial society. Large-scale production
offers certain advantages which help in reducing the cost of production. Economies arising out of large-scale
production can be grouped into two categories; viz., internal economies and external economies. Internal
economies arise purely due to endogenous factors relating to efficiency of the entrepreneur or his
managerial talents or the type of machinery used or the marketing strategy adopted. These economies arise
within the firm and are available exclusively to the expanding firm. On the other hand, external economies
are the benefits accruing to each member firm of the industry as a result of expansion of the industry.
Internal Economies and Diseconomies: We saw that returns to scale increase in the initial stages and after
remaining constant for a while, they decrease. The question arises as to why we get increasing returns to
scale due to which cost falls and why after a certain point we get decreasing returns to scale due to which
cost rises. The answer is that initially a firm enjoys internal economies of scale and beyond a certain limit it
suffers from internal diseconomies of scale. Internal economies and diseconomies are of the following main
kinds:
(i) Technical economies and
diseconomies: Large-scale
production is associated with
economies of superior
techniques. As the firm increases
its scale of operations, it
becomes possible to use more
specialised and efficient form of
all factors, specially capital
equipment and machinery.
However, beyond a certain point,
a firm experiences net
diseconomies of scale. This
happens because when the firm
has reached a size large enough
to allow utilisation of almost all
the possibilities of division of
labour and employment of more
PROF AKHILESH DAGA

efficient machinery, further increase in the size of the plant will bring about high long-run cost
because of difficulties of management. When the scale of operations becomes too large, it becomes
difficult for the management to exercise control and to bring about proper coordination.
Eg. Blood Bank
(ii) Managerial economies and diseconomies: Managerial economies refer to reduction in managerial costs.
When output increases, specialisation and division of labour can be applied to management. It becomes
possible to divide its management into specialised departments under specialised personnel, such as
production manager, sales manager, finance manager etc. If the scale of production increases further,
each department can be further sub-divided; for e.g. sales can be split into separate sections such as for
advertising, exports and customer service. Since individual activities come under the supervision of
specialists, management’s efficiency and productivity will greatly improve.
However, as the scale of production increases beyond a certain limit, managerial diseconomies set
in. Communication at different levels such as between the managers and labourers and among the
managers become difficult resulting in delays in decision making and implementation of decisions
already made. Management finds it difficult to exercise control and to bring in coordination among
its various departments. The managerial structure becomes more complex and is affected by greater
bureaucracy, red tapism, lengthening of communication lines and so on.
Eg. Yo Bykes
(iii) Commercial economies and diseconomies: Production of large
volumes of goods requires large amount of materials and
components. A large firm is able to place bulk orders for
materials and components and enjoy lower prices for them.
Economies can also be achieved in marketing of the product. If
the sales staff is not being worked to full capacity, additional output
can be sold at little or no extra cost. Moreover, large firms can
benefit from economies of advertising. As the scale of production
increases, advertising costs per unit of output fall. In addition, a large firm may also be able to sell its
by-products or process it profitably; something which might be unprofitable for a small firm. There are
also economies associated with transport and storage.
These economies become diseconomies after an optimum scale. For example, advertisement
expenditure and other marketing overheads will increase more than proportionately after the optimum
scale.
Eg. Force Motors (Force One) Amitabh Bacchan
(iv) Financial economies and diseconomies: A large firm has
advantages over small firms in matters related to procurement
of finance for its business activities. It can, for instance, offer
better security to bankers and avail of advances with greater
ease. On account of the goodwill enjoyed by large firms,
investors have greater confidence in them and therefore would
prefer their shares which can be readily sold on the stock
exchange. A large firm can thus raise capital at lower cost.
However, these costs of raising finance will rise more than
proportionately after the optimum scale of production. This may
happen because of relatively greater dependence on external
finances.
Eg. Mukesh Bhai
(v) Risk bearing economies and diseconomies: It is said that a large business with diverse and multi-
production capability is in a better position to withstand economic ups and downs, and therefore, enjoys
economies of risk bearing. However, risk may increase if diversification, instead of giving a cover to
economic disturbances, increases these.
External Economies and Diseconomies: External economies and diseconomies are those economies and
diseconomies which accrue to firms as a result of expansion in the output of the whole industry and they
 THEORY OF PRODUCTION AND COST

are not dependent on the output level of individual firms. They are external in the sense that they accrue
to firms not out of their internal situation but from outside i.e. due to expansion of the industry. These are
available to one or more of the firms in the form of:
1. Cheaper raw materials and capital equipment: The expansion of an industry may result in exploration
of new and cheaper sources of raw material, machinery and other types of capital equipments. Expansion
of an industry results in greater demand for various kinds of materials and capital equipments required
by it. The firm can procure these on a large scale at competitive prices from other industries. This reduces
their cost of production and consequently the prices of their output.
2. Technological external economies: When the whole industry expands, it may result in the discovery
of new technical knowledge and in accordance with that, the use of improved and better machinery
and processes than before. This will change the technical co-efficient of production and enhance
productivity of firms in the industry and reduce their cost of production.
3. Development of skilled labour: When an industry expands in an area, the labourers in that area are well
accustomed with the different productive processes and tend to learn a good deal from experience. As
a result, with the growth of an industry in an area, a pool of trained labour is developed which has a
favourable effect on the level of productivity and cost of the firms in that industry.
4. Growth of ancillary industries: Expansion of industry encourages the growth of a number of ancillary
industries which specialise in the production and supply of raw materials, tools, machinery, components,
repair services etc. Input prices go down in a competitive
market and the benefits of it accrue to all firms in the
form of reduction in cost of production. Likewise, new
units may come up for processing or recycling of the
waste products of the industry. This will tend to reduce
the cost of production in general.
5. Better transportation and marketing facilities: The expansion of an industry resulting from entry of new
firms may make possible the development of an efficient transportation and marketing network. These
will greatly reduce the cost of production of the firms by avoiding the need for establishing and running
these services by themselves. Similarly, communication systems may get modernised resulting in better
and speedy information dissemination.
6. Economies of Information: Necessary information regarding technology,
labour, prices and products may be easily and cheaply made available to the
firms on account of publication of information booklets and bulletins by industry
associations or by governments in public interest.
External diseconomies are disadvantages that originate outside the firm, especially in the input markets. An
example of external diseconomies is rise in various factor prices. When an industry expands the requirement
of various factors of production, such as raw materials, capital goods, skilled labour etc increases. Increasing
demand for inputs puts pressure on the input markets. This may result in an increase in the prices of factors of
production, especially when they are short in supply. Moreover, too many firms in an industry at one place
may also result in higher transportation cost, marketing cost and high pollution control cost. The government
may also, through its location policy, prohibit or restrict the expansion of an industry at a particular place.

SYNOPSIS:
 Accounting costs are explicit costs and includes all the payments and charges made by the entrepreneur to
the suppliers of various productive factors.
 Economic costs take into account explicit costs as well as implicit costs. A firm has to cover its economic
cost if it wants to earn normal profits.
 Outlay costs involve actual expenditure of funds.
 Opportunity cost is concerned with the cost of the next best alternative opportunity which was foregone
in order to pursue a certain action.
 Direct costs are those which have direct relationship with a component of operation. They are readily
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identified and are traceable to a particular product, operation or plant.

 Indirect costs are those which cannot be easily and definitely identifiable in relation to a plant, product,
process or department. They not visibly traceable to any specific goods, services, processes, departments or
operations.
 Incremental cost refers to the additional cost incurred by a firm as a result of a business decision.
 Sunk costs are already incurred once and for all, and cannot be recovered.
 Historical cost refers to the cost incurred in the past on the acquisition of a productive asset.
 Replacement cost is the money expenditure that has to be incurred for replacing an old asset.
 Private costs are costs actually incurred or provided for by firms and are either explicit or implicit.
 Social cost, on the other hand, refers to the total cost borne by the society on account of a business
activity and includes private cost and external cost.
Economists are generally interested in two types of cost functions; the short run cost function and the long
run cost function.
➢ Short-run cost functions are
 Fixed or constant costs which are not a function of output. These are inescapable or uncontrollable.
 Variable costs are a function of output in the production period.
 Short run is a period of time in which output can be increased or decreased by changing only the amount
of variable factors such as, labour, raw material, etc. ,
 Long run is a period of time in which the quantities of all factors may be varied. In other words, all factors
become variable in the long run.
 Stair-step costs remain fixed over certain range of output; but suddenly jump to a new higher level
when output goes beyond a given limit.
 Total cost of a business is defined as the actual cost that must be incurred for producing a given quantity
of output.
 AFC is obtained by dividing the total fixed cost by the number of units of output produced.
 Average variable cost is found out by dividing the total variable cost by the number of units of output
produced.
 Average total cost is the sum of average fixed cost and average variable cost.
 Marginal cost is the addition made to the total cost by the production of an additional unit of output.
➢ Long run cost of production is the least possible cost of producing any given level of output when all
individual factors are variable.
 A long run cost curve depicts the functional relationship between output and the long run cost of
production.
 The long run average cost curve, often called a planning curve, is so drawn as to be tangent to each of
the short run average cost curves.
 LAC curve is not tangent to the minimum points of the SAC curves.
➢ Economies of scale are of two kinds - external economies of scale and internal economies of scale.
 External economies of scale accrue to a firm due to factors which are external to a firm.
 Internal economies of scale accrue to a firm when it engages in large scale production.
 Increase in scale, beyond the optimum level, results in diseconomies of scale.
 THEORY OF PRODUCTION AND COST

SELF - EVALUATION
1. The marginal, average, and total product curves encountered by the firm producing in the short run
exhibit all of the following relationships except:
(a) when total product is rising, average and marginal product may be either rising or falling.
(b) when marginal product is negative, total product and average product are falling.
(c) when average product is at a maximum, marginal product equals average product, and total product
is rising.
(d) when marginal product is at a maximum, average product equals marginal product, and total product
is rising.

2. Which of the following is the best definition of “production function”?

(a) The relationship between market price and quantity supplied.
(b) The relationship between the firm’s total revenue and the cost of production.
(c) The relationship between the quantities of inputs needed to produce a given level of output.
(d) The relationship between the quantity of inputs and the firm’s marginal cost of production.
3. Which of the following cost curves is never ‘U’ shaped?
(a) Average cost curve. (b) Marginal cost curve.
(c) Average variable cost curve. (d) Average fixed cost curve.
4. In the short run, when the output of a firm increases, its average fixed cost:
(a) increases. (b) decreases.
(c) remains constant. (d) first declines and then rises.
5. Which of the following is an example of “explicit cost”?
(a) The wages a proprietor could have made by working as an employee of a large firm.
(b) The income that could have been earned in alternative uses by the resources owned by the firm.
(c) The payment of wages by the firm.
(d) The normal profit earned by a firm.
6. Which of the following statements is true of the relationship among the average cost functions?
(a) ATC = AFC – AVC. (b) AVC = AFC + ATC.
(c) AFC = ATC + AVC. (d) AFC = ATC – AVC.
7. The positively sloped (i.e. rising) part of the long run average total cost curve is due to which of the
following?
(a) Diseconomies of scale. (b) Increasing returns.
(c) The firm being able to take advantage of large-scale production techniques as it expands its output.
(d) The increase in productivity that results from specialization
8. Economic costs of production differ from accounting costs of production because
(a) Economic costs include expenditures for hired resources while accounting costs do not.
(b) Accounting costs include opportunity costs which are deducted later to find paid out costs.
(c) Accounting costs include expenditures for hired resources while economic costs do not.
(d) Economic costs add the opportunity cost of a firm which uses its own resources.
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9. A firm producing 7 units of output has an average total cost of Rs.150 and has to pay
Rs. 350 to its fixed factors of production whether it produces or not.
How much of the average total cost is made up of variable costs?
(a) Rs. 200 (b) Rs. 50
(c) Rs. 300 (d) Rs 100
10. The average product of labour is maximized when marginal product of labour:
(a) equals the average product of labour. (b) equals zero.
(c) is maximized. (d) none of the above.

Answers:

1. (d) 2 (c) 3 (d) 4. (b) 5. (c)

6. (d) 7. (a) 8. (d) 9. (d) 10. (a)