UNIT-III

(Production and Cost Analysis)

MODULE- 3: COST OUTPUT RELATIONSHIP –II

CONTENTS

3.0: Objectives
3.01: Average fixed cost and output
3.02: Average Variable Cost and Output
3.03: Average cost and output
3.04: Marginal Cost and Output
3.05: Relationship between AC and MC
3.06: Long run Average Cost and Output
3.07: Cost functions and Estimation of TC,AFC,AVC,
AC, MC.
3.08: Cost Forecasting
3.09: Summary
3.10: References
3.11: Self assessment test.

3.0: Objectives:

The objective of this module is to discuss average cost and output

relationship in the short run and long run. After reading this
module you should be able to understand the relationship between:

Average fixed cost and output

Average variable cost and output
Average cost and output in the short run
Long run average cost and output.
3.01: Average Fixed Cost (AFC) and Output (Q):

Business firm can arrive at average fixed cost i.e. fixed cost per
unit, by dividing total fixed cost with the level of output.

TFC
AFC = -----.
Q

If the TFC is Rs 1000 and the level of output is 100 units, then
AFC is Rs.10. The basic feature of AFC is that it decreases
continuously as the volume of output increases. This is due to the
fact that TFC remains constant in the short-run .

Y
GRAPH-1
AFC

AFC

X
Quantity

3.02: Average Variable Cost (AVC) and Output (Q):

We can arrive at average fixed cost by dividing total variable cost

(TVC) with the level of output.

TVC
 AVC = -----
-
Q

If the total variable cost of producing 100 units of output is Rs

2000, then the AVC is Rs 20. The basic feature of AVC is that, in
the beginning, it decreases as the level of output increases. But
after certain level of output, it increases due to diminishing returns
experienced by the business firm.

GRAPH-2

AVC
AVC

X
0
Quantity

3.03: Average Cost (AC) and Output (Q):

We can arrive at average cost by adding together AFC and AVC at

any given level of output. For example to produce 100 units of
output, the AFC is Rs 10 and the AVC is Rs 20. So that AC is Rs
30. In the beginning as output increases AC decreases. Beyond a
level of output as output increases AC decreases.
GRAPH-3

AC
AC

0 Quantity

3.04: Marginal Cost (MC):

The change in total cost as a result of an additional one unit

increase in output is called marginal cost. In the short marginal
cost depends on AVC. We can calculate marginal cost as:

MCn =
TCn - TCn -1.

Here MCn is the marginal cost of nth unit of output. TCn is the
total cost of ‘n’ units of output. TCn -1 is the total cost of n-1 units
of output. For example TCn is Rs 100 where as TCn-1 is Rs 87.
MCn is Rs 13. In the beginning, as output increases MC decreases.
After certain level of output, MC increases. Marginal cost i.e. the
cost of producing an additional unit plays an important role in
decision making by business firms.
 Y
GRAPH-4
MC

MC

X
Quantity

3.05: Relationship between AC and MC:

As the volume of output increases AC and MC decrease. But the

rate of fall in MC is more than the rate of fall in AC. On the other
hand as AC increases MC also increases. But the rate of increase in
MC is more than the rate of increase in AC. According to
numerical example given in the next page, as output increases from
1 unit to 5units AC decreased from Rs130 to Rs 32.40. On the
other hand MC decreased from Rs.30 to Rs.2. When out increased
from 8 units to 10 units, AC increased from Rs 32.50 to Rs 40.
Where as MC increased from Rs 55 to 75.

GRAPH-5

MC AC
We can understand the relationship between output and AFC,AVC,
AC,MC with the following example.

Output TFC TVC TCs

AFC AVC AC
MC

0 100 --- 100

Infinite nil infinite --
-
1 100 30 130
100.0 30.0 130.0
30
2 100 45 145
50.0 22.5 72.50
15
3 100 55 155
33.3 18.33 51.63
10
 4 100 60 160
25.0 15.0 40.00
5
5 100 62 162
20.0 12.40 32.40
2
6 100 78 178
16.66 13.0 29.66
16
7 100 105 205
14.30 15.0 29.30
27
8 100 160 260
12.50 20.0 32.50
55
9 100 225 325
11.10 25.0 36.10
65
10 100 300 400
10.0 30.0 40.0
75

3.06: Long run Average Cost (LAC) and Output (Q):

In the long run a business firm can make perfect adjustment in its
production capacity through introducing changes in fixed factors of
production along with variable factors of production. The shape of
long run average cost curve depends on the nature of economies of
scale experienced by the business firm. The derivation of LAC
curve is shown below.

GRAPH-6

SAC1 SAC
SAC3

R LAC Curve
According to the above graph, SAC1, SAC2, SAC3 are short run
average cost curves, which represent cost of production or the state
of technology in that short period. A firm can produce OQ1 level
of output with Q1M average cost in short period -1. If there is
increase in the demand for the product, with SAC1 technology the
average cost of producing OQ2 is Q2S. If the firm operates in the
long run, it can adopt new technology represented by SAC2. With
SAC2, firm can produce OQ2 output with average cost Q2N. This
is less than Q2S. Firm can expand its output to OQ3 at which the
average cost is Q3T. If the firm produces OQ4, with SAC2
technology, the average cost is Q4R. By going advanced
technology such as SAC3, it can produce OQ4 with OH average
cost. The thick line which touches all the short run average cost
curves is known as long run average cost curve (LAC curve). The
minimum point of LAC curve is touching the minimum point of
SAC2 at point T. This indicates that in the long run a business firm
can produce OQ3 volume of output with the minimum average
cost Q3T. Since OQ3 level of output corresponds to minimum
average cost in the long run, it ( OQ3) is called as optimum output.
A firm which produces output corresponds to minimum average
cost in the long run is called as an ‘optimum firm’ or most efficient
firm. LAC curve also known as planning curve or envelope curve.

3.07: Cost functions and Estimation of AFC, AVC, AC, and

MC:

Linear cost function:

Y = a+ b X. In this function Y is the total cost, ‘a’ is the total fixed

cost and b X is the total variable cost.

a
AFC = ----
X

bX
AVC = ----- = b
X

a bX
AC = --- + -----
X X

NOTE-1

AC = +b

MC = = b
Given the estimated cost function Y = 100 + 20X, at 100 units of
output
Y i.e total cost = Rs 2100, TFC = Rs 100, TVC = Rs 2000
AFC = Rs 1, AVC =20, MC = Rs 20, AC = Rs 21

Quadratic cost function

Y = a + bX + C X2

AC = = + +

= + b + CX

AFC =

AVC = b + CX

MC = = b+2CX

Given the estimated cost function Y = 5000 + 250X + 1 X2, at 100

units of output

Y = Rs 40,000
AFC = Rs 50
AVC = Rs 350
AC = Rs 400
MC = Rs 450

Cubic cost function:

Y = a +bX – C X2 + dX3

AC = = + - +
AFC =

AVC = b – CX + dX2

MC = = b-2cx+3dx2

Given the cost function Y=18+30X-10X2+x3, at 100 units of

output

Y = Rs 903018
AC = Rs 9030.18
AFC = Rs 0.18
AVC = Rs 9030
MC = Rs 31970

Cost Forecasting
Based on the estimated cost functions, we can forecast the TC, AC,
AFC, and MC at different levels of output
Given the linear cost function
Y = 100+20X, it is possible to forecast Y at different levels of
output.
For example

Output(X) (Units) Total Cost

(Rs)
100 2100
200 4100
300 6100
400 8100
500
10100
In the same way using quadratic and cubic cost functions, it is
possible to forecast total cost, AFC, AVC, AC and MC at different
levels of output.

ACTIVITY-1

1. Given the estimated cost function Y = 6000 + 200 X – 0. 2 X2,

estimate the TC, AFC, AVC, MC at the level of output 200 units
and 300 units. Observe, is there any change in average cost
structure as a result of increase in output.

3.09: Summary:
In this module an attempt has been made to discuss the cost output
relationship in terms of AC, AFC,AVC, MC AND LAC. As output
increases, AFC decreases continuously. AFC curve is a rectangular
hyperbola. As output increases, in the beginning AVC decreases.
Beyond a level of output AVC increases. AC also decreases in the
beginning. Later on it takes an upward movement. MC also
decreases in the beginning and later on it increases. AVC, AC, MC
curves are ‘U’ shaped. LAC curve shows the nature of average cost
in the long run. It is possible to have an idea about optimum firm
with the help of LAC curve. Managers’ generally use different cost
functions based on data availability, to estimate cost output
relationship and to forecast the cost of production corresponding to
different level of planned output.

3.10: References:
1. P.L.Mehta : Managerial Economics- Analysis,Problems and
Cases.
2. Dominick Salvatore : Managerial Economics in a global
economy
3. R.L Varshney and Maheswari : Managerial Economics.
4. H.Craig Petersen and Cris Lewis: Managerial Economics

3.11: Self assessment test:

1. Discuss the relationship between output and AFC, AVC, AC,
MC in the short run.