CHAPTER

Cost Theory and Analysis

Preview
Speial Topics in Cost Theory
The Economic Concept of Cost ProfitContribution Analyses
Opportunity Costs Operating Leverage
Explicit and Implicit Costs Estimating Cost Functions
Normal Profit and Costs Short-Run Cost Functions
Marginal, Incremental, and Sunk Costs Long-Run Cost Functions
The Cost of Long-Lived Assets
Production and Cost
Summary
Discu<sion Questions
Short-Run Cost Functions
Problems
Long-Run Cost Functions

PREVIEW

The theory of cost, together with the principles of demand and production, constitute three of
the basic areas of managerial economics. Few significant resource-allocation decisions are
made without a thorough analysis of costs. For the profit maximizing firm. the decision to add
anew product is made by comparing additional revenues to the additionai costs associated
with that new product. Similarly, decisions on capital investment (e.g. new machinery or &
warehouse) are made by comparing the rate of return on the investment with the opportunity
cost of the funds used to make the capital acquisitions. Costs are also important in the non
profit sector. For example, to obtain funding for a new dam, the Department of Irigation must
demonstrate that the value of the benefits of the dam, such as flood control and water suppiv.
exceeds the cost of the project.
This chapter focuses on those priniples of cost theory integral to decisions about optimal
price and output rates. In contrast to the traditional approach to costs where historie cOst data
are typically used, the economist focuses on the concept of opportunity cost. In the first sec
tion, this economic concept of cost is developed. Next, the link between productioa theory and
the principles of cost is developed. It is shown that efficient resource combinations for pru
ducing speciicrates of output can be translated into cost data. Cost functions are then devel
oped for both the short-run and long-run cases. Then, two special cost-related topics are dis
cussed-profit contribution analysis and the principle of operating leverage. Finally, the
methods used to empirically estimate cost functions are developed and applied.
 CHAPTE

CONCEPT OF COST
THE ECONOMIC the term bedefined
Because the termcosthas
different meanings,it is essential
tends to
that
locIS On the
precisey
cxpliitand hitorit
definition
the traditional
Assuggested previously, ccononmic approach to cost emphasIe% opportunity cost
dimensionof cost. Incontrast, the both explicit and implicit costs.
includes
rather than historical cOst and
Opportunity Costs
the managerial economist is the concept of opportunity cost, The best mea
Fundamentalto production iswhat must be givenup to ob
a consumer product or a factor of
Sure ofcost of who pays Rs. 50 for dinner may have to
tan that product or factor. For example, aconsumer
additional secretary may have to forgo
give up going toa movie. The manager who hires an s0Ciety ol
hiring an additional clerk in the shipping department, Alternatively, the cost to cquip
adding another soldier tothe army is not only the rupee outlay for salary, uniforms, and
worker. In
ment but also the foregone output this individual would bave produced as a civilian
general, the opportunity cost of anydecision is the value of the next best alternative that must
be foregone.
Inorder to maximize the value of the firm,the effective manager mustview costs from this
perspective. For example, budgeting is fundamental to most organizations. The very nature of
that process implies that opportunity costs are incurred whenever budget resources are allo
cated to one department rather than another. Areallocation from the production department
to the research and development group may result in new and better products in the future but
the cost is lower production and profit for the current period. Obviously, such adecision should
be made only when management is convinced that the potential for even greater profit in the
future outweighs the reducedprofit for the current periodso that shareholder value wil be en
hanced.

Explicit and Implicit Costs

Sometimes, the full opportunity cost of abusiness decision is not accounted for because of fail
ure to include implicit costs. In general,explicit costs are those costs that involve an actual pay
ment toother parties, while implicit costs represent the value of foregone opportunities but do
not involve an actualcashpayment. Implicit costs are just as importantas explicit costs butmay
be neglected because they are not as obvious. For example, amanager who runs his own busi
ness forgoes the salary that could have been earned by him while working for someone else.
This implicit cost generally is not reflected in accounting statements, but rational decision mak
ingrequires that it be considered.

TABLE 7.1 Traditional versus Economic Approach to DeterminingE

ProfitPer Unit of Output for aBakery
Traditional Economic
Approach Approach
Price of finished product (Rs.) 20 20
Less: Cost of wheat input 3 6
Less: Other costs 15 15
Net profit per unit 2 -1
 224
PART III Production and Costs
To see how reliance on
historical rather than opportunity cost can lead to a poor decision,
COnstder the following examplc. A bakerv bas an inventory of wheat that was purchased at Rs.
per KgS but is now worth Rs. 6 per kes. The firm is considering using, this wheat to make a new
WiOe wheat jumbo bread that willbe sold to stores for Rs. 20 per unit. Suppose that one kgs of
weat is required to make each unit of this new type of jumbo bread, while Rs. 15 of labor, en.
ergy, and other costs per unit of output are also incurred.
Ihe traditional approach to cost would value the wheat input at Rs. 3 per kgs and estimate
profit on the finished product to be Rs. 2 per unit,as shown in Table 7.1. In contrast, the eco.
nomic approach to cost would value the wheat at the current market price of Rs. 6 per kgs. An
alyzing the decision to produce the new bread from this approach indicates a loss of Re. I per
unit of output. Note that the only difference in the two approaches is the value placed on the
Inventory of wheat.
Consider the same problem in another way. The money spent on the inventory of wheatis
gone; now, how can the firm best use the inventory? That is, what will be the net revenue per
kgs if the new bread is manufactured compared to selling the wheat inventory in the market
without processing it? If the decision is made to manufactuze the bread, the firm willhave a
net cash flow of Rs. 5 per kgs, that is, the Rs. 20 selling price less Rs. 15 of other costs. In con
trast, if the wheat is simply sold rather than processed, the firm would receive a net cash flow
of Rs. 6per kgs. Clearly, selling the wheat rather than producing the bread is the better alter
native because profits willbe greater. The example demonstrates that the use of the correct
cost concept is essential to sound decision making. It also suggests that costs incurred in the
past generaliy are irrelevant when making decisions.
Normal rofit and Costs
As willbe demonstrated in chapter 9, in industries characterized by substantial competition,
principles of economies predict that profits will be driven to zero in the long run. While this
sounds inconsistent with the conventional idea that most firms report a profit each year, the
apparent nconsistency disappears when the concepts of economic costs and economic profits
are understood and used to measure revenues and costs.
Because all opportunity costs must be accounted for, the proper concept of cost includes
a normal payment to all inputs, including managerial and entrepreneurial skills and capital
Supplied by the owners of the firm.A normal return to management or capital is the minimum
payment necessary to keep those resources from moving to some other firm or industry. Thus,
cost includes a normal rate of profit. The term economic profit refers to profit in excess of these
normal returns. That is, economic profit is detined as revenue lessall economic costs.
Afirm carning zero economic profitgenerally would show a positive profit on the income
statement prepared by itsaccountants. This is because the normal returns to entrepreneurial
skill and capital supplied by the owners are not included as costson that statement. Unless oth
erwise indicated, the term cost will refer to all explicit and implicit costs, and the term profit
willrefer to revenues after all economic costs, including the normal returns just described, have
been subtracted.

Marginal, ncremental, and Sunk Costs

Clearly, cost is an important consideration in decision making. But as the bakery example
showed, it is essential that only those costs that matter be considered. Three types of cost need
to be identified: sunk costs, marginal costs, and incremental costs.
 the fast that tnst
have fvern made in
8} fenhtmes that payments

fox Pe per month leatiy the frm shout

s*R the spcr ht finde that thr be et oofie: s gre ater than fhe adsfrai cst
TA tha! ffe thr additioma teyenHe Rs )per onth

ente fhe
R The decsrn to rent the whtehser seya(r in retrpect, the deciri tn
afd neriteie
RRr wB* # mtake u! the coete ac/x iated with that deisien afe unk
Vant in the decikion about what to dey wnth thye watehRe
Marginal ost Tefers tn the change in totai cost assrnciated with a oge nit change in 3*
pt Ths concepl is integral to shott un decisons ahout profit max1mng rates of ratpt rof
CXamjle., in an automobile manufactuing plant the marginal cost of makng one aita!
CA pes production pernd would be the labor. materials, and energy costs d1rectly assoXated
Withthat extacar. In cont ast, thetecrm incremental cost rcfers to the total additional ct of
implementing a managcrial decision. The costs associated with add1ng a new product liE,
quiring a major conpetitor, or developing an in-house legal staff fali into the broader clas5 ot
Incremental costs. In ascnsc. marginal cost is that subcategory of incremental cost that reters
to the additional cOst associated with the decision to make
marginal variations in the rate of
output.
In the warehouse rental cxample,the only incremental costs the firm
icasing the property may be the cost of preparing and negotiating the faces when sub
rental agreement. Clearly, the Rs. 1,000 per month sunk cost is details of the new
not a component of incre
mental cost.It is essential that incremental cost
measurement be done carefuily so that al!
possibie additional costs are included, but costs that are sunk are not incuded.
The Cost of Long-Lived Assets
Another area where accounting and economic definitions of cost
as buildings, machinery, and other types of capital diverge is for assets such
years. These are referred to as long-lived assets. Theequipment that may last for a number of
periodic cost of these assets is to combine historicaltraditional approach to measuring the
cost and one of several depreciatiça
methods toassign part of the historical cost to each year of the
that the total expenses over that life will equal the defined life of the asset so
straight-line depreciation method, an asset costing historical cost. For example, using the
Rs. 1,000 and having a five-year life
Would be depreciated at the rate of Rs. 200 per year. Thus, the
exbausted entirely over this five-year period. The asset may havetotal historical cost will be
firm after this period, but this is not reflected in such an considerable value to the
tax guidelines and considerations dictate the decision onaccounting statement. Generally.
the depreciation method used.
This approach to cost measurement is adequate if the
method for reporting on the flow of funds into and out ofobjective
the
is to have an arbitrary
terval or to meet income tax regulations. However, as a tool forbusiness over some time in
ing, the approach is flawed. managerial decision mak
In contrast,the economic approach determines the cost as the
market value of the asset at the beginning and end of the period. If the difference between the
machine just discussed was Rs. 1,000 at the beginning of the year and Rs.market value of the
600 at the end, the
 26

ife depreciat thethod i

value cves time, imptying thist
thet

Key Concepte

* Roth explicit snd inphcit costs muet he contide redin deciaion making
*tceno profn is revenue minus all coste inclvding normal returns to mane ent
andcaptal
In general,onv incrementaland marginalcosts are re levant in decision making snk
covts are of litte ot no mportance
" The economic cOst of along lived asset during a period is the ch..nge in t market
value from the beginning to the end of the period.

PRODUCTION AND COST

A cost function relates cost to the rate of output. The basis for acost function is the produc
tion function and the prices of inputs. Recall from chapter 6 that the expansion path defines
the efficient combination of capital and labor input rates for producing any rate of output. Thus
the minimum costof agiven rate of output is found by multiplying the efficient rate of each
input by their respective prices and summing the costs. The combination of that cost and the
associated rate of output defines one point on the cost function.
Inchapter 6it was shown that the production function, Q = 100 KL",has an expansion
path K= (wir)L. Thus if the price of labor is 2and the price of capital is 1, the expansion path
would be K -2L, and the firm would expand by adding inputs at the rate of two units of cap
ital for each additional unit of labor. Table 7.2 shows a set of efficient labor -capital combina
tions, the rate of output associated with each combination, and the cost of those inputs.
Columns (3) and (6) represent the long-run totalcost schedule for this production function.
given that input prices are w= 2and r= 1.This schedule shows the total cost of producing var
ious rates of output. For example, the total cost of efficiently producing an output rate of 283
units per period is Rs. 8.That is, four units of capital at a price of Re. 1 per unit and two units

TABLE 7.2 Production and Cost Data

Cost (Rs.)
K Capital Labor Total
2 1 141 2 2 4
4 2 283 4 4
6 3 424 6 6 12
8 4 565 8 8 16
10 5 707 10 10 20
 Analysss
iAPTIR1 Con Theory and 22
ptoducing 424

2rehope, a empioyent rintrat

jhte of thr rHte f oitpt A vhe term kese om a
of sunk 1
T1HHm11hets th81 ma tesult in fiyrd (uxte ived coats fall inte the cátegrty
nature of the
AsHjrsted in chates 6. the length of the oner afing perind varies with fhe
businesAsmallhuonese may be abie tovary al inputs in amatier of day (onveriey. o
additional capacity to anucdeat genesat1ng facility could take years The length of ths pt
depends om the degree of assct specializatron, theeconomic hife of the assets, the tme neces
Narv to ordetand install new capitalcquipment, and the arnount of training that ahof require.
Axxet specalizatton refers to the number of uses of an asset For example, a nuclear gen
erator carn only be uNcd to gencratc clectricityin anuclcar power plant and is a very speciat
ized asset Thus itmight be difficult to scll that gencrator hecause only another nuciear power
piant could tuNe it Converscly, many trucks can be used to haul avariety of products and are
rather unspccial1zed asscts Ifafirm decides that onc of its trucks is no longer needed, it couid
casily be sold in thc market and its cost climinated.
Clearly. the longer the life of the asset, the longer the period defined as the short run.
Buildings and some types of machinery may have an economic life of many years. Once in
place, theircosts may be fixed for along period of time. Also, it may take months or even years
to order andinstall certain types of capital equipment and/or to develop aparticular set of
skills in labor. In such cases the firm may find that part of the cost of its productive capacity is
fixed for that period.

Key Concepts
" The long-run total cost of any rate of output is determined by the expansion path of
the firm(which relates output rates and efficient input combinations) and the prices
of the inputs.
" Ifone input is fixed, the costs associated with that input are called fixed costs, and the
firm is said to be operating in the short run. The costs associatedwith thc nonfixed in
puts are called variable costs.

SHORT-RUN COST FUNCTIONS

Managerial decision making is facilitated by information that shows the cost of each rate of
outpu:. Consider a production process that combines variable amounts of labor with afixed
capitalstock, say, 10 machines. In this process, the rate of production is changed by varying
the rate of labor input. Assume that the firm can vary the labor input freely at acost of
 uCHOn and Costs

TABLE7.3 Short-Run Production and Cost IData

Input Rate Rate Total Total
Fixed Varlable Total
Capital Labor usput Cost (Rs.) Cost (Rs.) Cost (R.)
10 0 1,000 1,000
10 2.00 1 1.(000 2(0 1.200
10 3.67 1,000 367 1.367
10 S.10 3 1,000 510 1,510
10 6.77 1,000 677 1,677
10 8.77 1,000 877 1.877
10 11.27 6 1,000 1,127 2,127
10 14.60 7 1,000 1,460 2,460
10 24.60 8 1,000 2.460 3,460

Rs 100 per unit of labor per period. Therefore, the expenditure for labor is the variable cost.
If the 10 machines are rented under a long-term lease at Rs. 100 per machine per produc
tion period, the fixed cost would be Rs. 1,000 per period.
Table 7.3 summarizes the relevant production and cost data for this production process,
and the data are shown graphically in Figure 7.1a. Note that fixed cost is indicated by a hori
zontal line; that is, this cost is constant with respect to output. The totalvariable cost function
(TVC) begins at the origin, increases at adecreasing rate up to an output rate between3 and
4, and then increases at an increasing rate. Total cost (TC) has the same shape as toial variable
cost but isshifted upward by Rs. 1,000, the amount of fixed cost. These functions relate an out
put rate to the total cost of producing that output rate.
Functions that indicate the cost per unit of output also can be determined.Often, these are
more useful for decision making than are total cost functions. This is because managers must
compare cost per unit of output to the market price of that output. Recall that market price is
measured per unit of output. By dividing atotal cost function by output, a corresponding per
unit cost function is determined. That is,
TC
AVERAGE TOTAL COST: AC= (7-1)
TVC
AVERAGE VARIABLE COST:AVC = (7-2)
TFC
AVERAGE FIXED COST:AFC= (7-3)

The marginal cost per unit of output (MC) is the change in total cost associated with aone-unit
change in output, that is,
ATC
MARGINAL COST: MC = (7-4)
 (HAPTER1(ot Thesry and Aralysis 229

Total fixed cost

7
Rate of output

(a) Totalcost functions

Cost per unit
(RsJQ)

Marginal cost

Average cost

Average variable cost

4 6 7
Rate of output

(b) Per unit cost functions

FIGURE7.! Short-Run Cost Functiona
230
PART III Production and Costs
TABLE 74 Per-Unit Cost Functions
Average Pixed Average Varlable Average Total Marginal
Cost (Rs.) Cost (Rs.) Cost (Rs.) Cost (Rs.)
Output (AFC) (AVC) (AC) (MC)

1,000 200 1.200 200

S00 184 684 167
333 170 503 143
4 250 169 419 167
200 175 375 200
167 188 355 250
7 143 209 351 333
125 307 432 1,000

the total
As is true of all associated total and marginal functions, marginal cost is the slope of
cost function.
total cost function.
Using calculus, marginal cost is determined as the first derivative of the
That is, if the total cost function is
TC =A0)
marginal cost would be

MC = d(TC) (7-5)
dQ
Based on the total cost functions in Table 7.3, data for each per-unit cost function are re
ported in Table 7.4 and shown graphically in Figure 7.1lb. The average total cost, average vari
able cost, and marginal cost functions are important in managerial decision making. In con
difference
trast, the average fixed cost function has little value for such decisions. Further, the
between average total cost and average variable cost is average fixed cost. Thus the AC and
AVC curves provide information on fixed cost per unit should such information be needed.
The per-unit cost functions for many production systems have the Ushape shown in Fig
ure 7.1b. At low rates of production, there is too little of the variable input relative to the fixed
input. As the variable input is increased, output rises rapidly, and the cost per unit falls. Initialy,
total cost increases but at a decreasing rate. This implies that marginal cost (the slope of totai
cost) is falling. Because of the law of diminishing marginal returns, additionalunits of the vari
able input result in smaller additions to output and ultimately marginal cost rises. When mar
ginal cost exceeds average cost, the average cost function begins to rise.
As is true of allmarginal and average functions, as long as marginal cost is below the av
erage cost curve, the average function will decline. When marginal is above average, the aver
age cost curve will rise. This implies that marginal cost intersects both the average total cost
end average variable cost functions at the minimum point of the average curves (points aanu
bin Figure 7.1b).
 Key (onept

*argihal e uni ie the chahge m ot si cost ax0ctated with a ne anit chnge in

RpU hat

cost and average variable cost functs

* Margnalcost intersects both the average total

LONG-RUN COST FUNCTIONS

operate in the short run but plan in the long run. At any point in timne, the frm has one
Firms production decisions must be made based on
or more fixed factors of production. Therefore, the scale of their operation in the long
short-run cost curves. However, most firms can change
to a preferred short-run cost function.
run by varying allinputs, and in doing so, move increasing, decreasing, or constant, de
Recal! from chapter 6 that returns to scale are
on whether a proportional change in both inputs results in output increasng more
pending
proportion, less than in proportion, or in proportion to the increase in inputs. These
than in Figure 7.2.
three possibilities are shown in the left-hand panels of scale in production and the long-run
There is a direct correspondence between returns to inputs are increasing less than n
increasing,
cost function for the firm. If returns to scale are
prices are constant, it follows that total cost
proportion to increases in output. Because input shown in Figure
output. This relationship is
also mustbe increasing less than in proportion to
If decreasing returns to scale apply, the total cost function increases at an increasing
7.2(a).
willchange in proportion to changes in
rate. Constant returns toscale implies that total cost
(b) and (c) of Figure 7.2.
output. The latter twO relationships are shown in parts

Case Sudy
Economies of Scale in the U.S. Banking Industry

of banks in every part of the United States. In

The past 15 years have seen numerous mergers reductions (i.c., increasing
variably, the managerS of these banks pointed to significant cost
 Theory andAndl
(HAPTER 1Cot

Total cost

Rateof
Rte of
0)

í8) Increaing retarnN to sCaie

Rate of vutput Cost

(Q) (Rs) Total cost

Output

Rate of Rate of
input output
(K,L) (0)
(b) Decreasing returms to scale

Rate of output Cost

(0) (Rs.)
Output
Total cost

Rate of Rate of
input output
(K,L)
(c) Constant returns to scale

returns to scale) associated with consolidation of computer systems, combining of neighboring

branch outlets, and reduction of corporate overhead expenses as justification.
Many of these mergers involved multibilion dollar banks, which appeared to be incon
sistent with existing empirical research on bank costs that showed significant diseconomies of
 PART II
Productom ond Coste

Rate of

PHGURE 7.3 Total Coxt Curve for a Production Function Characterised by nereasing Raturns.
Then by Dcreasing Returns

Used
scale for hankswith more than $2.5-5.0 crores in deposits. Unfortunateiy. these studies
Shaf
dataonly for banks with less than $100 crores in deposits. In a more recent study. Sherril in
$12,100crores
fer andEdmond David used data for large banks (those with $250 crores to
size
deposits) and found increasing returns to scale (i.e., declining per unit costs) up to a bank
of $1.500 crores to $3,700 crores.
actual cost
Clearlv, the owners and managers of the merged banks knew more about their
functions than did the earlier economic analysts. The consistent pattern of mergers of banks
much larger than $2.4 crores to $5.0crores in deposits was strong evidence that the exist1ng re
Search was not Correct.

Sce G. Benston, G. A. Hanweck, and B. Hurnphrey, "Scale Economies in Banking: A Restructuring and
Reassessment," Journal of Money, Credi, and Banking 14 1982:435-56; and T. Gilligan, M. Smirlock, and W.
Marshall. "Scale and Scope Economies in the Multi-Product Banking Firm." Journal of Monetary Economcs 13
1984:393-405.
s. Shaffer and E. David, "Economies of Superscale in Comnercial Banking," Applied Economics 23 1991:283-293.

The production process of many firms ischaracterized first by increasing returns and then
bydecreasing returns. In this case, the long-run total cost function first increases at a decreas
ing rate and then increases at an increas1ng rate, as shown in Figure 7.3. Such a total cost func
ion would be associated with a U-shaped long-run average cost function.
Suppose that afirn can expand the scale of operation only in discrete units For example.
the generators for large electric power plants are made in only afew sizes Often, these power
plants are built in multiples of 750 megawatts (MW). That is, output capacity of alternative
plants would be 750 MW, 1500 MW, 2250 MW, and so on. The short-run average costfunctions
in Figure 7.4 (labeled SAC, through SAC) are associated with each of four discrete scales of
 235

Rate of

operation.The iong-run average cost function for this firm is defined by the mnmum aver
age cost of cach levcl of output. For example, output rate Q, could be produced by piant size
1at an average cost of Cor by plant size 2 at a cost of C. Clearly, the cost is lower for piant

FIGURE 7.5 Shor-Run and Long-Run Cost Curves

Cost per unit
(Rs/Q)
LMC
SAC
SAC, SACG
SAC, SMC 10
SAC,
SAC0

C,

Rate of
output
(0)
 Costs
Size 1, and
process for
thus point a is one
point on the
of zero to O,various rates of output,
plant 1is the most the long-run long-tun AVerage cost curve. By repeating
function. For efficient
Qi plant 3is output rates Q, to Q plant 2 is and averagc
that
cost is deternined. For
output this
the most cfficient, and for the long-runratcoes
part of SAC, parf of
is
the most
the
long-run average COstcfficient.
Firms plan to be on this
The
scal
curve for this lo p-
firm. shaped
This
CH Ve sihown in holdfaceoutput rates
in ,o
Figure 74%
boldfaced curve is called an envelope
plant sizc 2and envelope curve in the long run. Consider afirm currently Cirye
Q,,the firm willproducing units at a cost of C, per unit. If output is cxpected to operating
,
plan to adjust tot plant sizc 1, thus
Most firms will remain at
reducing per-tunit cost to Cj
average cost curve have many alternative plant sizes to cho0se from, and there is a
few of the short-run average cost curvesshort -run
plants are shown incorrespondi ngt
t
o cach.A
Figure 7.5. Only onc point or averysmall arc of each short-run cost for these
will lieon the CHrVe
long-Tun
smooth U-shaped curveaverage cost function. Thus long-run average cost can be shown as the
labecled LAC. Corresponding to this long-run average Cost function
I5 a tong-Tån marginal cost curve LMC. which
1S also the minimum point of short-run
intersccts LAC at its minimum point a, which
average cost curve 10. The
Curve (SMCo) corresponding to SACi0 is also shown. But SMCIo =short-run marginal cost
SACy at the Minimum
point of SAC10:
Thus at point aand only at point a thefollowing unique resultoccurs:
SAC =SMC= LAC= LMC (7-6)
Ihe long-Tun cost curve serves as a long-run planning mechanism for the firm. For
example, suppose that the firm is operating on short-run average cost curve SAC, in
Figure 7.5,and the firm is currently producing an output rate of *, By using SAC, it is seen that
the firm's cost per unit is C.Clearly, if projections of future demand indicate that the firm could
expect to continue selling Ounits per period, profit could be increased by increasing the scale of
plant to thesize associated with short-run average curve SACio: With this plant, cost per unit for
anoutput rate of O* would be C, and the firm's profit per unit would increase by C-G Thus
total profit would increase by (C - C) Q*,

Example Fixed Cost, Economies of Scale, and Global Market Expansion

A firm'saverage total cost function is depicted in the following figure. If the firm serves only
the Indian market, it will sell 1,000 units, but if it also sells in Europe and the U.S. it can sell
2,000 units.
a. What is the explanation for the declining average cost function?
b. Assuming the firm is operating in the short run and that the average fixed cost is 20 per
cent of average total cost at an output rate of 1,000: (i) what is total fixed cost and what is
average fixed cost at an output rate of 2,000? (1) Is average variable cost increasing or
decreasing between Q=1,000 and =2,000.
Solution
a. If the firm is operating in the long run the answer is that the production process is char
acterized by increasing returs to scale. If the firm is operating in the short run, part of
the explanation is that fixed cost is being spread over a larger number of units produced
and that marginal cost(whether increasing or decreasing) is below average total cost.
b. (i) At Q= 1,000, AFC = Rs. 120(i.e., 20 percent of Rs. 600). Thus, total fixed cost is 0
AFC= Rs. 1,000 -120 = Rs. 1,20,000. At Q=2,000, AFC = Rs. 1,20,0002.,000 = Rs. 60.