5

THE COSTS OF PRODUCTION

 Introduction
Concept of Costs
Costs are the monetary expenses incurred in the process of production of a commodity.
Different inputs like land, labour, capital, etc. are used while producing output and the
expenses incurred on these inputs are called cost of production. The following are some
of the basic concepts of costs.
1. Implicit and explicit cost : The cost that takes the form of cash outlay and is
recorded in the books of account is called explicit cost. For example, purchase of a
machine, materials, depreciation etc. Implicit cost is cost of firm or entrepreneur
which is not recorded in account. For example salary of owners as manager.
2. Accounting cost and economic cost: Accounting cost is the cost that is recordable on
the books of account. They are explicit costs. These costs are the costs that are paid
directly to the hired or purchased factors of production. For example, wages
salaries, interest etc. (Economic cost= Implicit cost+ Explicit Cost)
3. Historical cost and replacement cost : Historical cost is the expenditure incurred
while purchasing the inputs. It does not reflect the present market value of inputs.
Replacement cost reflect current market value.
4. Separable and common cost : Costs that can be assigned to a particular division,
department or users are called separable cost. These costs are identifiable when two
or more goods produced from the same inputs or single process (known as joint
products) passes through the stage of production called split off point.
 Cost Function
Cost function is the functional relationship between the cost of
production and the various factors affecting the cost of production.
Functionally, it can be represented as,
C = f (Q, T, G, Pi…)
Among the factors, output is the most important factor affecting cost of
production. Hence, the above cost function can simply be expressed as:
C = f(Q)

Short-Run and Long-run costs

Short-run cost
Short-run cost is the cost that incurs when the firm varies its output by
changing its variable factor of production, keeping some factors
constant. Thus, short-run costs are the costs in short-run.
Long-run cost
Long-run cost is the cost that incurs when the firm varies its output by
changing all the factors of production. Thus, long-run costs are the
 Derivation of Short-Run Cost Curves
In short-run, some factors are variable and some are fixed. Accordingly,
total cost in the short run can be divided into total fixed cost and total
variable cost. Thus,
TC = TFC + TVC
These three concepts are explained below:
1. Total Fixed Cost (TFC)
These costs are the expenses that are paid to the fixed factors of
production. These costs have a constant relation with the output.
Change in output has no effect on fixed costs. It includes expenses on
items like rent, contractual salaries, insurance premium etc.
2. Total Variable Cost (TVC)
It is the cost incurred in the payment for the variable factors of
production. The change in variable factor causes a change in the
output and thus total variable cost and output have a positive relation.
As output increases total variable cost also increases but initially at a
decreasing rate and then at an increasing rate because of the law of
variable proportions. Thus, TVC has an inverse 'S' shape
 Contd…
The nature and relationship between these three cost curves can be
explained
Output below.TFC TVC TC
(in units) (in Rs.) (in Rs.) (in Rs.)
0 30 0 30
1 30 20 50
2 30 30 60
3 30 45 75
4 30 80 110
5 30 145 175

Y
180 TC
In the figure , the output is measured
160 along the X-axis and cost along the Y-
140 TVC axis. TFC is Rs. 30 even when output is
120
Total Cost

100
zero and is parallel to the output axis
80 because the fixed cost does not change
60 with output. TVC starts with zero
40
TFC because if no any variable factor is used
20
X
then the output will be zero and so the
O 1 2 3
Output
4 5
cost. TC is the vertical summation of TVC
and TFC so at output zero TC equals TFC
Short-run Average Cost Curves

1. Average Fixed Cost (AFC)

It is the fixed cost per unit of output produced. It is the total
fixed cost divided by the total output produced.

AFC goes on decreasing as output increases because fixed

amount of TFC is divided into more and more units of output.
It is shown in the table below:
Output Total Fixed cost Average Fixed cost
0 30 -
1 30 30
2 30 15
3 30 10
4 30 7.5
5 30 6
 Contd…
Y
In the above table, AFC is the total fixed
cost divided by output. When output is
zero, TFC is 30. Since 30 divided by zero
Total Cost

30
TFC is indefinite, AFC cannot be calculated.
20
When output is 1 unit TFC is 30 and AFC
10 is also 30 so, When output goes on
increasing upto 5 units TFC remains the
same as shown in upper panel of figure.
X
O When this TFC is divided by increasing
units of output, AFC goes on declining.
Y
Thus AFC goes on falling as output
increases but never touches the axis
Average Fixed Cost

30
which is shown in lower panel of figure.
20

10

AFC
X

O
Output
Contd…
2. Average Variable Cost (AVC)
Average variable cost is per unit cost of the variable factor. It is
the total variable cost divided by the total unit of output
produced

It can be shown from following table and figure:

Output TVC AVC
0 0 -
1 20 20
2 30 15
3 45 15
4 80 20
5 145 29
 Contd…
180 Y

150
TVC

120
Total Cost

90

60
In the figure , as output increases TVC
30
goes on increasing at decreasing rate and
then at increasing rate which is shown in
X
1 2 3 4 5 upper panel. TVC increases at a
O
decreasing rate up to 2 units of output
Y
and AVC up to this 2 units of output is
Total Variable Cost

30 TVC declining as shown in lower panel. At 2

and 3 unit of output AVC remains at its
20 minimum. Further increase in output
10 causes TVC to increase at an increasing
rate, which is shown in upper panel, and
X AVC starts increasing as shown in the
1 2 3 4 5
O
Output
lower panel. Thus, AVC is U-shaped.
Contd…

3. Average Total Cost/Average Cost (ATC/AC)

Average cost is the total cost divided by the total output
produced or it is the summation of Average Fixed Cost (AFC) and
Average Variable Cost (AVC)

It can be shown in the following table and figure:

Output Total cost Average cost (TC/Q)
0 30 -
1 50 50
2 60 30
3 75 25
4 110 27.5
5 175 35

[Above values of total cost calculation can be seen under the

topic Total cost we discussed before.]
 180 Y TC
In the upper panel of the figure,
150 TC increases at a decreasing rate
120 up to 2 units of out output due to
the operation of increasing
Total Cost

90
returns. Up to 3 units of output AC
60 goes on declining as shown in
30
lower panel of the figure. From 3
units of output as output increases
X TC increases at an increasing rate
O
1 2 3 4 5 due to the operation of
Y
50
diminishing returns which is
shown in upper panel. AC then
Total Variable Cost

40 AC
starts increasing which is shown in
30
lower panel thus, AC is 'U' shaped.
20

10

X
O 1 2 3 4 5
Output
 Marginal Cost (MC)
It is the change in total cost due to the change in units of output
produced. In other words, it is the addition made to the total cost due to
one additional unit of output produced.
Symbolically,

MC can also be expressed as MC =

Here, MC is the derivative of the total cost with respect to output. MC is

the slope of TC The calculation and diagrammatical representation of MC
is shown below:
Output Total cost MC
0 30 -
1 50 20
2 60 10
3 75 15
4 110 35
5 175 65
 Contd…
180 Y TC

150
In the figure, TC is measured in upper
panel of figure and MC in lower panel of
120
figure. MC is the slope of TC. TC
Total Cost

90 increases at decreasing rate up to 2

60 units of output due to increasing
returns which is shown in upper panel.
30
And Up to this 2 units of output MC or
O X the slope of TC is decreasing so MC
Y
1 2 3 4 5
curve slopes downward as shown in
70 MC
lower panel. At 3, 4 and 5 units of
60
output TC increases at an increasing
rate due to decreasing returns as
50
shown in upper panel. At these 3, 4 and
40
5 units of output, MC or the slope of TC
Marginal Cost

30
is increasing so MC curve starts rising.
20
Therefore, MC is also 'U' shaped
10
X
O 1 2 3 4 5
Output
 Reason for 'U'-shape of AC or ATC

Average total cost curve is U-shaped. This implies that, as output increases,
AC at first decreases, reaches its minimum and starts increasing. This
behaviour of AC can be explained under the following reasons.
1. Because of the Behaviour of AVC and AFC
Since AC =AVC + AFC the behaviour of AC is also affected by the behaviour
of AVC and AFC. As long as both AVC and AFC fall AC also falls. Once AVC
reaches its minimum and starts rising, the following three steps take place:
First, the falling rate of AFC more than offsets the initial rising rate of AVC
which causes AC to fall further.
Second, the falling rate of AFC exactly equals the rising rate of AVC which
causes the AC to reach its minimum.
Third, the falling rate of AFC becomes less than the rising rate of AVC which
causes AC to rise.
2. Because of law of variable proportion
The shape of AC can be explained with the help of short-run production
function as well.
First, as variable factors starts increasing against fixed factor of
Relationship between ATC and AVC
ATC is TC divided by output, AVC is TVC divided by output but AVC is
a part of ATC because of ATC = AVC + AFC. The relationship between
ATC and AVC can be explained with following diagram.
Y

ATC

B AVC

Cost
A
AFC

X
O Q1 Q2
Output

In the figure , cost is measured along the y-axis and output along the
x-axis, the relationships between AC and AVC can be pointed out as
following.
1. Both the curves are 'U'-shaped because of the law of variable
proportion
2. The minimum of AVC (A) at output Q1comes before the minimum of
 Relationship between AC and MC
AC is the total cost divided by output produced and MC is the change in TC per
unit change in output. The relationship between AC and MC can be explained
from the following
Y figure:
MC

Cost AC

X
O Q1 Q
Output

In the figure , cost and output are measured along the Y-axis and X-axis
respectively. Marginal cost is represented by MC and Average cost by AC. So the
relationship between them can be pointed as :
1.
2. Both
Both AC
areand MC are calculated from TC
U-shaped
3. The minimum of MC (Point A) comes before the minimum of AC (Point B).
4. MC cuts AC at its minimum (Point B).
Example – 1 Complete the following table:
Q TC TFC TVC AC AFC AVC MC
0 125
10
20 10.5 5
30 110
40 255
50 3
60 3
70 5
80 295

Solution:
Given,
We know TVC at 0 units of output is 0.
TC at 0 units of output is =125
Or, TVC+TFC at 0 units of output = 125
Or, 0 + TFC = 125
TFC = Rs.125
At 20 units of output AC = Rs.10.5
We know TC = AC × output
Contd…
 TC at 20 units of output = 10.5×20 = Rs.210
TC at 10 units of output = TC at 20 units of output -MC at 20
units of output
= 210 – 5 = Rs.205.
TC at 20 units of output = TVC at 20 units of output + TFC
Or, 210 = TVC at 20 units of output + 125
 TVC at 20 units of output = Rs.85
Q TC TFC TVC AC AFC AVC MC
0 125 125 0 - - - -
10 205 125 205- 205/10=20.5 125/10=12.5 80/10=8 80
125=80
20 210 125 85 10.5 6.25 4.25 5
30 235 125 110 7.833 4.167 3.67 25
40 255 125 380 6.375 3.125 3.25 20
50 275 125 150 5.5 2.5 3 20
60 278 125 153 4.64 2.084 2.55 3
70 350 125 225 5 1.786 3.214 72
80 420 125 295 5.25 1.563 3.688 70
 Derivation of Long-Run Cost Curves
Long-run Average Cost (LAC)
It is derived by dividing long-run total cost (LTC) by output (Q)
produced.

Long-run average cost curve is obtained from short-run average cost

curves which is explained below.
Y In the figure , the output is measured
along the X-axis and cost along the Y-
SAC3
SAC1 SAC2 axis. In the short-run, the firm will be
operating under any one plant, in the
long-run as the firm increases its
Cost

capital stock there will be more plants.

Suppose a firm has three plants,
namely SAC1, SAC2 and SAC3. If the firm
X has to produce output below Q2 level
O Q1 Q2 Q3 Q4
than it is beneficial to use the plant
Output
SAC1 as at outputs below Q2 the firm
enjoys the lowest cost in SAC than any
Contd…
Therefore, if we join all the points of SAC’s used for production in
the long-run, we will have a smooth long-run LAC as shown below:
Y

SAC1 SAC3 LAC

SAC2
Cost

X
O Q1 Q2 Q3
Output

In the figure , there are 3 short run average cost curves. Because the
firm can employ more capital or plants in the long- run, when it
employs plant SAC2 the minimum point of SAC2 lies below SAC1
because of the economics of scale. Due to the economies of scale, in
the above figure, the long-run average cost (LAC)curve falls
 Derivation of Long-Run Marginal Cost Curve
(LMC)
Long-run Marginal cost is the change is long run total cost due to
per unit change in output.

Cos SMC3 LMC

t
SAC3
In the figure 6.10, we have 3 Short-run
SAC1
SMC1 F LAC
Cost curves or plants as; SAC1, SAC2,
A
SMC2
SAC2
SAC3 and the corresponding Short-run
C
Marginal Cost curves as; SMC1, SMC2
D
and SMC3. LAC is tangent to these
B SAC’s at points A, B and C of SAC1, SAC2
and SAC3 respectively. We draw a
perpendicular line from these points of
O X tangency
Q1 Q2 Q3
(i.e. from points A, B and C) towards
Output
the output axis.
 Economies and Diseconomies of Scale
Economies of scale
It is a decrease in the long-run average cost from the expansion of the
production scale. The economies of scale are the cost saving factors that
arise both inside the firm and outside the firm (but inside the industry).
The former is known as internal economies where the latter is known as
external economies.
A. Internal Economies
The internal economies (cost saving factors) arise within the firm as a
result of the expansion of its own size or scale of production. They arise
from the use of methods that small firms cannot employ.
Technical Economies
Technical economies are those which arise to a firm from the use of better
machines and techniques of production. As a result, production increases
and per unit cost of production falls. Technical economies into following:
i. Economies of Increased Dimension: Economies arise with the
installation of large machines. The average cost of operating large
machines is less than that of operating small machines. For example,
the manufacturer of the double – Decker bus is lower as compared to
 Contd…
ii. Economies of Linked Processes: A large firm can reduce its per-unit cost
of production by linking the various production processes. For example, a
dairy and fodder farm. Sugar factory and sugar – cane farm, paper -
making and pulp - making can be combined to reduce average costs of
production.
iii. Economies of the use of By-Products: A large firm can utilize its waste
materials as a by-product. For example, the molasses left over after
manufacturing sugar from sugarcane can be used for producing spirit by
installing a subsidiary plant.
iv. Economies of Superior Technique: A large firm can afford a costly
machine with advance technology. Such machines are more productive
than small machines. For example, only a big newspaper can use rotary
press.
v. Economies of Increased specialization: A large firm can enjoy the benefits
of the division of labor and increased specialization. For example, Henry
Ford Company has divided the manufacturer of a car into 84 subs-
processes to employ super specialized factors.
Managerial Economies
 Contd…

Marketing Economies
A large firm also reaps the economies of buying and selling in bulk. Large businesses
have beginning advantages. They can get freight concessions from transport, cheap
credit from bank, prompt delivery and careful attention from all dealers.
Financial Economies
A large firm is in a better position than a small firm to spread its risks. It can produce
a variety of products, and sell them in different areas. By the diversification of
markets, it can counter balance the loss of one product by the gain from other
products.
B. External Economies
External economies are those economies which arise due to the expansion of the
industry. External economies benefit all firms within the industry as the size of the
industry expands. As the industry grows, subsidiary and correlated firms may
produce cheaper inputs and utilize waste materials.
The external economies of scale are as follows:
1. Skilled labour is available to all firms.
2. Means of transportation and communication are improved.
3. Research centre is established to convey information regarding innovations, new
markets, new inputs etc.
 Diseconomies of Scale
It is the production scale. The diseconomies of scale are the cost raising
factors, which arise both inside the firm and outside the firm (but inside the
industry). The former is known as internal diseconomies where the latter is
known as external diseconomies.
A. Internal diseconomies
They are exclusive and internal to a firm as they arise within the firm.
Once the division of labour and potentials are fully exploited, warehouses
are used in full capacity, the optimum level of the plant is used
diseconomies begin although some economies may still be left. Internal
diseconomies arise because of two factors:
a. Managerial inefficiency: As expansion of scale of production the
communication between the owner and manager, manager and labour
get reduced. With the expansion of the scale, the number of key
managerial personnel gets bigger and decision making becomes
complex and is delayed.
b. Labour inefficiency: expansion of scale leads to increase in
overcrowding of labour and it becomes difficult to control their
productivity and accountability.
B. External diseconomies
They originate outside the firm especially in the input markets. When all
Economies of Scope

Economies of scope arise when a single firm produces two or more

than two products jointly at a lower cost rather than producing them
separately.
According to Edwin Mansfield, “Economies of scope occur when the
cost of producing two (or more) products jointly is less than the cost
of producing them separately.”
In the world of modern business, two or more products are produced
jointly in order to reduce per unit cost of production. The economies
of scope exist if the total cost of jointly producing product A and B is
smaller than if two products were produced separately.
TC (A, B) < [TC (A) + TC (B)]
The degree of economies of scope can be measured by using the
following formula:
 Contd…
Example
Consider the following cost schedule:
Output (Q) 0 1 2 3 4 5 6 7 8 9
TVC 0 10 18 24 32 50 80 124 180 260

a. Compute TC, AFC, AVC, AC and MC under fixed cost Rs. 100.
b. Prove that AC is influenced by the trend of AFC and AVC.
c. Prove that SMC is independent with fixed cost.
Solution:
a. Computation of TC, AFC, AVC, AC and MC under fixed cost Rs.100
Output (Q) TVC TFC TC AFC AVC AC MC
0 0 100 100 - - - -
1 10 100 110 100 10 110 10
2 18 100 118 50 9 59 8
3 24 100 124 33.3 8 41.3 6
4 32 100 132 25 8 33 8
5 50 100 150 20 10 30 18
6 80 100 180 16.7 13.3 30 30
7 124 100 224 14.3 17.7 32 44
8 180 100 280 12.5 22.5 35 56
9 260 100 360 11.1 28.9 40 80
 Contd…
b. Initially, at the output range of 1 to 3 units, AFC and AVC both are falling. Hence, AC is
also falling.
At the output range of 4 and 5 units, the rate of fall in AFC is greater than the rise in
AVC. Hence, AC is falling.
At the output range of 5 and 6 units, the rate of fall in AFC is equal to the rate of rise in
AVC. Hence, AC remains constant where MC is the minimum.
At the output range of 6 to 9 units, the rate of fall in AFC is less than the rate of rise in
AVC. Hence, AC is rising.
Thus, it is proved that AC is influenced by the trend of AFC and AVC.
c. Short-run marginal cost (SMC) is the change in total cost due to the change in one unit
of output in the short-run. Total cost is the sum total of total fixed cost (TFC) and total
variable cost (TVC). Hence, change in total cost is due to the change in total variable
cost and not influenced by total fixed cost. It can be explained as follows:
We know that,
MCn = TCn – TCn – 1
= (TFC + TVCn) – (TFC + TVCn – 1)
= TFC + TVCn – TFC + TVCn – 1
= TVCn – TVCn – 1
Contd…
Example
Consider the following table:
Output TFC TVC TC AFC AVC AC MC
0 50 0 - - - - -
1 - 30 - - - - -
2 - 55 - - - - -
3 - 77 - - - - -
4 - 102 - - - - -
5 - 132 - - - - -
6 - 169 - - - - -
7 - 216 - - - - -
8 - 278 - - - - -

a. Define TFC and TVC.

b. Explain the relationship between AC and MC.
Solution:
a. Definition of Total Fixed Cost (TFC) and Total Variable Cost (TVC)
Total Fixed Cost (TFC)
TFC is the total cost of the fixed factors of production. It is independent
of the level of output. It means total fixed cost is not affected by the
level of output. Whether the output is zero or maximum total fixed cost
 Contd…
Total Variable Cost (TVC)
Total variable cost is the cost of the variable factors of production. It depends on
the level of output. When output is zero, TVC is also zero (i.e. when Q = 0, TVC =
0). It goes on increasing with the increase in level of output.
Completion of the given table
Output TFC TVC TC AFC AVC AC MC
0 50 0 50 - - - -
1 50 30 80 50 30 80 30
2 50 55 105 25 27.5 52.5 25
3 50 77 127 16.67 25.67 42.33 22
4 50 102 152 12.5 25.5 38 25
5 50 132 182 10 26.4 36.4 30
6 50 169 219 8.33 28.17 36.5 37
7 50 216 266 7.14 30.86 38 47
8 50 278 328 6.25 34.75 41 62

b. Relationship between AC and MC

1. Initially AC and MC both are declining.
2. The minimum point of MC occurs when the level of output is 3 units and the
minimum point of AC occurs when the level of output is 5 units.
3. AC is declining up to 5 units of output but is greater than MC.
4. AC rises after 5 units of output but is less than MC.`
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