Cost Concept

Cost Concept in Traditional Theory

Types of Cost

Opportunity Implicit Cost

Money Cost Real Cost Explicit Cost
Cost
Money Cost
• When we talk of the cost of a firm, the immediate idea about costs
that comes to our mind is the money cost
• The costs that accountants often list, the money outlays of a farm on
the processes of production of its output
• The money costs of producing a certain output of a commodity is the
sum of all the payments to the factors of production engaged in the
production of that commodity.
• Thus money cost is the cost which enters the records of the
accountants of a company.
Real Cost:
• The total cost of something which may include more than just the
price tag. It can also refer to the efforts and sacrifices a producer
makes to produce a desired output.

Opportunity Cost/Alternative Cost:

• Opportunity cost of a particular product is the value of the foregone
alternative product that resources used in its production could have
produced.
• The alternative or opportunity cost of producing one unit of
commodity X is the amount of commodity Y that must be sacrificed in
order to produce X rather than Y.
• Opportunity cost has to be stated in relative terms.
Explicit and Implicit Cost
• Explicit costs are the actual costs a business incurs and
pays, such as wages, rent, and utilities. They are also known
as accounting costs, and are recorded in a company's books
and financial statements.
• An implicit cost is a cost that exists without the exchange of cash and is
not recorded for accounting purposes.
• Implicit costs represent the loss of income but do not represent a loss of
profit.
• These costs are in contrast to explicit costs, which represent money
exchanged or the use of tangible resources by a company.
Fixed Variable
Cost Cost
• Fixed cost are those costs that do • Vary in Short period
not vary with the size of the output. • Function output vary with volume
• Salaries of administrative staffs, output
• Insurance Premium • The raw materials (short use expenses;
seed, fertilizer, manure, pesticides, etc)
• Property taxes • Cost of direct labour,
• Depreciation of machinery • Running expenses of fixed capital (fuel,
• Permanent labor wage ordinary repairs, routine maintenance)
• Machine/tractor • Marketing expenses (packaging,
labeling and wrapping, and selling)
• Building or rented building
• Fall to zero when output is zero
Total Variable and Fixed Cost
Cost function
• Cost function refers to the mathematical relation between cost of a product
and the various determinants of its costs.
• In the cost function, the dependent variable is unit cost or total cost and
the independent variables are the price of a factor, the size of output or any
relevant phenomenon which has a bearing on cost. In symbols, we may
state the cost function as
• C=
• Thus, both the short-run and in the long-run, total cost is the multivariable
function. i.e. total cost is determined by many factors
• Cost function can be linear or curve-linear depending upon the cost
behavior and response to the dependent variable studied
Short Run Cost
• A short run is the period in which certain inputs cannot be increased or decreased.
It means that some factors of production are fixed while other are other variable.
• Costs over the period of production during which some factors of production
(usually capital equipment and management) are fixed
• Production can be increased or decreased by changing variable costs only but can
not be change fixed factors
• Short run cost function:
• C=
• Where X: Output, T: technology Pf: Price of factors, K : fixed factors)
• A firm’s short run cost are split up into total fixed cost and total variable cost.
TC=TVC + TFC
Average Cost (ATC/AC)
• Average cost is the overall cost per unit of output.
• ATC= = = = AFC +AVC
• As AVC is U shaped, AC is also U-shaped
• AFC: AFC is computed by dividing the total fixed cost by total output.
• AFC Curve: TFC remains the same
• AFC declines as we produce more and more
• As we produce more, TFC is same but output is high. So AFC declines
• AFC curve is negatively sloped
• AFC curve is rectangular hyperbola showing the same level of total fixed cost at all its
point.
• Asymptotic (don’t touch either axes)
• ATC=
• Average Variable Cost (AVC)
• AVC=
• AVC curve is U shape (due to law of variable proportion)
• Initially average product of variable factor increase (when small unit of
variable factor is employed)
• The AVC falls at first, reaches a minimum and starts raising beyond a point
• Average productivity constants --- AVC is also constant
• Average productivity of variable factor rises –AVC falls
• Average productivity of variable factors fall---AVC rises
 80

70
Average Fixed Cost 60

50

40 AFC
30

20

10

0 0 1 2 3 4 5 6 7
Output

Fig. Average Fixed Cost

 14
0

12
0

Average variable Cost

10
0

8
6 AVC
0
0

4
0

2
0

0
0 1 2 3 4 5 6 7
Output
 18
0

16
0

14
0

12
0

10
Cost

AF
0
80 C
AV
60 C
AC
40

20

0 1 2 3 4 5 6 7
Marginal Cost
• Change in total cost resulting from a unit change in output
• It can be calculated by subtracting the total cost of producing n-1 units
from the total cost of producing ‘n’units
• MC for 3rd unit production is
• MC3 =TVCn-TVCn-1
• MC doesn’t depend upon fixed cost, MC only depends on variable cost
• At initial MC decreases, reaches to minimum and then rises as output is
increased
• MC=
Relationship between AC and MC
• In price theory, relationship between AC and MC is of great importance
• MC curve cuts the AC curve from below and at the minimum point of AC
1. Both AC and MC are calculated from the total cost of production
AC = and MC =
2. When average cost is falling, the MC is always lower than the AC
3. When AC is raising, MC lies above AC and rises faster than AC
4. The MC curves cuts the AC curve at it’s minimum points
Relation between AC and MC
Unit of Total Average Marginal
output cost(TC) cost(AC) Rs. cost(MC)Rs.
Rs.

1 150 150.0
2 190 96.0 40
3 220 73.3 30
4 236
Kamal Regmi,
59.0 10
16
IAAS,Paklihawa 5

5 270 54.0 34
6 324 54.0 54
7 415 69.3 91
8 600 75 185
 25
0

20
0

Cost
15 AC
0
10
MC
0

5
0

0 0 1 2 3 4 5 6 7

Output

⚫Marginal cost decreases at first, reaches minimum and then rises as

output is increased.
 Long run cost/cost in
long run
The long run costs are cost over the period long enough to permit the change of all factors of
production. All factors of production become variable.
It is the time-period in which new plant can be installed and new firm can enter/exit the
market.
Long-run cost function: C=
⚫Long run isa condition in which no factors of production are fixed
i.e. almost all factors of production are variable factors.
⚫The land, labor, capital goods, and entrepreneurship all vary to reach
the long run cost of producing a good or service.
⚫Long run cost curves are derived from short run cost curves.
⚫Long run cost curves represent short run cost curves of a firm suitable
for making adjustment of long run production.
Long Run Cost
• No factor is fixed and everything is variable.
• There is enough time to change all the factors of production
• Can construct new house, can use new land
• Long run Average cost curve (LAC)
• LAC is envelop curve as it envelopes SAC
• LAC is also U shaped (traditional)
• L shaped (modern)
• At left of minimum point of LAC, it is tangent to the falling point of SAC
• At minimum point LAC is tangent to minimum point of SAC
• At right of maximum point (M) of LAC, LAC is tangent to the increasing point
of SAC
 Derivation of Long
Run Cost(LAC)
⚫Long run cost curves can be drawn by making tangent to SAC curves of different firms of
different capacity.
Envelope curve or

Cost
SAC1 SAC3 planning curve
SAC2

LAC

0 A B Q C D Output
 Relationship between LAC
and SAC
1. LAC can only be tangential to SAC.
 The reason is that for any given level of output, the average cost cannot be
higher in long run than in short run.
 On the other hand it is not always possible in short run to produce given output
in cheaper way possible.

2. LAC does not touches the lowest point of any short run cost curve
except for one which is tangent to SAC at lowest point of LAC.
When LAC is falling, it is tangential to falling portion of SAC curve and when it
is rising it is tangential to rising portion of SAC curve and minimum at minimum
portion of SAC curve.
Thus to produce an output less than OQ at the least cost, the firm operates the
plant at less than its full capacity or less than its minimum cost of average
production.
To produce an output larger than OQ at the least cost, the firm operates the
plant beyond its optimum capacity.
OQ is the optimum point because the output OQ is produced at the minimum
Optimum size of firm
• Optimum scale is that one which gives most efficient utilization of resources-
determined by minimum LAC
• Given state of technology there is unique size of firm and level of output
associated with least cost concept.
• This point is determined by the point of intersection between LAC and LMC
curves.
• At this point SAC= SMC= LAC= LMC
Economics of Scale
 The above figure shows that LAC and LMC decrease till a certain level of output is
achieved then begin to increase
 The decrease in LAC and LMC is attributed to economies of scale
 Economics of scale is cost saving resulting from the increase in the scale of production
while diseconomies of scale is an increase in cost due to the increase in the scale of
production

Factors causing a decrease in LAC or Economics of Scale

The cost advantage due to an increase in production can arise from factors inside as well as
outside the firm, so divided into two categories:
1. Internal economics
2. External economics
1. Internal economics or real economics: arise from the addition of a plan or increasing
capacity of the plant or the product is diversified
A. Economics of production: increasing returns to scale resulting from the expansion of
production
I. Technical economics: advance in machinery, indivisibility of machinery, building with
reserve capacity, one-time investment in technology
II. Labor economics: specialized skilled manpower and division of labor
B. Economics in Marketing
C. Managerial economics: specialization and mechanization of managerial function
D. Economics of transportation and storage

2. External economics/ pecuniary economics

 Large-scale purchase of raw material
 Large-scale acquisition of finance
 Growth of ancillary companies
1. Diseconomies of scale
A. Internal diseconomies
I. Managerial inefficiency
II. Labor inefficiency
B. External diseconomies
 Concept of
Revenue
⚫The amount of money which the firms receive by sale of its
output in the market is known as revenue.
⚫Total revenue: It refers to the total amount of money that a
firm receives from the sales of its products.
Mathematically,
TR = price * output
⚫Average revenue: It is the revenue per unit of commodity
sold. It is calculated by dividing the total revenue by total
output. Mathematically,
AR = total revenue/ total output = price Thus,
average revenue is the price of the product.
⚫Marginal revenue: Addition made to total revenue by
sales of
 Relationship between AR and MR
curves
When AR (price) remains constant, MR will also remain constant and will coincide with
AR.
⚫Eg: suppose price is Rs. 10
No of unit TR AR MR
sold
0 0 -- --
1 10 10 10
2 20 10 10
3 30 10 10
4 40 10 10
5 50 10 10
6 60 10 10
 7
0

6
0
Revenu
4
5
0 TR
3 AR
e

0
MR
2
0

1
0
0 1 2 3 4 5 6 7
0 No. of
unit sold
⚫MR curve never touches Y-axis
⚫It implies at zero quantity, MR is undefined.
⚫AR curves should be asymptotic to Y-axis. However,
since AR curve also depicts/shows demand curve, we
simply say that at a high price, there will be zero
demand. Thus, AR can touch Y-axis.

11
5
AR/Price

Demand
  Suppose price varies than,
In markets like imperfect markets, the price tends to fluctuate and adjust according to
the market forces of demand and supply. A firm can increase its volume of sales only by
decreasing the price, so the AR falls with an increase in sales. The revenue from every
additional unit; i.e., MR will be less than AR. As a result, both AR and MR curves slope
downwards from left to right
No of unit TR AR MR
sold
0 0 - -
1 10 10 10
2 18 9 8
3 24 8 6
4 28 7 4
5 30 6 2
6 30 5 0
 12

10

Revenue 8

6
AR
MR
4

0 1 2 3 4 5 6 7
Output
 Usefulness/significance of cost
concept
1. Measurement of profit
 Profit = TR-TC
 Aim of firm is to maximize profit i.e. to increase positive difference
between TR and TC.
 Producer will be at equilibrium when TR=TC.
 Also if we consider
 MR and MC, firm tries to maximize MR and gap
between MR and MC. Thus, the firm is in equilibrium when,
MR = MC
MC cuts MR from below
 1600
1400
1200
1000
Revenue/Cost

800 TR
TC
600

400

200
0 1 2 3 4 5 6 7 8 9
Output
0
 Revenue/Cost

Output
MC

MR
2. Determine breakeven point
Point at which firms revenue just covers cost of production in which firm is neither
in loss nor in profit.

1600

140
0

120
0
Revenue/Cost

1000

800
TR

600 breakeven point

TC
400

200

0 1 2 3 4 5 6 7 8 9

Output
3. Determine shut down
point
 Point at which firm AR only
covers AVC.
 Firm is in loss to average fixed
cost. AC

Revenue/Cost
 Firm should stop production.

MC
AV
C

AR

Output
 4. To know economics of scale of
production.
 If LAC decrease as level of production increases upto normal capacity, it is known as
economics of scale of production.
a
c

Cos
t

LAC

Output