In This Lecture…

 Concepts of Costs:
Economic Costs,
Accounting Costs, Sunk
Costs
 Short-run and Long-run
Costs: Total, Average
and Marginal Costs
 Cost Schedules, Cost
Curves, Characteristics
and their Relationships
 Business Firm
An entity that employs factors of
production (resources) to produce goods
and services to be sold to consumers,
other firms, or the government.
 Why Do Business Firms
Arise in the First Place?
Firms are formed when benefits can
be obtained from individuals
working as a team.
 Economic Cost
Economic cost is the cost to a
firm for utilizing economic
resources in production,
including opportunity cost.
 Accounting Cost
Accounting cost is that cost which
includes actual expenses plus
depreciation charges for capital
equipment.
 Sunk Cost
A cost incurred in the past that
cannot be changed by current
decisions and therefore cannot be
recovered.
Explicit and Implicit Cost
 Explicit Cost - A cost incurred when
an actual (monetary) payment is
made.
 Implicit Cost - A cost that represents
the value of resources used in
production for which no actual
(monetary) payment is made.
 Production and Cost:
Short and Long Run
 Short Run - A period of time in which
some inputs in the production process
are fixed.
 Long Run - A period of time in which
all inputs in the production process
can be varied (no inputs are fixed).
 Short-run Cost
 The short-run costs are the costs
over the period during which
some factors are in fixed supply –
like plant, machinery etc.
 It is a sum total of fixed cost and
variable cost incurred by the
producer in producing the
commodity.
 Long-run Cost
 The long-run costs are the costs
over the long period enough to
permit changes in all factors of
production.
 It is a sum total variable cost
incurred by the producer in
producing the commodity.
 Fixed and Variable Costs

 Fixed Costs – The cost

incurred in those inputs
whose quantity cannot be
changed as output
changes.
 Variable Costs – the
cost incurred in those
inputs whose quantity
can be changed as output
changes.
 Costs in Short-run
 Fixed Costs (FC) - Costs that do not vary
with output; the costs associated with fixed
inputs.
 Variable Cost (VC) - Costs that vary with
output; the costs associated with variable
inputs.
 Total Cost (TC) - The sum of fixed costs and
variable costs. TC = TFC + TVC
 Marginal Cost (MC) - The change in total
cost that results from a change in output: MC
= ΔTC/Δ Q.
Fixed Cost / Overhead Cost
 Fixed Costs (FC) - Costs that do not vary
with output; the costs associated with fixed
inputs.
 Overhead expenses, Wages/Salaries,
Depreciation of Machinery, Insurance
Amount etc.
Output TFC
0 10
1 10
2 10
3 10
4 10
 Fixed Cost / Overhead Cost
Cost
20

15

10 TFC
5

O 1 2 3 4
Output

 Total Fixed Cost Curve (TFC Curve) –

Horizontal line
 Total Variable Cost/ Prime
Cost
 Variable Cost (VC) - Costs that vary
with output; the costs associated with
variable inputs.
 Cost of direct labor, Running expenses
like cost of raw materials, fuels etc.
Output TVC
0 0
1 10
2 18
3 30
4 45
 Total Variable Cost/ Prime
Cost
Cost
40
TVC

30

20

10

0 1 2 3
4 Output
 Total Variable Cost Curve (TVC Curve) – Inverse
S-shaped Curve
 Total Cost
 Total Cost (TC) - The sum of fixed
costs and variable costs. TC = TFC
+ TVC
 It is the aggregate of all costs of
producing
Output any
TFC given level of
TVC TCoutput

0 10 0 10
1 10 10 20
2 10 18 28
3 10 30 40
4 10 45 55
 Total Cost/ Prime Cost
Cost TC
50
TVC

40

30

20 TFC

10
TFC

0 1 2 3
4 Output
 Total Cost Curve (TC Curve) – Inverse S-shaped Curve
 Fixed Cost vs. Variable Cost
Fixed Cost (FC) Variable Cost (VC)
1. FC are incurred in fixed 1. VC are incurred in
FOP. variable FOP.
2. FC do not change with the 2. VC changes with the
change in output. change in the level of
3. FC cannot be changed output.
during short-run. 3. VC can be changed during
4. FC can never be zero even short-run.
at zero level of output. 4. VC can be zero at zero
5. Production at the loss of level of output.
FC may continue. 5. Production at the loss of
6. TFC curve is parallel to x- VC will not continue.
axis. 6. TVC curve is inverse S-
shaped.
Average Fixed, Variable and
Total Cost
 Average Fixed Cost (AFC) - Total
fixed cost divided by quantity of
output: AFC = TFC / Q.
 Average Variable Cost (AVC) -
Total variable cost divided by
quantity of output: AVC = TVC / Q.
 Average Total Cost (ATC), or Unit
Cost - Total cost divided by quantity
of output: ATC = TC / Q.
Average Fixed Cost, Average Varible Cost &
Average Cost
Average Fixed Cost, Average Variable Cost &
Average Cost
Average Fixed Cost, Average Variable Cost &
Average Cost
Average Fixed Cost, Average Varible Cost &
Average Cost
Average Fixed Cost, Average Varible Cost &
Average Cost
Average Fixed Cost, Average Variable Cost &
Average Cost
 Average Cost Curve is U-
shaped
 Basis of AFC : AC includes AFC and
AFC falls continuously with
increase in output. Once AVC
reaches its minimum point and
starts rising, its rise is initially
offset by the fall in AFC. Hence, AC
continues to fall. After a certain
point the rise in AFC becomes
greater than the fall in AFC and AC
starts rising
 Average Cost Curve is U-
shaped
 Basis of Law of Variable Proportion
: According to this Law initially
when variable factor is combined
with the fixed factor, production
increases at an increasing rate
implying AC falls till the best
combination of fixed and variable
factors is attained. Beyond this
point, AC starts to rise.
 AFC, AVC and AC Curves
Cost
AC
AVC
A C
B
A1 C1
B1 AFC
A2 C2
O A4 B2 C3
Output

 Short run AC curve is a vertical summation of AFC and AVC

curves.
 AVC = A2A4, AFC = A1A4. AC = AVC + AFC = A2A4 + A1A4
= AA4
 AC and AVC Curve
 AVC is a part of AC as AC = AVC + AFC
 The minimum point of AC will always be
to the right of minimum point of AVC
 Both AVC and AC are U-shaped curves
 The difference between AC and AVC
decreases with the rise in the level of
output as AC is the aggregation of AVC
and AFC; and, AFC falls continuously as
output increases. AVC and AC never
meets each other as AFC is a
rectangular hyperbola and can never
touch x-axis
 Marginal Cost
 Marginal Cost (MC) - The change in total
cost that results from a change in output:
MC = ΔTC/Δ Q.
 Short run MC can be estimated from TVC as
well
MC = TCn – TCn-1
= (TFCn + TVCn) - (TFCn-1 + TVCn-1)
= (TFCn + TVCn) - (TFCn + TVCn-1)
= TVCn - TVCn-1
 Marginal Cost
Output TFC TVC TC MC

0 10 0 10 -
1 10 10 20 10
2 10 18 28 8
3 10 30 40 12
4 10 45 55 15
 Marginal Cost
Cost MC

O
Output
 MC curve is U-shaped curve due to Law of
Variable Proportion
 MC and AC
Cost MC
AC

O a b
Output
 MC and AC
 Both MC and AC are derived from TC.
MC= ΔTC/ΔQ and AC = TC/Q
 Both AC and MC curves are U-shaped,
reflecting the law of variable proportion.
 When AC is falling MC is below AC
 When AC is rising MC is above AC
 When AC is neither falling or rising AC=MC
 There is a range over which AC is falling but
MC is rising (ab)
 MC curve cuts AC from its minimum point.
 MC and AVC
Cost MC
AC

AVC

AFC

O a b
Output
 MC and AVC
 Moth MC and AVC are derived from TVC.
MC= ΔTVC/ΔQ and AVC = TVC/Q
 Both AVC and MC curves are U-shaped,
reflecting the law of variable proportion.
 When AVC is falling MC is below AVC
 When AVC is rising MC is above AVC
 When AVC is neither falling or rising
AVC=MC
 There is a range over which AVC is falling
but MC is rising (ab)
 MC curve cuts AVC from its minimum point.
 The minimum point of AVC curve occurs to
the right of the minimum point of MC curve.
Production and Costs in the
Long Run
 In the short run, there are fixed
costs and variable costs; therefore,
total cost is the sum of the two.
 A period of time in which all inputs
in the production process can be
varied (no inputs are fixed). In the
long run, there are no fixed costs, so
variable costs are total costs.
 Long-Run Average Total
Cost (LRATC) Curve
A curve that shows the lowest (unit)
cost at which the firm can produce
any given level of output.

A firm attempts to maximize long

run profits by selecting a short scale
of plant that minimizes its costs.
 Long-Run Average Total
Cost
Curve (LRATC )
 There are three
short-run average
total cost curves for
three different
plant sizes.
 If these are the only
plant sizes, the
long-run average
total cost curve is
the heavily shaded,
blue scalloped
curve.
 Long-Run Average Total
Cost
Curve (LRATC )
 The long-run average
total cost curve is the
heavily shaded, blue
smooth curve.
 The LRATC curve is
not scalloped because
it is assumed that
there are so many
plant sizes that the
LRATC curve touches
each SRATC curve at
only one point.
 Economies of Scale
 Economies of Scale exist when inputs
are increased by some percentage and
output increases by a greater percentage,
causing unit costs to fall.
 Constant Returns to Scale exist when
inputs are increased by some percentage
and output increases by an equal
percentage, causing unit costs to remain
constant.
 Diseconomies of Scale exist when
inputs are increased by some percentage
and output increases by a smaller
percentage, causing unit costs to rise.
Why Economies of Scale?
Up to a certain point, long-run unit
costs of production fall as a firm grows.
There are two main reasons for this:
 Growing firms offer greater
opportunities for employees to
specialize.
 Growing firms can take advantage of
highly efficient mass production
techniques and equipment that ordinarily
require large setup costs and thus are
economical only if they can be spread
over a large number of units.
 Why Diseconomies of
Scale?
In very large firms,
managers often find it
difficult to coordinate
work activities,
communicate their
directives to the right
persons in
satisfactory time, and
monitor personnel
effectively.
Economies of Scale

The lowest output

level at which
average total costs
are minimized.
 LAC and LMC
Costs
LMC LAC

O X
Output
Increasing Decreasing
Returns to Scale Returns to
Scale

Constant Returns to Scale

 LAC and LMC
 Both LMC and LAC curves are flatter
U-shaped curves are compared to
SMC and SAC
 LMC cuts LAC at its minimum point
 When LAC is falling LMC is below it
 When LAC is rising LMC is above it
 When LAC is neither falling or rising
LMC = LAC
 Shifts in Cost Curves

A firm’s cost curves will shift if there

is a change in:
Taxes
Input prices
Technology.