Theory of Cost

CPT Section C: General Economics

Chapter 3 Unit 2
Ms. Anita Sharma

COST

COST ANALYSIS
Cost Analysis Refers to the Study of
Behavior of Cost in Relation to
Production

Various concepts of cost

Accounting costs & economic costs

Outlay costs & opportunity costs
Direct costs & indirect costs
Fixed & variable costs

Accounting costs & economic costs

Accounting costs

Economic costs

Accounting costs are

Economic cost include

also called as Explicit

costs.
It refers to all payments

made to suppliers.

explicit cost and

implicit cost.
It refers to all payments

made to suppliers as
well as imputed
payments

Accounting Costs

Accounting Costs
It take care of all the payments and charges made

by the entrepreneur to the suppliers of various

productive factors.
Example: wages to workers,
price of the raw material,
rent of the building etc.

ECONOMIC COSTS

ECONOMIC COSTS
The economic cost include :
The normal returns on money capital invested by the

entrepreneur himself in his own business.

The wages or salary not paid to entrepreneur, but
could have been earned if the services had been
sold somewhere else.
Example: monetary rewards for all factors owned by
the entrepreneur himself.

Economic costs
Explicit
Costs

Implicit
Costs

Economic
Costs

OR

Accounting
Costs

Implicit
Costs

Economic
Costs

Outlay Costs & Opportunity Costs

Outlay Costs

It involves actual

expenditure of funds on
say wages, rent,
interest etc.
Outlay costs are

recorded in the books

of accounts.

Opportunity Costs

It is concerned with the

cost of forgone
opportunity.
Opportunity Costs are

not recorded in the

books of accounts.

Opportunity Costs
It involves a
comparison
between the policy
that was chosen
and the policy that
was rejected.
Example: The
opportunity cost of
using capital is the
interest it can earn
in the next best use
of capital with equal
risk.

Types of Costs

Cost

Direct cost
(Traceable cost)

Indirect Cost
(Non-traceable cost)

Direct Cost
Cost that are readily identified and are traceable to a

particular product, operation or plant.

Example: Manufacturing cost

Indirect Cost
Cost that are neither readily identified and are nor

visibly traceable to specific goods, services,

operations etc.
But they bear some functional relationship to
production
Example: Electric power, Common costs for general
operation

Fixed & variable costs

Fixed Costs

Costs which do not

change with the

change in level of
output.

Variable Costs

The costs which

change with the

change in the level of
output.

An example of Fixed & Variable costs

Fixed cost

Variable cost

Fixed Costs

Fixed Costs
These costs vary with the size of plant and are a

function of capacity.
Fixed costs do not vary with the volume of output
within a capacity level.
Fixed costs cannot be avoided.
They can be avoided only when operations are
completely closed down
Example: rent, property taxes, depreciation, interest
on loans etc.

Variable Costs
Costs that are a function of output in the production

period.
Variable costs vary directly and sometimes
proportionately with output.
Example: wages, raw material etc.

Cost function
It refers to the mathematical relation between cost of a

product and the various determinants of costs.

C = f (QX)
C = cost
f = function
(QX) = quantity produced

Time Period

Time Period

Short-run

Long-run

Short-run
It is a period of time in which output can be

increased or decreased by changing only the

amount of variable factors.
Such as labor, raw materials etc.
In the short run, quantities of fixed factor cannot be
varied

Long-run
It is a period of time in which output can be

increased or decreased by changing quantities of all

factors.
E.g.: Building, Machinery, Raw material, Labor etc.

Short-run
It is a period of time in

which only variable

factors can be varied.
Quantities of fixed factor

remain unchanged.

Long-run
It is a period of time in

which the quantities of all

factors may be varied.
No factor is fixed in long-

run.

Short-run

In short-run factors
are of two types

Fixed Factor

Variable Factor

Fixed Factor
Factors which cannot be

easily varied.
E.g.- machinery, building,

capital equipments, top

management team etc.

Variable Factor
Factors which can be

easily varied.
E.g.- workers, raw

material, fuel, power etc.

Short run Costs

Short run
costs
Short-run
Unit costs

Short-run
Total costs

TFC

TVC

TC

AFC

AVC

ATC

MC

Short-Run Total Costs

Total Fixed Costs (TFC)

Total Variable Costs (TVC)
Total costs (TC)

Total fixed costs (TFC)

Costs which are independent of output.
They do not change with change in output.
E.g.- rent, insurance fee, maintenance cost etc.

Total fixed costs (TFC)

Total Fixed Cost

TFC

Output

Total variable costs (TVC)

Costs which change with change in output.
If a firm shuts down for a short period then it will not

incur any variable cost.

E.g.- wages of labor, prices of raw material, fuel &
power etc.

Total variable costs (TVC)

Y

Total Fixed Cost

TVC

Output

Total semi-variable costs

Some cost which are neither perfectly variables, nor

absolutely fixed in relation to the changes in the size

of output.
E.g.- Electricity

Total semi-variable costs

Y

Variable
component
production

Fixed
component

A stair-step variable cost

Y

TVC

Variable cost

Output

Total cost of a business is the sum of Total

Variable cost and Total Fixed cost.

TFC, TVC & TC

TVC

TC

TFC

How to get TC curve?

The total cost curve has been obtained by

adding vertically the total fixed cost curve
and the total variable cost curve.

Short run unit cost curves

Average Fixed Cost (AFC)

Average Variable Cost (AVC)
Average Total Cost (ATC)
Marginal Cost (MC)

Average Fixed Cost (AFC)

It is fixed cost per unit of output.

AFC = TFC/Q
AFC will slope downward nut never touches either of
axis.
AFC can not be zero.

Average Fixed Cost (AFC)

cost

AFC

Output

Average Variable Cost (AVC)

AVC is variable cost per unit of output

AVC = TVC/Q
AVC first falls, then reaches a minimum and then
rises
It is a U-shaped curve.

Average Variable Cost (AVC)

Y

cost

AVC

Output

Average Total Cost (ATC)

It is the sum of AFC and AVC

ATC = AFC + AVC

Shape of ATC is also U-shaped curve.
ATC

cost

AVC

AFC
Output

Average Total Cost (ATC)

cost

ATC

Output

Why ATC is U-shaped?

Because ATC = AFC + AVC
ATC

cost

AVC

AFC

Output

Unit cost curves

Initially both AFC & AVC fall.
Therefore, ATC falls.
When AFC and AVC intersect with each other, ATC is

minimum.
As, output increases AVC rises but AFC continues to
fall
Therefore AC rises
Due to the behavior of AFC & AVC the ATC curve is
U-shaped.

Average unit cost curves

ATC
AVC

AFC

MARGINAL COST (MC)

Marginal Cost is the addition made to the total cost

by the production of an additional unit of output.

MC = TCn TCn-1
OR
MC = TC/Q
TC = Change in total cost
Q = Change in output

MARGINAL COST (MC)

Cost

MC

Output

Features of marginal cost

Marginal cost (MC)

not affected by
fixed cost.

Marginal cost (MC)

is due to changes
in variable cost
which changes
with the changes
in variable costs.

Features of marginal cost

Marginal cost
(MC) curve is U
shaped.

Marginal cost
(MC) initially falls,
reaches to
minimum then
rises.

Why marginal cost curve is U-shaped?

Due to the operation of Law of variable proportion.
In the beginning due to increasing returns, Marginal

cost falls.
Then after due to diminishing returns, Marginal cost
rises.

Relationship between AC & MC

1) When AC decreases, MC < AC.
2) When AC is minimum, MC = AC.
3) When AC increases, MC > AC.
4) MC curve cuts AC curve at its minimum point.

Relationship between AC & MC

Y
MC
AC

Q1

Q2

Short run costs

Units of
Output

TFC

TVC

TC

AFC

AVC

ATC

MC

20

20

20

30

50

20

30

50

30

20

45

65

10

22.50

32.50

15

20

55

75

6.67

18.33

25.00

10

20

75

95

5.00

18.75

23.75

20

20

110

130

4.00

22.00

26.00

35

20

165

185

3.33

27.50

30.83

55

Behavior of different costs

Fixed cost does not change with increase in output

upto a given level.

AFC comes down with increase in output but never
becomes zero.
Variable cost increases, but not necessarily in the
same proportion as the increase in output.
AVC is U-shaped.
MC is the additional cost divided by the additional
units produced.

Long run Costs

Long-run is a period of time during which the firm

can vary all of its inputs.

In the long-run the firm moves from one plant to
another

Long run Costs

It can acquire a big plant if it wants to increase its

output.
Long run cost is least possible cost of producing any
given level of output.

Long run Costs

Long run TC
Long run AC
Long run MC

Long run Average Cost Curve

How long run AC is derived?

It can be derived with the help of short run AC

curves.
Suppose, we take three short run AC curves

Short run cost curves (SACs)

are also called plant curves

How long run AC is derived?

Diagram
In the long run the firm will examine with which size of

plant (SAC), it should operate to produce a given level

of output, so that total cost is minimum.

Diagram
Upto OB

amount of
output, the
firm will
operate on
the SAC1
so the cost
can be
minimum.

Diagram
If the level

of output is
OA the firm
will produce
again on
SAC1 to
minimize
the cost

Diagram
If the firm

plan to
produce an
output
which is
larger than
OB but less
than OD.
Now, the
firm will
produce on
SAC2.

Diagram
The firm will

use SAC3
for output
larger than
OD.

Multiple Average Cost Curves

In long run there are infinite number of plants

corresponding to which there are numerous average

cost curves.

Long run AC curves

LONG RUN AVERAGE COST

In such a case the long run Average cost curve will

be a smooth curve enveloping all these short run

average cost curves

How to draw a long-run AC curve?

The long run AC curve is so drawn as to be tangent to

each of the short-run average cost curves.

Every point
on the longrun average
cost curve will
be a
tangency
point with
some short
run AC curve.

A) When the

LAC curve is
declining, it
is tangent to
the falling
portions of
the short run
cost curve.

It is to be noted that LAC curve is not

tangent to the minimum points of the
SAC curves

When the
LAC curve
is rising, it
is tangent
to the rising
portions of
the short
run cost
curves.

It is to be noted that LAC curve is not

tangent to the minimum points of the
SAC curves

Output less than OQ

The firm will

operate it at
less than full
capacity
i.e., at less
than its
minimum AC
of production.

Output larger than OQ

The firm will

operate it
beyond its
optimum
capacity.

Output at OQ level

The firm
operate it only
at the
minimum point
of LAC and
corresponding
to SAC.

Only SAC4 is being operated

at the minimum point.

Long run AC is also called a planning curve

Why long-run AC curve is U-shaped?

The shape of LAC curve depends upon the returns

to scale.
It is flattened U shaped curve.

Returns to Scale

Due to increasing returns to scale

LAC curve first declines

Due to constant returns to scale LAC

curve is constant

Due to diminishing returns to scale

LAC curve finally rises

Long Run AC curve

Long run
AC curve

Planning
curve

Envelope
curve

Shape of Long run AC curve

It can be U-shaped (technically constant)
OR
It can be L-shaped (technically changes in long run)

Formulas

Formulas

TC

TFC

TVC

OR

TC

TFC

MC

TC

AC

TC

TFC at zero level output

Formulae

TFC

TFC

TFC

TC

AFC

TVC

AFC at one unit output

Formulae

TVC

TC

TVC

TFC

AVC

TVC

MC

Formulae

Formulae

Formulae

Formulae

1. Which Cost Increases Continuously

With the Increase in Production?
a) Average cost
b) Marginal cost
c) Fixed cost
d) Variable cost
Answer. (d)

2. Which of the Following Cost Curves is

Never U-shaped?
a)Average cost curve
b) Marginal cost curve
c) Average variable cost curve
d) Average fixed cost curve
Ans. (d)

3. Total cost in the short run is classified into fixed costs

and variable costs. Which one of the following is a
variable cost?

a) Cost of raw material

b) Cost of equipment
c)Interest payment on past borrowings
d)Payment of rent on building
Ans. (a)

4. In the Short Run, When the Output of a

Firm Increases, Its Average Fixed Cost:

a) Increases
b) Decreases
c) Remains constant
d) First declines and then rises
Ans. (b)

5. Which One of the Following is Also

Known as Planning Curve?

a) Long run average cost curve

b) short run average cost curve
c) Average variable cost curve
d) Average total cost curve
Ans. (a)

6. The Efficient Scale of Production is

the Quantity of Output That Minimizes:

a) Average fixed cost

b) Average total cost
c) Average variable cost
d) Marginal cost
Ans. (b)

7. The Cost of One Thing in Terms of

the Alternative Given Up is Known as:

a) Production cost
b) Physical cost
c) Real cost
d) Opportunity cost
Ans. (d)

8. With Which of the Following is the Concept

of Marginal Cost Closely Related?

a) variable cost
b) fixed cost
c) opportunity cost
d) economic cost
Ans. (a)

9. Which of the Following Statement is

Correct?

a) When the average cost is rising ,the marginal cost must be rising

b) When the average cost is rising ,the marginal cost must be falling.

c) When the average cost is rising ,the marginal cost is above the
average cost.

d) When the average cost is falling, the marginal cost must be rising.

Ans. (c)

10. Which of the Following is an Example of

Explicit Cost ?
(A) The Wages A Proprietor Could Have Made By Working as An
Employee of A Large Firm.
(B) The Income That Could Have Been Earned In Alternative
Uses By the Resources Owned By the Firm.
(C) The Payment of Wages By the Firm.

(D) The Normal Profit Earned By a Firm.

Ans. (C)

11. Which of the Following is an Example

of Implicit Cost ?
(a) interest that could have been earned on retained earnings used
by the firm to finance expansion.
(b) the payment of rent by the firm for the building in which it is
housed.
(c) the interest payment made by the firm for funds borrowed from a
bank.
(d) the payment of wages by the firm.
Ans. (a)

MCQs
12. Use the following data
Output
(O)

Total
cost
(TC)

Rs. 240

Rs. 330

Rs. 410

Rs. 480

Rs. 540

Rs. 610

Rs. 690

The average fixed cost of 2 unit of output is

(a) Rs 80
(b) Rs 85
(c) Rs 120
(d) Rs 205
Ans. (c)

13. The Marginal Cost of the Sixth Unit of

Output is :

(a) 133
(b) 75
(c) 80
(d) 450
ans. (c)

14. Diminishing Marginal Returns Start to

Occur Between Units:

a) 2 and 3
b) 3 and 4
c) 4 and 5
d) 5 and 6
ans. (c )

15. Marginal cost is defined as:

a) The Change in total cost due to a one unit change in out put .
b) Total cost divided by output.
c) The change in output due to a one unit change in an input.
(d) Total product divided by the quantity of input.
ans.(a)

16. Which of the following is true of the relationship

between the marginal cost function and the average
cost function?

a) If MC is greater than ATC, then ATC is falling.

(b) The ATC curve intersects the MC curve at minimum MC.
(c) The MC curve intersects the ATC curve at minimum ATC.
(d) If MC is less than ATC then, ATC is decreasing.
ANS. (c)

17. Which of the Following Statement is True of

the Relationship Among the Average Cost
Functions?

a) ATC = AFC AVC

b) AVC = AFC + ATC
c) AFC = ATC + AVC
d) AFC = ATC AVC
ans. (d)

18. If the Average Cost is Falling ,Then:

a) Marginal cost is rising

b) Marginal cost is falling
c) Marginal cost is equal to average cost
d) It is impossible to tell if marginal cost is rising or falling.
ans. (d)

19. In the long run ,if a very small factory

were to expand its scale of operations, it is
likely that it would initially experience

a) An increase in pollution level

b) Diseconomies of scale
c) Economies of scale
d) Constant returns to scale
ans. (c)

20. Marginal Cost Changes Due to Changes

in------

a) Total cost
b) average cost
c) variable cost
d) Quantity of output
ans. (c)

Thank You