Costs

Costs and Production

Cost Curves
Returns to Scale – Revisited

ME – 7(A)
Cost in Economics

• Costs are understood differently in Economics and

Accounting
• The goal of Cost Analysis in economics is to arrive at
true value of production –
– Profit is an element of cost in economics rather than a residue
– Opportunity Costs are important in decision making – especially
in use of self-owned assets
– Depreciation charges are based on actual estimation of wear
and tear
– Historical and replacement costs
– Private and Social costs
Basic Concepts in Costs

• Total Costs (TC) = Total costs incurred in producing a

given level of Output. Total costs comprise of Total Fixed
Costs (TFC) and Total Variable Costs (TVC)
• Total Fixed Costs (TFC) = are costs incurred in fixed
assets that remain constant over a given range of Output
levels – eg. Land and building, plant and machinery, etc.
• Total Variable Costs (TVC) = costs that vary with the
level of output eg. Raw material, labour, electricity, etc.
Basic Concepts in Costs

• Average Fixed Cost (AFC) = TFC/Output

• Average Variable Cost (AVC) = TVC/Output
• Average Cost (AC) = TC/Output
• Marginal Cost (MC) = Cost of producing the last unit of
Output = ∆TC/ ∆TP.
– Given TFC as constant - ∆TC = ∆TVC.
– Therefore –
MC = ∆TVC/ ∆TP
Cost And Production Function
 Production Function
Marginal Product will Total Product will

Output
Increase initially (OA) Increase at increasing rate (OD) Marginal Product
A
Then decrease after certain level (AB) Increase at decreasing rate (DE) 30

Will reach Zero (B) Reach a maximum (E)

Then becomes negative (BC) Start declining (EF)

Kapital Labour MP TP AP
B
100 1 10 10 10 O
3 Labour Units 7
100 2 20 30 15 C
102
100 3 30 60 20 E

Output
F
100 4 20 80 20

100 5 15 95 19 Total Product

D
100 6 7 102 17

100 7 0 102 15
O Labour Units
100 8 -10 92 12 3 7
Cost and Production Function
Kapital Labour MP TP AP TFC= TVC= TC= AVC= AFC= AC= MC=
K L K*r L*w TFC+TVC TVC/TP TFC/TP TC/TP ∆TVC/∆TP
100 1 10 10 10 500 20 520 2.00 50.00 52.00 2.00
100 2 20 30 15 500 40 540 1.33 16.67 18.00 1.00
100 3 30 60 20 500 60 560 1.00 8.33 9.33 0.67
100 4 20 80 20 500 80 580 1.00 6.25 7.25 1.00
100 5 15 95 19 500 100 600 1.05 5.26 6.32 1.33
100 6 7 102 17 500 120 620 1.18 4.90 6.08 2.86
100 7 1 103 14.7 500 140 640 1.36 4.85 6.21 20.00

Assume –
• Conclusions – • Per unit cost of Kapital = r = Rs. 5
Per unit cost of labour = w = Rs. 20
– MC, AC and AVC are ‘U’ shaped •

– Thus TC and TVC will initially increase at diminishing rate and

then increase at increasing rate
– When MC is falling AC and AVC are above MC
– MC intersects AVC at min of AVC after which MC is above AVC
– Intersection of MC and AC is to the right of min of AVC
Cost Curves

• Conclusions – AC

AC, AVC, MC
– MC, AC and AVC are ‘U’ shaped
– Thus TC and TVC will initially
AVC
increase at diminishing rate and then MC

increase at increasing rate

AFC
– When MC is falling AC and AVC are
above MC Output TC

TC, TVC, TFC

– MC intersects AVC at min of AVC after
TVC
which MC is above AVC
– Intersection of MC and AC is to the
TFC
right of min of AVC
Output
Cost Curves and Product Curves

• Given fixed wage rate ‘w’ there exists an inverse

relationship between MC and MPL
MC = dVC/dQ = w. dL/dQ
But as MPL = dQ/dL
MC = w/MPL

• Thus when MPL is rising MC is falling and vice versa

• Given the ‘U’ shape of MC curve it follows that the MC is
a quadratic function.
• TC is a cubic function.
Returns to Scale - Revisited
Long Run Costs

• The Long run costs generally

LMC, LAC
display the same shapes as the LMC
short-run curves LAC
• However – while in the short-run
the source of the ‘U’ shape of AC
is the diminishing marginal
Economies Diseconomies of Scale
returns from factors –
• Whereas in Long-run the ‘U’ Output

shape of the AC is due to the

economies and diseconomies of
scale
Long Run Cost Curves

• The LAC is an envelope curve

LMC, LAC
covering a series of SACs – LMC
assuming a continuous LAC
increment in plant sizes is
available
• LMC, however bears no direct
Economies Diseconomies of Scale
relation with SMCs.
• This is because while SMC is Output

essentially VC, while LMC will

also include FC
 Costs and Constant Returns to Scale

• In case of Constant Returns to Scale –

– Unit increase in inputs leads to a unit increase in Output
– LAC is thus a horizontal line parallel to X axis and LMC = LAC
– Successive SACs are such that the minimum point of SAC lies
on the LAC

SAC1 SAC3
SAC2
Costs

LAC = LMC

SMC1 SMC2 SMC3

Long Run Output

 Costs and Increasing and Decreasing Returns to Scale

• In case of returns to scale that are not constant –

– The LAC will initially be downward sloping due to economies of scale
– After a point the LAC will move upwards as diseconomies set-in
– The LAC will thus be ‘U’ shaped
– The minimum of successive SACs will not be on the LAC – except
where LAC is minimum.
SAC3

SAC1 LAC
SAC2
Costs

SMC1
SMC3

LMC
SMC2
Long Run Output