Cost of production - Aggregate of price paid for the
factors used in producing a commodity.
Cost concepts :
1. Used for accounting purposes.
2. Analytical, used in economic analysis.
Opportunity cost and Actual cost
Opportunity cost is the income foregone for the
current best use of a resource.
Business Costs and full costs – Actual cost or real
cost i.e. all payments and contractual obligations
made by the firm and is used for calculating
Accounting costs are the costs most often associated with the
costs of producing.
Economic costs are not only the costs of producing a good, it
also includes the opportunities forgone by producing this
Example: If a firm is producing Computers then the
accounting costs are the costs incurred for producing the
computers. Economic costs include the cost of producing the
computers as well as opportunity cost. Suppose, If this firm
could lease its office and the plant for say $100,000 then that
is the oppurtunity cost.
Explicit and Implicit costs – Explicit is the actual
money expenses recorded in the books of
Cost not appearing in the accouning system are
implicit costs. E.g. opportunity costs.
Explicit + Implicit costs = Economic costs
Total Cost (TC)
Total Fixed Cost (TFC)
Total Variable cost (TVC)
Average Fixed cost (AFC)
Average Variable cost (AVC)
Average total cost (ATC)
Marginal cost (MC)
Fixed and variable costs
Total, Average and marginal costs.
Short run and long run costs
Incremental and sunk costs
Historical and replacement costs
Private and social costs
Total fixed cost is the cost associated
with the fixed input.
EXAMPLE:- charges such as
contractual rent , insurance fee ,
maintenance cost , property tax,
interest on the borrowed funds etc.
AFC = TFC/Q
AFC is the fixed cost per unit of
As output increases , the total fixed cost
spreads over more & more units &
therefore avg. fixed cost becomes less &
Total variable cost is the cost associated
with the variable input.
EXAMPLE: it includes payment to labour
employed , the prices of the raw material
, fuel & power used etc.
It is often drawn like a
flipped over S, first
getting flatter & flatter,
& then steeper & steeper.
This shape reflects the
increasing & then
returns we discussed in
the section on production.
AVC = TVC/Q
AVC is the variable cost per unit of
Suppose X is the amount of variable input & PX is its
AVC = TVC/Q = (PXX)/Q
= PX [1/(Q/X)]
= PX [1/AP].
So since AP had an inverted U-shape, AVC must have
TC = TFC + TVC
The TC curve
looks like the TVC
curve, but it is
shifted up, by the
amount of TFC.
Like AVC, ATC is
U-shaped, but it
reaches its minimum
after AVC reaches its
This is because
ATC = AVC +AFC &
AFC continues to fall
& pulls down ATC.
Marginal Cost (MC)
Marginal cost measures the additional
cost of inputs required to produce each
successive unit of output
MC = ΔTC/ ΔQ
Alternatively, MC = dTC/dQ .
MC is the first derivative of the TC curve or
the slope of the TC curve.
Suppose the firm takes the prices of inputs as given.
MC = ∆TC/∆Q
= PX ∆X/ ∆Q
= PX [1/(∆Q/∆X)]
= PX [1/MP].
So since MP had an inverted U-shape, MC must have
Labour (variable) and capital (fixed) are two factor
Price of labor : Rs.10/unit
Price of capital : Rs.25/unit
FC remains constant at all levels of output
TVC varies with output
TVC does not change in the same proportion
TC varies in the same proportion as the TVC.
The graph above is also a result of linear cost
TC = a + bQ
a = TFC, Q = quantity produced, TC = total cost
b = change in TVC due to change in Q
AC= a/Q + b
MC = b
AVC = b
AFC decreases as the output increases.
AVC first decreases and then increases as the
ATC first decreases , remains constant and then
increases as the output increases.
MC first decreases and then increases as the
When the average cost is minimum, MC=AC
AVC is U shaped indicating its three phases i)
Decreasing ii) Constant iii) increasing.
Corresponds to the law of variable proportions.
ATC : vertical summation of AFC and AVC curves.
It is U shaped indicating that if the output is
increased, initially the average cost decreases,
remains constant and then starts rising .
ATC = AFC + AVC
ATC falls in the beginning since AFC and AVC
At a certain point, even though AVC starts rising,
ATC continues to fall because of predominance of
falling AFC curve over the rising AVC curve.
With further expansion of output, AVC takes over
AFC and hence ATC starts rising.
The point at which the rise of AVC nullifies the
falling AFC, ATC is constant.
The distance between ATC and AVC narrows
down as the curve moves up.
Economic reason – Fixed cost is important for a
firm till the normal capacity is exhausted. Beyond
that, more and more variable inputs are added to
increase output .
There is also a relationship between marginal
costs and average total costs.
◦ Average total cost is equal to total cost divided by the
number of units produced.
◦ Marginal cost is the change in total
cost due to a one-unit change in the production rate.
When marginal costs are less than average
variable costs, the latter must fall.
When marginal costs are greater than average
variable costs, the latter must rise.
AC is minimum, MC is
equal to AC .
At this point , MC cuts AC from
This is the optimization point of
cost to output in the short run .
◦ What do you think—is there a predictable relationship
between the production function and AVC, ATC, and
◦ As long as marginal physical product rises, marginal cost
will fall, and when marginal physical product starts to fall
(after reaching the point of diminishing marginal product),
marginal cost will begin to rise.
Firms’ short-run cost curves are a reflection of the
law of diminishing marginal product.
Given any constant price of the variable input,
marginal costs decline as long as the marginal
product of the variable resource is rising.
At the point at which diminishing marginal product
begins, marginal costs begin to rise as the
marginal product of the variable input begins to
If the wage rate is constant, then the labor cost
associated with each additional unit of output will
decline as long as the marginal physical product
of labor increases.
Long Run Total Cost
All inputs are variable in the long
run. There are no fixed costs.
LONG-RUN TOTAL COST CURVE
The LAC curve is an envelop curve of all possible
plant sizes. Also known as “planning curve”
It traces the lowest average cost of producing
each level of output.
It is U-shaped because of
◦ Economies of Scale
◦ Diseconomies of Scale
LONG-RUN AVERAGE COST CURVE
Building a larger sized plant (size 2)
will result in a lower average cost of
Likewise, a larger sized plant (size
3) will result to a lower average
cost of producing q1
• LRAC can never cut SRAC but it will be tangential
to each SRAC at some point.
• Average cost can not be higher in the long run
than in the short run;
1.Any adjustment which will reduce costs possible to
be made in the short run must also be possible in
the long run
2.It is not always possible in the short run to produce
a given output in the cheapest possible way as all
the factors are not variable.
Long run average cost curve
Based on assumption of unchanging
LRAC is flatter curve than the SRAC.
In economics ,we define long period
as that during which size of the
organization can be altered to meet
Output increases and average costs
But in long run, size of the firm Can
increased therefore Variable
costs are likely to rise less sharply.
Hence a flatter curve.
is the lowest
output level for
which LRAC is
Diseconomies of Scale
Economies of Scale
LONG-RUN AVERAGE COST CURVE
LONG-RUN AVERAGE and MARGINAL COST CURVES
Long-run Average Cost (LAC) curve
◦ is U-shaped.
◦ the envelope of all the short-run average cost
◦ driven by economies and diseconomies of size.
Long-run Marginal Cost (LMC) curve
◦ Also U-shaped;
◦ intersects LAC at LAC’s minimum point.
MC = ΔTC/ΔQ
or MC = dTC/dQ
MC < ATC when ATC is decreasing,
MC > ATC when ATC is increasing, &
MC = ATC when ATC is at its minimum.
long run MC & short run marginal cost will
be equal at that output.
That is, the LR MC & SR MC will intersect at
condition for optimisation is
the same as Short run curve.
LAC= LMC= SAC= SMC
LAC and SAC are at their
In the long run, all inputs are variable.
◦ What makes up LRAC?
Labor Specialization: Jobs can be subdivided and
workers performing very specialized tasks can
become very efficient at their jobs.
Managerial Specialization: Management can also
specialize in a larger firm (in areas such as
marketing, personnel, or finance).
Equipment that is technologically efficient but only
effectively utilized with a large volume of production
can be used.
The Long-Run Cost Function
• Reasons for Economies of Scale…
Increasing returns to scale
Specialization in the use of labor and capital
Economies in maintaining inventory
Discounts from bulk purchases
Lower cost of raising capital funds
Spreading promotional and R&D costs
ADVANTAGES AND DISADVANTAGES OF LARGE SCALE PRODUCTION
Economy of labour
buying and selling
Reduction in costs when the scale
of production increases is called
Large scale production provides
opportunities for technological
Large scale production workers of
varying skills & qualifications are
employed which facilitates division
of labour as per specialization
.. Large scale selling
of firms own
.. Large scale
purchase of raw
materials & other
.. Advertising cost
Improves the overall
performance of the firm
.. Specialization in
.. Mechanization of
management of the
.. Proper utilization of
.. Helps in reducing
CAUSES OF INTERNAL ECONOMIES
Bigger capacity lowe
Spreading of costs
Shorter period of
CAUSES OF EXTERNAL ECONOMIES
Common Pool of
The benefits which
companies derive from
trade publications and
By virtue of location,
common pool of
research can be created
and benefits can be
Breaking up of
processes which can be
handled by specialist
Expansion of the management hierarchy leads to
problems of communication, coordination, and
bureaucratic red tape, and the possibility that
decisions will fail to mesh. (“The left hand doesn’t
seem to know what the right hand is doing.”) The
result is reduced efficiency.
In large facilities, workers may feel alienated and may
shirk (not work as much as they should). Then
additional supervision may be required and that
adds to costs.
The Long-Run Cost Function
• Reasons for Diseconomies of Scale…
Decreasing returns to scale
Input market imperfections e.g. wage rate
Management coordination and control
Disproportionate rise in transportation costs
Disproportionate rise in staff and indirect
the long run, a firm exercises its choice
with regard to the size of the plant and
scale of production, on the basis of long run
Selection of the optimal plant size according
to the expected demand.
Avoid unnecessary costs due to inappropriate
The reasons for the LAC curve being L shaped are
as follows :
Technological progress :In economics
theory,technological is assumed to be
constant.But technology changes in real life.Due
to this,the average cost decline and does not rise
Learning by doing :The LAC curve completely
slopes completely downwards due to learning by
doing.Since the efficiency of firm increases due to
continuous work,it is able to reduce cost.As the
output is increased,there is not only the increase
in knowledge of many things,there is also an
improvement in the management of plant.Due to
this LAC curve is L shaped
Management technique :According to the modern
management theory,appropriate administrative
structure is available to operate the plant of each
size.There exists appropriate management
technique in different levels of management.The
management technique is available in large and
small size.The cost of different management first
fall up to certain plant size.The managerial cost
slowly increases to very large level of output.
Break even point (BEP) is located at that level of
output or sales at which net income or profit is
BEP is located at that level of output at which the
price or AR is equal to AC.
Contribution margin = Price – AVC
Formula for calculating BEP=
TFC/ P- AVC where P- AVC
BEP in terms of sales value
BEP = FC/ Contribution ratio
Contribution ratio = TR-TVC/ TR
BEA can be used for determining ‘safety margin’
regarding the extent to which the firm can permit a
decline in sales without causing losses.
Safety Margin = Sales- BEQ/ Sales *100
BEA can be useful in determining the target profit
Target profit sales vol = TFC- Target profit /