2. NATURE OF COSTS
Actual cost: cost incurred in production
Opportunity cost: return from the second best use of
firm’s resources which the firm foregoes in order to
avail the return
Explicit / Accounting Costs : Actual money spent in
purchasing or hiring services of factor
Implicit / Imputed cost: Cost of self-owned and self-
employed resources
3. Fixed costs: Costs which do not change with change
in Out Put.
Variable or Prime costs: Costs which change with
change in level of Out Put
Accounting costs: Cost as stated in books of
accounts (explicit cost only)
Economic Costs: includes both explicit & implicit cost
NATURE OF COSTS
4. Marginal cost: Change in total cost associated with
a one-unit change in output
Incremental Costs: Total additional cost of
implementing a managerial decision
Sunk Costs: costs which do not change by varying
the nature or level of business activity
NATURE OF COSTS
5. NATURE OF COSTS
Private cost: Actually incurred or provided for by an
individual for its business activity
Social cost: Cost to society on account of production of
good
Original cost: cost incurred originally
Replacement cost: cost incurred in replacing
6. EXERCISE
A Carpenter makes 100 chairs per month & sells them at
Rs 150 per piece. His expenses on rent of shop, cost of
wood & other materials are worth Rs 5000. He employs 2
workers whose monthly wage bill stand at Rs 2400 & pays
electricity bill of Rs 500 per month. He has invested Rs
50,000 in the form of machines, tools & inventories of
which Rs 25,000 is from his own fund & remaining 25,000
is a loan from bank at interest rate of 18% p.a. Assuming
imputed cost of his own time, own shop & own savings of
Rs 25000 as Rs 3000, Rs 1000 & Rs 250 respectively,
find:
Explicit cost
Implicit cost
Accounting profit
Economic profit
8. COST FUNCTION
C = f (S, O, P, T……)
Where:
C: Cost of O/P
S: Size of plant
O: level of O/P
P: price of I/Ps used in production
T: nature of technology
9. SR RELATIONSHIP BETWEEN PRODUCTION AND
COST
A firm’s cost structure is intimately related to its
production process
Costs are determined by the production technology and
input prices
10. SR RELATIONSHIP BETWEEN PRODUCTION AND COST
In order to illustrate
the relationship,
consider the
production process
described in table
Total
Input
(L) Q (TP) MP
0 0
1 1,000 1,000
2 3,000 2,000
3 6,000 3,000
4 8,000 2,000
5 9,000 1,000
6 9,500 500
7 9,850 350
8 10,000 150
9 9,850 -150
11. SR RELATIONSHIP BETWEEN PRODUCTION & COST
Total variable
cost (TVC) is
the cost
associated with
the variable
input, in this
case labor
Assume that
labor can be
hired at a price
(w) of Rs 500
per unit
TOTAL
I/P (L) Q (TP) MP
TVC
(wL)
MC
(∆TVC/
∆Q)
0 0 0
1 1000 1000 500 0.5
2 3000 2000 1000 0.25
3 6000 3000 1500 0.16
4 8000 2000 2000 0.25
5 9000 1000 2500 0.5
6 9500 500 3000 1
7 9850 350 3500 1.4
8 10000 150 4000 3.33
9 9850 -150 4500
12. SR RELATIONSHIP BETWEEN PRODUCTION & COST
TP and TVC are mirror images of each other
When TP increase at an increasing rate, TVC increase at a
decreasing rate
13. RELATION B/W MP & MC
When MP is
increasing, MC is
decreasing
When MP is
decreasing, MC is
increasing
Total
Input
(L) Q MP
TVC
(wL) MC
0 0 0
1 1,000 1,000 500 0.50
2 3,000 2,000 1,000 0.25
3 6,000 3,000 1,500 0.17
4 8,000 2,000 2,000 0.25
5 9,000 1,000 2,500 0.50
6 9,500 500 3,000 1.00
7 9,850 350 3,500 1.43
8 10,000 150 4,000 3.33
9 9,850 -150 4,500
15. SHORT-RUN COST FUNCTIONS
Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC =TVC/Q
Average Total Cost = ATC = TC/Q
Average Total Cost = AFC + AVC
Marginal Cost = ∆TC/∆Q =∆TVC/∆Q
17. 0
50
100
150
200
250
0 1 2 3 4 5 6
Output
Output
Cost
Cost
Total Cost Function
Per Unit Cost Function
0
10
20
30
40
50
60
70
80
90
0 1 2 3 4 5 6
T C
A V C
A C
M C
T F C
T V C
AFC
18. SHORT RUN COST FUNCTION: IMPORTANT
OBSERVATIONS
AFC declines steadily over the range of production
In general, AVC, AC, and MC are U shaped
When MC<AVC, AVC is falling
When MC>AVC, AVC is rising
When MC=AVC, AVC is at its minimum
The distance between AC and AVC represents AFC
19. SHORT-RUN COST FUNCTIONS
Average Variable Cost
AVC = TVC = w L
Q Q
= w = w
Q/L APL
Marginal Cost
∆TC/∆Q = ∆TVC/∆Q = ∆(w L)/∆Q
= w = w
∆Q/∆L MPL
20. LR RELATIONSHIP B/W PRODUCTION & COST
All I/Ps variable
No fixed costs
LR cost structure of firm is related to firm’s long run
production process which is described by RTS
Economists hypothesize that a firm’s long-run
production function may exhibit at first IRS then CRS
& finally DRS
21. LR RELATIONSHIP B/W PRODUCTION & COST
IRS:
A proportional increase in all I/Ps increases O/P by a greater
percentage than costs
Costs increase at a decreasing rate
CRS:
A proportional increase in all I/Ps increases O/P by same
percentage as costs
Costs increase at a constant rate
DRS:
A proportional increase in all I/Ps increases O/P by a
smaller percentage than costs
Costs increase at an increasing rate
27. LONG-RUN COST FUNCTION
When LRAC declines: firm experiences
economies of scale (per-unit costs are falling)
When LRAC increases: firm experiences
diseconomies of scale (per-unit costs are rising)
31. MANAGERIAL USES OF COST FUNCTIONS:
DETERMINING OPTIMUM OUTPUT LEVEL
O/P level at which AC is minimum
Necessary condition: ∂(AC) / ∂Q = 0
Sufficient condition: ∂2
(AC) / ∂Q2
> 0
32. MANAGERIAL USES OF COST FUNCTIONS:
DETERMINING OPTIMUM SCALE
Value of plant size (K) at which total cost (C) is
minimum
Necessary condition: ∂C / ∂K = 0
Sufficient condition: ∂2
C / ∂K2
> 0
37. EXAMPLE
Fixed cost = Rs 10,000
Price = Rs 20
AVC = Rs 15
How much O/P should the firm produce in order
to break even?
Answer: 2000 units
Also : TR = 20Q
TC = 10,000 + 15Q
TR = TC
43. (4) LEARNING CURVE
Workers improve with practice so per unit cost of
additional O/P declines
Measures % decrease in additional labor cost
each time O/P doubles
An “80 percent” learning curve implies that each
time O/P doubles, L costs associated with
incremental output decrease to 80% of previous
level
44. UTILITY OF LEARNING CURVES
To forecast needs of
personnel
machinery
raw materials
Scheduling production
Determining Selling price of product
45. (5) ECONOMIES OF SCOPE
The reduction of a firm’s unit cost by producing two or
more goods or services jointly rather than separately
Degree of economies of scope =
TC(Q1) + TC(Q2) – TC(Q1 + Q2)
TC(Q1 + Q2)
46. EXAMPLE
Firm A produces 100 units of X & 500 units of Y per
month at the TC of Rs 1,00,000. If X & Y are
produced separately by firms B & C then the TC to
firm B of producing 100 X is Rs 25000 & firm C of
producing 500 Y is Rs 90,000.
Check whether firm A is experiencing economies or
diseconomies of scope
Answer: 0.15 so economies of scope
NOTE:
Positive: economies of scope
Negative: diseconomies of scope
