Cost Concepts, Cost Function and Cost curves in Short run and Long run

1. THEORY OF COST
Subject : CC03 – Managerial Economics
Class : S1 MBA (2017-19Batch)
Presented By : MUHAMMED NOWFAL
Designation : Assistant Professor
Department : Department of Management Studies
Institute : KMM College of Arts and Science – Kochi

2. LEARNING OBJECTIVES
After this chapter you learn:
• The various cost concepts
• Cost function and application of cost analysis
• Short run cost behaviour with change in one input
• Long run cost behaviour with change in two inputs
• Meaning and sources of economies of scale and diseconomies of scale
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3. COST CONCEPTS
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ACCOUNTING COST CONCEPTS ANALYTICAL COST CONCEPTS
1. Opportunity cost and actual cost
2. Business cost and full cost
3. Explicit cost and implicit cost
4. Out of pocket cost and book cost
1. Fixed and Variable cost
2. Total, Average and marginal cost
3. Short run and long run cost
4. Incremental cost and sunk cost
5. Historical and Replacement cost
6. Private and Social cost

4. COST CONCEPTS :- ACCOUNTING COST CONCEPTS
Opportunity cost and actual cost
 Opportunity Cost is the expected return from the second best use of the resources
( alternative use) were forgone due to the scarcity of resources - Opportunity
cost refers to the value forgone in order to make one particular investment instead
of another.
 Actual costs are those which are actually incurred by the firm in payment for the
labour, material, plant, building machinery etc. - Total money expenses recorded
in the books of accounts are for all practical purposes is actual cost
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5. COST CONCEPTS :- ACCOUNTING COST CONCEPTS
Business cost and full cost
 Business cost includes all the expenses included to carry out a business – Includes
all the payments and contractual obligations made by the firm together with the
book cost of depreciation on plant and equipment
 Full cost includes business cost, Opportunity cost and Normal profit – Normal
profit is necessary minimum earning in addition to the opportunity cost, that the
firm may receive to remain its present occupation
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6. COST CONCEPTS :- ACCOUNTING COST CONCEPTS
Explicit and Implicit cost (Economic Cost)
 Costs that falls under actual and business cost entered in the books are called
explicit cost – For example: Wages, salaries, materials, insurance premium – these
cost involves cash payments and are recorded
 There are certain cost which do not take the form of cash outlays, nor do appear in
the accounting system is called implicit cost – For example; Opportunity cost
(Implicit rent, Implicit wage)
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7. COST CONCEPTS :- ACCOUNTING COST CONCEPTS
Out of Pocket and Book Cost
 The items of expenditure which involves cash payments including both recurring
and non recurring expenses are called out of pocket costs
 There are some actual cost which do not involve cash payements, but a provision
is made in the books of accounts are known as book cost – example payment
made by the firm to itself
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8. COST CONCEPTS – ANALYTICAL COST CONCEPTS
Fixed and Variable costs
 Fixed costs are those which remain fixed in volume over a certain level of output
– it do not vary with variation of output for certain level of output – Example; cost
of managerial and administrative staff
 Variable cost are those which vary with the variation in output – cost of raw
material, running cost of fixed capital i.e. Fuel, Power
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9. COST CONCEPTS – ANALYTICAL COST CONCEPTS
Total, Average and Marginal cost
 Total cost is the total expenditure incurred on the production of goods and services – it
includes both total fixed cost and total variable cost
TC = TFC + TVC
 Average cost is of statistical nature – it is not an actual cost – it is obtained by dividing
the total cost by the total output
AC = TC / Q
 Marginal cost is the addition to the total cost on producing one additional unit of product
MC = TCn – TCn-1
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10. COST CONCEPTS – ANALYTICAL COST CONCEPTS
Short run and Long run costs
 Short run costs are those which has short run implications in the production
process and vary with variation in output – Variable cost
 Long run costs are the cost which incurred on the fixed assets – Fixed costs
 Short run costs are those associated with variables in the utilization of fixed plant
and other facilities and long run cost are associated with the changes in the size
and kind of plant
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11. COST CONCEPTS – ANALYTICAL COST CONCEPTS
Incremental cost and sunk costs
 Incremental cost is the total additional cost associated with the decision to expand
the output or to add a new variety of product
 Sunk costs are those which are incurred once for all – such cost cannot be altered,
increased or decreased by varying the rate of output
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12. COST CONCEPTS – ANALYTICAL COST CONCEPTS
Historical and Replacement cost
• Historical cost is the cost of the assent acquired in the past where as replacement
cost is the expenditure made for replacing and old asset
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13. COST CONCEPTS – ANALYTICAL COST CONCEPTS
Private cost and social cost
• Costs paid out or provided for by the firms (for purchase of good and services
from the market) is called private cost
• Cost not paid or born by the firms including the use of resources freely available
in the process of production is social cost – total cost born by the society due to
production of commodity
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14. COST FUNCTION
• Symbolic statement of the technological relationship between cost and
output
• Total cost function is expressed as TC = f(Q)
• This form tells only that there is a relationship between TC and output – but it
does not tell the nature of relationship – Since there is a positive relationship
between TC and output, the cost function may be written as
TC = f (Q), ∆𝑻𝑪/∆𝑸 > 𝟎
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15. SHORT RUN COST FUNCTIONS AND COST CURVES
 The cost output relationships are determined by the cost function and are exhibited
through cost curves
 The shape of cost curves depends on the nature of the cost function
 Cost function is derived from the actual cost data of the firms
 Estimated cost function may take a variety of forms, yielding different kind of cost
curves such as
 Linear cost function
 Quadratic cost function and
 Cubic cost function
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16. LINEAR COST FUNCTIONS
 Linear cost function expressed as
Where as a = TFC and b=
𝜕𝑇𝐶
𝜕𝑄
 Given the cost function AC and MC cab obtained as follows
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𝑨𝑪 =
𝑻𝑪
𝑸
= 𝒂 +
𝒃𝑸
𝑸
=
𝒂
𝑸
+ 𝒃 𝑴𝑪 =
𝝏𝑻𝑪
𝝏𝑸
= 𝑏
𝑻𝑪 = 𝒂 + 𝒃𝑸

17. LINEAR COST FUNCTIONS
• Assuming the cost function TC= a+bQ
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Behavior of AC and MC
MC is constant in this case
AC continuous to decline with the
increase in output

18. QUADRATIC COST FUNCTION
• A quadratic cost function is of the form
Where as a and b are constant
• Given the cost function AC and MC can be obtained as
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𝑻𝑪 = 𝒂 + 𝒃𝑸 + 𝑸 𝟐
𝑨𝑪 =
𝑻𝑪
𝑸
=
𝒂+𝒃𝑸+𝑸 𝟐
𝑸
=
𝒂
𝑸
+ 𝒃 + 𝑸 𝑀𝐶 =
𝜕𝑇𝐶
𝜕𝑄
= 𝑏 + 2𝑄

19. QUADRATIC COST FUNCTION
Given the cost function TC = a + bQ + Q2
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TFC remains constant
TVC increasing at an
increasing rate

20. QUADRATIC COST FUNCTION
• AC MC and AVC Curves
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21. CUBIC COST FUNCTION
• The cubic cost function is of the form
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𝑻𝑪 = 𝒂 + 𝒃𝑸 − 𝒄𝑸 𝟐
+ 𝑸 𝟑
AC =
𝐓𝐂
𝐐
=
𝒂+𝒃𝑸+𝒄𝑸 𝟐+𝑸 𝟑
𝑸
𝑴𝑪 =
𝝏𝑻𝑪
𝝏𝑸
= 𝒃 − 𝟐𝒄𝑸 + 𝟑𝑸 𝟐

22. CUBIC COST FUNCTION
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23. TFC, TVC And TC
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24. 10/13/2017 Theory of Cost 24

25. AC, AFC, AVC and MC Curves
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26. • ATC keeps going down with output.
• AVC goes down and then beyond a point starts rising.
• AFC keeps going down, and becomes very small as output increases.
• MC goes down but beyond a point starts to rise.
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27. SOME IMPORTANT RELATIONSHIPS
• Over a range of output both AVC and AFC fall, AC also falls because AC =AFC +
AVC
• When AFC falls but AVC increases, change in AC depends on the change in AFC and
AVC
• If decrease in AFC > increase in AVC, then AC falls
• If decrease in AFC = increase in AVC, then AC remains constant
• If decrease in AFC < increase in AVC, then AC increases
• When MC falls, AC follows over a certain level of output. When MC falling, the rate
of fall in MC in greater than that of AC i.e. AC decreases at a rate lower than MC
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28. LONG RUN COST CURVES
Long run Total Cost Curve :
• Long run Total Cost (LTC) refers to the minimum cost at which given level of output
can be produced.
• LTC represents the least cost of different quantities of output. LTC is always less than
or equal to short run total cost, but it is never more than short run cost.
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29. LONG RUN COST CURVES
 Long run Average Cost Curve
• Long run Average Cost (LAC) is equal to long run total costs divided by the level of
output.
• The derivation of long run average costs is done from the short run average cost
curves.
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30. LONG RUN COST CURVES
 Long run Marginal Cost Curve
 Long run Marginal Cost (LMC) is defined as added cost of producing an additional
unit of a commodity when all inputs are variable.
 This cost is derived from short run marginal cost.
 On the graph, the LMC is derived from the points of tangency between LAC and
SAC.
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31. ASSIGNMENT
Topic :
Economics of Scale and Diseconomies of Scale
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32. REFERENCES
• D N Dwiledhi, Essentials of business economics, Vikas publishing house Pvt Ltd,
New Delhi, 2009
• D.M. Mithani,Managerial Economics, 5/e, Himalaya Publishing
House,Mumbai,2011
• Yogesh, Maheswari, Management Economics,PHI Learnings, New
PHIlearning,NewDelhi,2012
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33. THANK YOU
MUHAMMED NOWFAL.S
Assistant Professor, Department of Management studies
KMM College of Arts and Science, Thrikkara, Kochi
Email ID :- muhammednowfal@kcmtcochin.com
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