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Topic-
Theory of cost
Cost of production
In order to produce a good , every
firm , makes uses of factor of
production . The amount spent on the
use of factor of production is called
cost of production . Cost of production
mainly depend upon quantity of
production . Ordinarily ,cost of
production increases with increases in
output . It can therefore be said that
cost of production is a function of
quantity of output , i.e.,C=f(Q)
Explicit cost and Implicit cost
. It refers to those
monetary payments
which made to
outsiders for their
services rendered.
For examples-
Payments of electricity
bills
-Wages paid to
workers
- Payment of raw
mon
. It refers to those
monetary payments
which are paid for use
of self owned
resources.
For examples –
payment of self owned
land
- Salary paid to owner
acting as a manager
in a firm
Explicit cost Implicit cost
Total cost = Explicit cost +Implicit cost
Theories of
cost
Traditional
theory
Modern
theory
Traditional Theory of Cost
 Under traditional theory, cost are
studied in two parts on the basis of
time-period: (i) Cost in short run
 (ii) Cost in the long run .
 Cost are mainly of three types :
 1. Total Cost
 2. Average Cost
 3.Marginal Cost
Cost in the short-run
 The amount of money spent on the
production of different levels of a good
is called total cost .
* Total Fixed Costs
Fixed cost are costs which do not
change with change in the quantity of
output . For eg .- Salary to permanent
staff
- Licensce fee
TC=TFC+TVC
Total fixed cost
Units of output Total fixed cost
0 10
1 10
2 10
3 10
4 10
5 10
6 10
TFC
Cost
Units of Output
Total variable cost
 Variable cost is one which varies as
the level of output varies. If output falls
these cost also falls and if output
increases rises these costs also rise .
Unit of output Total variable
cost
Change in total
variable cost
0 0 0
1 10 10
2 18 8
3 24 6
4 28 4
5 32 4
6 38 6
Relation between Total , Fixed and Variable
CostsOutput TFC TVC TC
0 10 0 10
1 10 10 20
2 10 18 28
3 10 24 34
4 10 28 38
5 10 32 42
6 10 38 48
7 10 46 56
AVERAGE COST
Per unit cost of a good is called its average
cost . AC=TC/Q
Average cost is composed of two types of costs
in the short period :
(i) Average fixed cost (ii) Average variable cost
AC=AFC+AVC
Average Fixed Cost
 Average fixed cost is equal to total
fixed cost divided by output ; i.e.,
AFC=TFC/Q
OUTPUT TFC AFC
1 10 10
2 10 5
3 10 3.3
4 10 2.5
5 10 2
6 10 1.7
7 10 1.4
Average variable cost
Average variable cost is total variable cost divided
by output . That is ,
AVC=TVC/Q
OUTPUT TVC AVC
1 10 10
2 18 9
3 24 8
4 28 7
5 32 6.4
6 38 6.3
7 46 6.6
8 62 7.8
MARGINAL COST
 Addition made to the total cost by the
production of one more unit of a
commodity is called marginal cost . Its
formula is :
MCn=TCn-TCn-1
OR
OUTPUT TC MC
0 0 -
1 20 20-0=20
2 28 28-20=8
3 34 34-28=6
4 38 38-34=4
5 42 42-38=4
6 48 48-42=6
7 56 56-48=8
Relationship b/w AC & MC
1. Both AC & MC are calculated from
TC
AC=TC/Q MC= TC/ Q
2.
OUTPUT TC AC MC
1 20 20 20
2 28 14 8
3 34 11.3 6
4 38 9.5 4
5 42 8.4 4
6 48 8 6
7 56 8 8
8 72 9 16
3. MC cuts AC from its lowest point
4. When AC rises MC also rises and have
a relation MC AC
5. When AC becomes constant MC becomes equal
to AC
6. When AC falls MC also falls and AC
MC
Costs in the Long-Run
 Each firm operates under short-run
production conditions , but it formulates
long-run production plans . In order to
know about the production plans of a
firm , it becomes essential to study long-
run cost .
 No cost is fixed in long-run . All costs
becomes variable costs in this period .
As in the case of short-run , there are 3
concepts of costs in the long-run also
,namely , (1)Long-run total cost(LTC) ,
(2)Long-run average cost (LAC) ,
(3)Long-run marginal cost(LMC) .
Long Run Total Cost
* The long run total cost curve shows
the total cost of a firm’s optimal choice
combinations for labor and capital as
the firm’s total output increases.
* Note that the total cost curve will
always be zero when Q=0 because in
the long run a firm is free to vary all of
its inputs.
Long Run Average Cost
 The Long Run Average Cost,
LRAC, curve of a firm shows the
minimum or lowest average total cost
at which a firm can produce any given
level of output in the long run (when all
inputs are variable).
Long-run marginal cost
 LRMC is the minimum increase in
total cost associated with an increase
of one unit of output when all inputs
are variable. The long-run marginal
cost curve is shaped by returns to
scale, along-run concept, rather than
the law of diminishing
marginal returns, which is a short-
run concept.
Modern theory of cost curves
 Modern theory of cost curves has
been propounded by economists like
Stigler , Andrews etc . According to
traditional theory of cost curves , cost
curves are U-shaped . But according
to modern theory , in real life , cost
curves are L-shaped .
Modern Theory of Average Fixed
Cost
Average Variable Cost
Short run Average Cost Curve
Modern Theory of Long run Cost
Curve
Long run Marginal Cost Curve
Thank you

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theory of cost

  • 2. Cost of production In order to produce a good , every firm , makes uses of factor of production . The amount spent on the use of factor of production is called cost of production . Cost of production mainly depend upon quantity of production . Ordinarily ,cost of production increases with increases in output . It can therefore be said that cost of production is a function of quantity of output , i.e.,C=f(Q)
  • 3. Explicit cost and Implicit cost . It refers to those monetary payments which made to outsiders for their services rendered. For examples- Payments of electricity bills -Wages paid to workers - Payment of raw mon . It refers to those monetary payments which are paid for use of self owned resources. For examples – payment of self owned land - Salary paid to owner acting as a manager in a firm Explicit cost Implicit cost Total cost = Explicit cost +Implicit cost
  • 5. Traditional Theory of Cost  Under traditional theory, cost are studied in two parts on the basis of time-period: (i) Cost in short run  (ii) Cost in the long run .  Cost are mainly of three types :  1. Total Cost  2. Average Cost  3.Marginal Cost
  • 6. Cost in the short-run  The amount of money spent on the production of different levels of a good is called total cost . * Total Fixed Costs Fixed cost are costs which do not change with change in the quantity of output . For eg .- Salary to permanent staff - Licensce fee TC=TFC+TVC
  • 7. Total fixed cost Units of output Total fixed cost 0 10 1 10 2 10 3 10 4 10 5 10 6 10 TFC Cost Units of Output
  • 8. Total variable cost  Variable cost is one which varies as the level of output varies. If output falls these cost also falls and if output increases rises these costs also rise . Unit of output Total variable cost Change in total variable cost 0 0 0 1 10 10 2 18 8 3 24 6 4 28 4 5 32 4 6 38 6
  • 9. Relation between Total , Fixed and Variable CostsOutput TFC TVC TC 0 10 0 10 1 10 10 20 2 10 18 28 3 10 24 34 4 10 28 38 5 10 32 42 6 10 38 48 7 10 46 56
  • 10. AVERAGE COST Per unit cost of a good is called its average cost . AC=TC/Q Average cost is composed of two types of costs in the short period : (i) Average fixed cost (ii) Average variable cost AC=AFC+AVC
  • 11. Average Fixed Cost  Average fixed cost is equal to total fixed cost divided by output ; i.e., AFC=TFC/Q OUTPUT TFC AFC 1 10 10 2 10 5 3 10 3.3 4 10 2.5 5 10 2 6 10 1.7 7 10 1.4
  • 12. Average variable cost Average variable cost is total variable cost divided by output . That is , AVC=TVC/Q
  • 13. OUTPUT TVC AVC 1 10 10 2 18 9 3 24 8 4 28 7 5 32 6.4 6 38 6.3 7 46 6.6 8 62 7.8
  • 14. MARGINAL COST  Addition made to the total cost by the production of one more unit of a commodity is called marginal cost . Its formula is : MCn=TCn-TCn-1 OR
  • 15. OUTPUT TC MC 0 0 - 1 20 20-0=20 2 28 28-20=8 3 34 34-28=6 4 38 38-34=4 5 42 42-38=4 6 48 48-42=6 7 56 56-48=8
  • 16. Relationship b/w AC & MC 1. Both AC & MC are calculated from TC AC=TC/Q MC= TC/ Q 2. OUTPUT TC AC MC 1 20 20 20 2 28 14 8 3 34 11.3 6 4 38 9.5 4 5 42 8.4 4 6 48 8 6 7 56 8 8 8 72 9 16
  • 17. 3. MC cuts AC from its lowest point 4. When AC rises MC also rises and have a relation MC AC
  • 18. 5. When AC becomes constant MC becomes equal to AC 6. When AC falls MC also falls and AC MC
  • 19. Costs in the Long-Run  Each firm operates under short-run production conditions , but it formulates long-run production plans . In order to know about the production plans of a firm , it becomes essential to study long- run cost .  No cost is fixed in long-run . All costs becomes variable costs in this period . As in the case of short-run , there are 3 concepts of costs in the long-run also ,namely , (1)Long-run total cost(LTC) , (2)Long-run average cost (LAC) , (3)Long-run marginal cost(LMC) .
  • 20. Long Run Total Cost * The long run total cost curve shows the total cost of a firm’s optimal choice combinations for labor and capital as the firm’s total output increases. * Note that the total cost curve will always be zero when Q=0 because in the long run a firm is free to vary all of its inputs.
  • 21.
  • 22. Long Run Average Cost  The Long Run Average Cost, LRAC, curve of a firm shows the minimum or lowest average total cost at which a firm can produce any given level of output in the long run (when all inputs are variable).
  • 23.
  • 24. Long-run marginal cost  LRMC is the minimum increase in total cost associated with an increase of one unit of output when all inputs are variable. The long-run marginal cost curve is shaped by returns to scale, along-run concept, rather than the law of diminishing marginal returns, which is a short- run concept.
  • 25.
  • 26. Modern theory of cost curves  Modern theory of cost curves has been propounded by economists like Stigler , Andrews etc . According to traditional theory of cost curves , cost curves are U-shaped . But according to modern theory , in real life , cost curves are L-shaped .
  • 27. Modern Theory of Average Fixed Cost
  • 29. Short run Average Cost Curve
  • 30. Modern Theory of Long run Cost Curve
  • 31. Long run Marginal Cost Curve