COST ANALYSIS

COST THEORY
Cost is a sacrifice or foregoing that has occurred or has
potential to occur in future, measured in monetary terms.
Cost results in current or future decrease in cash or other
assets, or a current or future increase in liability.
Cost is determined by various factors and each of this has
significant implications for cost decisions.
An increase in any of these will affect cost pattern.
The most important determinant is price(/s) of factor(/s) of
production, which are uncontrollable, as they are largely
determined by the external environment of any business.
The marginal efficiency and productivity of these factors is
strongly related to their cost, higher the productivity or
efficiency, lower will be the cost of the production, other things
remaining the same.
 COST ANALYSIS
Technology is the third important determinant and has the
same relationship with the cost as the efficiency of inputs.
Other things remaining the same, better the technology
enhances productivity and reduces the cost of production.
Production and cost analysis constitute the supply side of the
market.
The production analysis deals with the supply side in terms
of physical units of inputs and output, the cost analysis is
concerned with the supply side in terms of physical units of
output and the cost of production as expressed in nominal
terms.
 COST ANALYSIS
COST FUNCTIONS
Cost functions are derived functions.
They are derived from the production function, which describes the
availability efficient methods of production at any one time.
Economic theory distinguishes between short-run costs and long-run
costs.
Short-run costs are the costs over a period during which some factors
of production (usually capital equipment and management) are fixed.
The long-run costs are the costs over a period long enough to permit
the change of all factors of production. In the long run all factors
become variable.
Both in the short run and in the long run, total cost is a multivariable
function, that is, a total cost is determined by many factors.
Symbolically we may write the long run cost function as
C= f (X, T, Pf)
And the short run cost function as C = f (X, T, Pf, K)
Where, C = total costs, X = output, T = technology, Pf = prices of
factors, and K = fixed factor(/s)
 COST ANALYSIS
Graphically, costs are shown on two-dimensional diagrams.
Such curves imply that cost is a function of output, C = f (X), ceteris
paribus.
The clause ceteris paribus implies that all other factors which
determine costs are constant.
If these factors do change, their effect on costs is shown graphically
by a shift of the cost curve.
This is the reason why determinants of costs, other than output, are
called shift factors.
Mathematically there is no difference between the various
determinants of costs.
The distinction between movements along the cost curve (when
output changes) and shifts of the curve (when the other determinants
change) is convenient only pedagogically, because it allows the use
of two-dimensional diagrams.
But it can be misleading when studying the determinants of costs.
It is important to remember that if the cost curve shifts, this does not
imply that the cost function is indeterminate.
 COST ANALYSIS
VARIOUS TYPES OF COSTS
In economic analysis, the following types of costs are considered in
studying costs data of a firm:

Total Cost (TC)

Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Average Fixed Cost (AFC)
Average Variable Cost (AVC)
Average Total Cost (ATC)
and
Marginal Cost (MC)
 COST ANALYSIS
TOTAL COST (TC)
Total cost is the aggregate of expenditures incurred by the firm in
producing a given level of output.
Total cost is measured in relation to the production function by
multiplying factors of prices with their quantities.
If the production functions is: Q = f (a, b, c.n), then total cost is
TC = f (Q), which means total cost varies with output.
For measuring the total cost of a given level of output, thus, we have
to aggregate the product of factors quantities multiplied by their
respective prices.
Conceptually, total cost includes all kinds of money costs, explicit as
well as implicit.
Thus, normal profit is included in total cost. Normal profit is an
implicit cost. It is a normal reward made to the entrepreneur for his
organizational services. It is just a minimum payment essential to
retain the entrepreneur in a given line of production.
 COST ANALYSIS
If this normal return is not realized by the entrepreneur in
the long run, he will stop his present business and will shift
his resources to some other industry.
Now, an entrepreneur himself being the paymaster, he
cannot pay himself, so he treats normal profit as implicit
costs and adds to the total cost.
In the short run, total costs may be bifurcated into total
fixed cost and total variable cost.
Thus, total cost may be viewed as the sum of total fixed cost
and total variable cost at each level of output.
Symbolically, in the short-run,
TC = TFC + TVC.
 COST ANALYSIS

TOTAL FIXED COST (TFC)

Total fixed cost corresponds to fixed inputs in the short run
production function.
It is obtained by summing up the product of quantities of the fixed
factors multiplied by their respective unit prices.
TFC remains the same at all levels of output in the short run.
Suppose a small furniture shop proprietor starts his business by hiring
a shop at a monthly rent of Rs. 1,000 borrowing Rs. 50,000 from a
bank at an interest rate of 12% and buys capital equipment worth Rs.
2,000.
Then his monthly total cost is estimated to be:
Rs. 1,000 + Rs. 2,000 + Rs.500 = Rs. 3,500
(Rent) (Equipment cost) (Monthly interest on th loan)
 COST ANALYSIS
TOTAL FIXED COST CURVE

Cost (C)

C = Rs.
1,00,000

TFC
Curve

Output (Q)
O
 COST ANALYSIS
TOTAL VARIABLE COST (TVC)
Corresponding to variable inputs in the short-run production is the
total variable cost.
It is obtained by summing up the product of quantities of input
multiplied by their prices.
Again, TVC = F (Q), which means, total variable cost is an increasing
function of output.
Suppose, if a shop proprietor starts with the production of chairs and
he employs a carpenter on a wage of Rs. 200 per chair. He buys wood
worth Rs. 2,000 rexine sheets worth Rs. 1,500, spends Rs. 400 for
other requirements to produce 3 chairs.
Then this total variable cost for producing 3 chairs is measured as Rs.
2,000 (wood price) + Rs. 1500 (rexine cost) + Rs. 400 (allied cost) +
Rs. 600 (labour charges) = Rs. 4,500.
 COST ANALYSIS
TOTAL VARIABLE COST (TVC) CURVE

Cost (C)
TVC
Curve

Output (Q)
O
 COST ANALYSIS
TOTAL COST CURVE

Total Cost Curve

Cost (C)
TVC
Curve

TFC
Curve
Output (Q)
O
 COST ANALYSIS
AVERAGE FIXED COST (AFC) AND AFC CURVE
Average fixed cost is total fixed cost divided by total units of output.
AFC = TFC / Q, Where, Q = number of units of the product.
Thus, average fixed costs are the fixed cost per unit of output.
In the above example, when TFC = Rs. 3,500 and Q = 3, then AFC =
Rs. 3,500 /3 = Rs. 1,166.67

Cost (C)

AFC
Curve
Output (Q)
O
 COST ANALYSIS
SHORT-RUN AVERAGE VARIABLE COST (SAVC) AND SAVC CURVE
Average variable cost is total variable cost divided by total units of
output.
AVC = TVC / Q, where, AVC means average variable cost.
Thus, average variable cost is variable cost per unit of output.
If TVC = Rs. 4,500 for Q = 3, then AVC = 4,500 / 3 = Rs. 1,500

Cost (C)

SAVC
Curve

Output (Q)
O
 COST ANALYSIS
SHORT-RUN AVERAGE TOTAL COST (SATC)
Average Total Cost or average cost is total cost divided by total units
of output.
Thus: ATC or AC = TC / Q
In the short run, since TC = TFC + TVC
So, ATC = TC / Q = [TFC + TVC] / Q = (TFC / Q) + (TVC / Q)
Since, TFC / Q = AFC and TVC /Q = AVC,
Therefore, ATC = AFC + AVC.
Hence, average total cost can be computed simply by adding average
fixed cost and average variable cost at each level of output.
To take the above example,
ATC = Rs. 1,166.67 + Rs. 1,500 = Rs. 2,666.67 pr chair.
 COST ANALYSIS
SHORT-RUN AVERAGE TOTAL COST (SATC) CURVE

Cost (C)

SATC Curve

SAVC
Curve

SAFC Curve

Output (Q)
O
 COST ANALYSIS
SHORT-RUN MARGINAL COST (SMC)
The marginal cost is also per unit cost of production in additional
sense.
It is the addition made to the total cost by producing one more unit of
output. Symbolically, MCn = TCn TCn1, that is, the marginal cost of
the nth unit of output is the total cost of producing n units minus the
total cost of producing n1 (i.e. one less in the total) units of output.
Suppose the total cost of producing 4 chairs (i.e. n = 4) is Rs. 10,000
while that for 3 chairs (i.e. n1 is Rs. 8,000. Marginal cost of producing
the 4th chair, therefore, works out as under:
MC4 = TC4 TC3 = Rs. 10,000 Rs. 8,000 = Rs. 2,000.
Marginal cost is the cost of producing an extra unit of output.
In other words, marginal cost may be defined as the change in total
cost associated with a one unit change in output.
It is also an extraunit cost or incremental cost, as it measures the
amount by which total cost increases when output is expanded by one
unit. It can also be calculated by dividing the change in total cost by
the one unit change in output.
 COST ANALYSIS
SHORT-RUN MARGINAL COST (SMC) CURVE
Symbolically, thus, MC = TC / 1Q where, denote change in
output assumed to change by 1 unit only.
Therefore, output change is denoted by 1.
It must be remembered that marginal cost is the cost of producing an
additional unit of output and not of average product. It indicates the
change in total cost of producing an additional unit.
Cost (C)
SMC Curve
SATC or SAC Curve

Output (Q)
O
 COST ANALYSIS
RELATIONSHIP BETWEEN AC AND MC
Economists have observed a unique relationship between the two
as follows: -
When AC is minimum, the MC is equal to AC. Thus, MC curve
must intersect at the minimum point of ATC curve.
When AC is falling, MC is also falling initially, after a point MC
may start rising but AC continues to fall. However AC is greater
that MC (AC > MC). Hence ultimately at a point both costs will be
equal. Thus, when MC and AC are failing, MC curve lies below
the AC curve.
One MC as equal to AC, then the output increases AC will start
rising and MC continues to rise further but now MC will be greater
than AC. Therefore, when both the costs are rising, MC curve will
always lie above the Ac curve.
The above stated relationship is easy to see through geometry of
AC and MC curves, as shown in following figure.
 COST ANALYSIS
It can be seen that;
Initially, both MC and AC curve are sloping downward. When MC
curve lies below AC.
When AC curve is rising, after the point of intersection, MC curve is
above it.
It follow thus when MC is less than AC, it exerts a downward pull on
the AC curve. When MC us more than AC it exerts an upward pull on
the AC curve. Consequently, MC must equal AC, while AC is at the
minimum. Hence, MC curve intersects at the lowest point of AC
curve. It may be recalled that MC curve also intersects the lowest
point of AVC curve. Thus, it is a significant mathematical property of
MC curve that it always cuts both the AVC and ATC curve at their
minimum points.
In the following figure, the MC curve crosses the AC curve at point P.
At this point, for OQ level of output the average cost of PQ which is
minimum.
 COST ANALYSIS

Cost
MC AC

A M

P
B

N
C
Output
O L Q

Relationship between AC and

MC
 COST ANALYSIS
It should be noted that no such relationship can ever be
traced between the MC curve and the AFC curve simply
because by definition, the MC curve is independent.
Further, the area underlying the MC curve is equal to the
total variable cost of the given output.
In fact, the point on each average cost curve measures the
average cost but the area underlying them denote total costs
as under:
Total, area underlying the AFC curve measures the total
fixed cost.
The area underlying the AVC curve measures the total
variable cost.
The area underlying the MC curve measures the total
variable cost.
 COST ANALYSIS
The area underlying the ATC curve measures the total cost.
Finally, the MC curve is important because it is the cost
concept relevant to rational decision making.
It has greater significance in determining the equilibrium of
the firm.
On fact, the increasing MC due to diminishing returns sets a
limit to the expansion of a firm during the period.
Further, it is the MC curve which acts on the supply curve
of the firm.
From the above discussion of cost behavior we may
conclude that short run average cost curves (AVS, ATC and
MC curves) are U shaped, except then AFC curve, which is
an asymptotic and downward sloping curve.
 COST ANALYSIS
SHORT RUN AND LONG RUN CONCEPTS
The short run is a period during which one of the factors of production
is considered to be constant (assuming that there are only two factors
of production labor and capital) and the other is variable.
Usually it is assumed that capital is the fixed factor in the short run.
All costs are variable in the long run since factors of production, size
of plant, machinery and technology are all variable.
This in turn implies radical changes in the cost structure of the firm.
The long run cost function is often referred to as the planning cost
function and the long run average cost (LAC) curve is known as the
planning curve. As all cost are variable, only the average cost curve
is relevant to the firms decision-making process in the long run.
The long run consists of many short runs, e.g., a week consists of
seven days and a month consists of four weeks and so on.
So, the long run cost curve is the composite of many short run cost
curves.
 COST ANALYSIS
LONG RUN COST CURVES
In the long run, all inputs (factors of production) are variable and
firms can enter or exit any industry or market. Consequently, a firm's
output and costs are unconstrained in the sense that the firm can
produce any output level it chooses by employing the needed
quantities of inputs (such as labor and capital) and incurring the total
costs of producing that output level.
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).
The LRAC curve is the envelope of the short run average total cost
(SRATC) curves, where each SRATC curve is defined by a specific
quantity of capital (or other fixed input).
 COST ANALYSIS

LAC,
SACs SAC3

LAC

SAC1

SAC2

Q
O
 COST ANALYSIS
Economies / Dis-economies of Scale
The LAC curve is the mirror image of the returns to the scale in the
long run.
It is apparent that since returns to the scale are based on the internal
economies and the diseconomies of scale, the long run average cost
curve traces these economies of scale.
As a matter of fact that increasing returns to scale can be largely
traced to the economies which become available to a firm when it
expands its scale of operations.
As a result of these economies, the firm enjoys a number of cost
advantages and return in terms of total output.
Thus, economies of scale explain the falling segment of the LAC
curve.
This shows that the decline average cost of output in the long run is
due to economies of large scale enjoyed by the firm.
Increasing LAC is attributed to the diseconomies of scale after a
certain point of further expansion.
 COST ANALYSIS
In short, economies and diseconomies of large scale play a significant
role in determining the shape of the LAC curve.
Again the structure of an industry is also affected by the cost
consideration which is conditioned by the economies and
diseconomies of scale.
Of the many determinants of the number and size of firms in an
industry, the cost consideration and relevant economies and
diseconomies are a significant determining factor.
Increasing average costs in the long run, attributed to the growing
diseconomies of scale, set a limit to the further expansion of the firm.
Economies and diseconomies of scale reflect upon the behavior of
LAC curve.
Analytically speaking the downward slope of the LAC curve may be
attributed to the internal economies of scale.
Similarly, the upward slope of the LAC curve is caused by the internal
diseconomies of scale.
And the horizontal slope of the LAC curve may be explained in terms
of the balance between internal economies and diseconomies.
 COST ANALYSIS

Cost

A
D LAC

Net
Economies Diseconomies
Economies
=
Diseconomies
B C

Neutral Effect
Output
O Q

Internal Economies-Diseconomies and the LAC curve

 COST ANALYSIS
In short, the internal economies and diseconomies have their
significance in determining the shape of the LAC curve of a firm.
However, the shift in the LAC curve may be attributed to the external
economies and diseconomies.
External economies reflect in reducing the overall cost function of the
firm.
Thus, a downward shift in the LAC may be caused by external
economies as shown in following Figure.
In following figure, ABCD is the LAC curve. Its AB portion is the
downward slope, which is subject to the internal economies.
Its BC portion the horizontal slope is due to the balance between
economies and diseconomies.
Its CD portion the upward slope is subject to internal
diseconomies.
In following figure, the original LAC1 curve shifts downward as
LAC2 on account of external economies.
 COST ANALYSIS

Cost
LAC1

LAC2

External
Economies

Output
O

The effect of External Economies on the LAC curve

 COST ANALYSIS
Similarly, an upward shift in the LAC curve may be attributed to the external
diseconomies, as shown in following figure.

Cost
LAC2

LAC1

External
Diseconomies

Output
O

The effect of External Diseconomies on the LAC

curve

In above figure, the original LAC1 curve shifts up as LAC2 owning to

the external diseconomies