2. In This Lecture…
Concepts of Costs:
Economic Costs,
Accounting Costs, Sunk
Costs
Short-run and Long-run
Costs: Total, Average and
Marginal Costs
Cost Schedules, Cost
Curves, Characteristics and
their Relationships
3. Business Firm
An entity that employs factors of
production (resources) to produce goods
and services to be sold to consumers,
other firms, or the government.
4. Why Do Business Firms Arise in
the First Place?
Firms are formed when benefits can be
obtained from individuals working as a
team.
5. Economic Cost
Economic cost is the cost to a firm for
utilizing economic resources in
production, including opportunity cost.
7. Sunk Cost
A cost incurred in the past that cannot be
changed by current decisions and
therefore cannot be recovered.
8. Explicit and Implicit Cost
Explicit Cost - A cost incurred when an
actual (monetary) payment is made.
Implicit Cost - A cost that represents the
value of resources used in production for
which no actual (monetary) payment is
made.
9. Production and Cost:
Short and Long Run
Short Run - A period of time in which
some inputs in the production process are
fixed.
Long Run - A period of time in which all
inputs in the production process can be
varied (no inputs are fixed).
10. Short-run Cost
The short-run costs are the costs over the
period during which some factors are in
fixed supply – like plant, machinery etc.
It is a sum total of fixed cost and variable
cost incurred by the producer in
producing the commodity.
11. Long-run Cost
The long-run costs are the costs over the
long period enough to permit changes in
all factors of production.
It is a sum total variable cost incurred by
the producer in producing the
commodity.
12. Fixed and Variable Costs
Fixed Costs – The cost
incurred in those inputs
whose quantity cannot be
changed as output changes.
Variable Costs – the cost
incurred in those inputs
whose quantity can be
changed as output changes.
13. Costs in Short-run
Fixed Costs (FC) - Costs that do not vary with
output; the costs associated with fixed inputs.
Variable Cost (VC) - Costs that vary with
output; the costs associated with variable inputs.
Total Cost (TC) - The sum of fixed costs and
variable costs. TC = TFC + TVC
Marginal Cost (MC) - The change in total cost
that results from a change in output: MC =
ΔTC/Δ Q.
14. Fixed Cost / Overhead Cost
Fixed Costs (FC) - Costs that do not vary with
output; the costs associated with fixed inputs.
Overhead expenses, Wages/Salaries,
Depreciation of Machinery, Insurance
Amount etc.
Output
TFC
0
1
2
3
4
10
10
10
10
10
15. Fixed Cost / Overhead Cost
Cost
20
15
10
5
TFC
O
1
2
3
4
Output
Total Fixed Cost Curve (TFC Curve) – Horizontal line
16. Total Variable Cost/ Prime Cost
Variable Cost (VC) - Costs that vary with
output; the costs associated with variable
inputs.
Cost of direct labor, Running expenses
like cost of raw materials, fuels etc.
Output
TVC
0
1
2
3
4
0
10
18
30
45
17. Total Variable Cost/ Prime Cost
Cost
40
TVC
30
20
10
0
1
2
3
4
Output
Total Variable Cost Curve (TVC Curve) – Inverse Sshaped Curve
18. Total Cost
Total Cost (TC) - The sum of fixed costs
and variable costs. TC = TFC + TVC
It is the aggregate of all costs of producing
any given level of output
Output
TFC
TVC
TC
0
1
2
3
4
10
10
10
10
10
0
10
18
30
45
10
20
28
40
55
20. Fixed Cost vs. Variable Cost
Fixed Cost (FC)
1.
2.
3.
4.
5.
6.
FC are incurred in fixed FOP.
FC do not change with the
change in output.
FC cannot be changed during
short-run.
FC can never be zero even at
zero level of output.
Production at the loss of FC
may continue.
TFC curve is parallel to x-axis.
Variable Cost (VC)
1.
2.
3.
4.
5.
6.
VC are incurred in variable
FOP.
VC changes with the change in
the level of output.
VC can be changed during
short-run.
VC can be zero at zero level of
output.
Production at the loss of VC
will not continue.
TVC curve is inverse S-shaped.
21. Average Fixed, Variable and Total
Cost
Average Fixed Cost (AFC) - Total fixed
cost divided by quantity of output:
AFC = TFC / Q.
Average Variable Cost (AVC) - Total
variable cost divided by quantity of
output: AVC = TVC / Q.
Average Total Cost (ATC), or Unit Cost Total cost divided by quantity of output:
ATC = TC / Q.
28. Average Cost Curve is U-shaped
Basis of AFC : AC includes AFC and AFC
falls continuously with increase in
output. Once AVC reaches its minimum
point and starts rising, its rise is initially
offset by the fall in AFC. Hence, AC
continues to fall. After a certain point the
rise in AFC becomes greater than the fall
in AFC and AC starts rising
29. Average Cost Curve is U-shaped
Basis of Law of Variable Proportion :
According to this Law initially when
variable factor is combined with the
fixed factor, production increases at an
increasing rate implying AC falls till the
best combination of fixed and variable
factors is attained. Beyond this point, AC
starts to rise.
30. AFC, AVC and AC Curves
Cost
AC
AVC
A
C
B
A1
C1
B1
AFC
A2
O
A4
C2
B2
C3
Output
Short run AC curve is a vertical summation of AFC and AVC curves.
AVC = A2A4, AFC = A1A4.
AC = AVC + AFC = A2A4 + A1A4 = AA4
31. AC and AVC Curve
AVC is a part of AC as AC = AVC + AFC
The minimum point of AC will always be to
the right of minimum point of AVC
Both AVC and AC are U-shaped curves
The difference between AC and AVC decreases
with the rise in the level of output as AC is the
aggregation of AVC and AFC; and, AFC falls
continuously as output increases. AVC and AC
never meets each other as AFC is a rectangular
hyperbola and can never touch x-axis
32. Marginal Cost
Marginal Cost (MC) - The change in total
cost that results from a change in output:
MC = ΔTC/Δ Q.
Short run MC can be estimated from TVC
as well
MC = TCn – TCn-1
= (TFCn + TVCn) - (TFCn-1 + TVCn-1)
= (TFCn + TVCn) - (TFCn + TVCn-1)
= TVCn - TVCn-1
36. MC and AC
Both MC and AC are derived from TC.
MC= ΔTC/ΔQ and AC = TC/Q
Both AC and MC curves are U-shaped, reflecting
the law of variable proportion.
When AC is falling MC is below AC
When AC is rising MC is above AC
When AC is neither falling or rising AC=MC
There is a range over which AC is falling but MC is
rising (ab)
MC curve cuts AC from its minimum point.
38. MC and AVC
Moth MC and AVC are derived from TVC.
MC= ΔTVC/ΔQ and AVC = TVC/Q
Both AVC and MC curves are U-shaped, reflecting
the law of variable proportion.
When AVC is falling MC is below AVC
When AVC is rising MC is above AVC
When AVC is neither falling or rising AVC=MC
There is a range over which AVC is falling but MC
is rising (ab)
MC curve cuts AVC from its minimum point.
The minimum point of AVC curve occurs to the
right of the minimum point of MC curve.
39. Production and Costs in the Long
Run
In the short run, there are fixed costs and
variable costs; therefore, total cost is the
sum of the two.
A period of time in which all inputs in the
production process can be varied (no
inputs are fixed). In the long run, there are
no fixed costs, so variable costs are total
costs.
40. Long-Run Average Total Cost
(LRATC) Curve
A curve that shows the lowest (unit) cost
at which the firm can produce any given
level of output.
A firm attempts to maximize long run
profits by selecting a short scale of plant
that minimizes its costs.
41. Long-Run Average Total Cost
Curve (LRATC )
There are three
short-run average
total cost curves for
three different plant
sizes.
If these are the only
plant sizes, the longrun average total
cost curve is the
heavily shaded, blue
scalloped curve.
42. Long-Run Average Total Cost
Curve (LRATC )
The long-run average
total cost curve is the
heavily shaded, blue
smooth curve.
The LRATC curve is
not scalloped because it
is assumed that there
are so many plant sizes
that the LRATC curve
touches each SRATC
curve at only one point.
43. Economies of Scale
Economies of Scale exist when inputs are
increased by some percentage and output
increases by a greater percentage, causing unit
costs to fall.
Constant Returns to Scale exist when inputs are
increased by some percentage and output
increases by an equal percentage, causing unit
costs to remain constant.
Diseconomies of Scale exist when inputs are
increased by some percentage and output
increases by a smaller percentage, causing unit
costs to rise.
44. Why Economies of Scale?
Up to a certain point, long-run unit costs of
production fall as a firm grows. There are
two main reasons for this:
Growing firms offer greater opportunities
for employees to specialize.
Growing firms can take advantage of highly
efficient mass production techniques and
equipment that ordinarily require large
setup costs and thus are economical only if
they can be spread over a large number of
units.
45. Why Diseconomies of Scale?
In very large firms,
managers often find it
difficult to coordinate
work activities,
communicate their
directives to the right
persons in satisfactory
time, and monitor
personnel effectively.
48. LAC and LMC
Both LMC and LAC curves are flatter Ushaped curves are compared to SMC and
SAC
LMC cuts LAC at its minimum point
When LAC is falling LMC is below it
When LAC is rising LMC is above it
When LAC is neither falling or rising
LMC = LAC
49. Shifts in Cost Curves
A firm’s cost curves will shift if there is a
change in:
Taxes
Input prices
Technology.
