Cost Functions/Curves

Cost is the value of the inputs used to produce its

output, i.e. the firm hires labor and the cost is the
wage rate that must be paid for the labor

Economic Cost and Accounting cost

Opportunity Cost

Opportunity Cost Concept

Opportunity cost is foregone value.
Reflects second-best use.

Explicit and Implicit Costs

Explicit costs are cash expenses.
Implicit costs are noncash expenses.
Costs
In buying factor inputs, the firm
will incur costs
Costs are classified as:
Fixed costs costs that are not related directly to
production rent, rates, insurance costs, admin costs.
They can change but not in relation to output
Variable Costs costs directly related
to variations in output. Raw materials, labour, fuel, etc
Short-run and Long-run Costs

How Is the Operating Period Defined?

At least one input is fixed in the short run.
(Operative cost)
All inputs are variable in the long run.
(planning cost)

Fixed and Variable Costs

Fixed cost is a short-run concept.
All costs are variable in the long run.
Short-run Cost Curves

Short-run Cost Categories

Total Cost = Fixed Cost + Variable Cost
For averages, ATC = AFC + AVC
Marginal Cost (Incremental cost),
MC = TC/Q
A Firms Short Run Costs
Average Costs

Average Total cost firms total cost divided by its level of output
(average cost per unit of output)
ATC=AC=TC/Q

Average Fixed cost fixed cost divided by level of output (fixed

cost per unit of output)
AFC=FC/Q

Average variable cost variable cost divided by the level of

output.
AVC=VC/Q
Marginal Cost change (increase) in cost resulting from
the production of one extra unit of output

Denote - change. For example TC - change in total

cost

MC=TC/Q

Example: when 4 units of output are produced, the cost is 80,

when 5 units are produced, the cost is 90. MC=(90-80)/1=10

MC=VC/Q

since TC=(FC+VC) and FC does not change with Q

Cost Curves for a Firm
TC
Cost 400
(Rs.) Total cost
VC
is the vertical
sum of FC
and VC.
300
Variable cost
increases with
production and
the rate varies with
increasing &
200
decreasing returns.

Fixed cost does not

100 vary with output
50 FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output
Short Run Cost Graphs MC

ATC

1. 3. AVC

AFC AFC

Q Q

MC intersects lowest point

2. AVC
of AVC and lowest point of
ATC.

When MC < AVC, AVC declines

When MC > AVC, AVC rises
Q
 Average and marginal costs
MC
AC

AVC
Costs ()

x
AFC

Outputfig(Q)
Long-run Cost Curves

Returns to Scale/Economies and Dis-

Economies of Scale
U Shape curve/L Shape Curve
 Long Run Cost Functions
All inputs are variable SMC2
(can adjust) in the
long run.
LAC is long run SAC2 LMC
average cost
ENVELOPE of SAC
curves
LMC is flatter than
SMC curves. LAC
The optimal plant size
for a given output Q2 is
plant size 2. (A SR
concept.)
However, the optimal
plant size occurs at Q2 Q3
Q
Q3, which is the lowest
Long Run Cost Function (LAC)
Envelope of SAC curves
 Deriving long-run average cost curves:
factories of fixed size
SRAC1 SRAC SRAC5
2
SRAC4
SRAC3

5 factories
Costs

1 factory
2 factories 4 factories

3 factories

O
Output
fig
The relationship between short-run and long run cost

LRATC
Costs per unit

SRATC4
SRATC1
SRMC1
SRMC2 SRMC4
SRATC2SRATC3
SRMC3

0
Q2 Q3 Quantity
The LR Relationship Between
Production and Cost
In the long run, all inputs are
variable.
What makes up LRAC?
Return to Scale

Increasing Returns to scale: Output more than doubles

when the quantities of all inputs are doubled, Average cost
falls (Total cost rising at a decreasing rate)

Constant Return to Scale: Doubling of inputs leads to a

doubling of output, AC remain same

Decreasing Returns to Scale: doubling of inputs leads to a

less than doubling of output or in other words to double the
output one needs more than doubling of inputs, AC must be
increasing
Economies and Dis-economies of scale

ES- A situation in which output can be doubled for less

than a doubling of cost (Increasing Returns to Scale)

DES-A situation in which a doubling of output requires

more than a doubling of cost (Decreasing Returns to
Scale)
ES are often measured in terms of cost-output elasticity

Cost-Output Elasticity EC: (Change in the C/C)/(Change in

Q/Q)

When there are Economies of scale (When cost increases less

than proportionately with output), marginal cost is less than
average cost (both are declining) and Ec less than 1. Finally,
when there are diseconomies of scale, marginal cost is greater
than average cost and Ec is greater than 1

When EC = 1, neither ES nor DES or the situation is constant

return to Scale
Economies
Pecuniary
of Scale
Selling
Transport
Lower
Economies
prices
Lower
or &
Marketting
Storage
for
cost
Technical-Capital
Large-Scale
Lower
bulk
of finance
cost
buying Lower
Inventory
Exclusive
Lower
of
Promotion
advertising
transport
of wages
Model-change
raw
Economies
dealers
materials
rates
with
at large andfor
economies
obligation
scale salaries
Real Economies- Labor, Technical, Inventory economies

Labor economies: Specialization, time saving, Automation, cumulative

volume
Specialization and division of labor leads to invention of tools,
increases labor productivity

A classical example of the labor economies of large scale production is

the motor car industry. Introduction of assembly line (a process which
involves very wide specialization of workers, each one of whom
performs a single job to which he/she is assisted by special tools), this
high automation resulted in increase in the productivity of labor and
mass production made possible.

Production engineers and other employees tend to acquire considerable

experience from large scale operation this cumulative volume leads to
higher productivity to reduce costs at large level of outputs
Technical economies: Associated with fixed capital

Specialization and indivisibilities, set-up costs, initial fixed costs,

technical volume/input relations, reserve capacity requirements

Higher degree of mechanization for large scales of output. More

capital intensive technology,

Set-up costs are the costs involved in the preparation of

multipurpose machinery for performing a particular job or product.

Technical relationships: process industry like: oil refinery, chemical

industry, cement industry

Reserve capacity: in order to avoid disruption in production,

keeping two machines

Inventory economies
 Selling or Marketting Economies: Advertising, Large-scale
promotion, model change economies

Managerial Economies:

Pecuniary Economies: Economies realized from paying lower

prices for the factors used in production and distribution of the
product, due to bulk buying by the firm as its size increases

Lower prices of its raw materials bought at special discount from

its suppliers

Lower cost of external finance, Banks usually offer loans to large

corporations at a lower rate of interest and other favorable term

Lower advertising prices may be granted to larger firms if they

advertise at large scales