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Cost Output Relationship - Notes

Fixed costs remain constant regardless of output levels in the short run. Total costs are equal to fixed costs plus variable costs, which increase with output. Marginal cost is the change in total cost from producing one additional unit of output. As output increases, average fixed costs decline while average variable costs initially decrease and then increase, resulting in a U-shaped average total cost curve. In the long run, all costs are variable and economies of scale can cause long run average costs to decrease with larger output, though diseconomies of scale may later cause costs to rise, forming the characteristic U-shape of the long run average cost curve.

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Umamaheswari Rajan
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520 views

Cost Output Relationship - Notes

Fixed costs remain constant regardless of output levels in the short run. Total costs are equal to fixed costs plus variable costs, which increase with output. Marginal cost is the change in total cost from producing one additional unit of output. As output increases, average fixed costs decline while average variable costs initially decrease and then increase, resulting in a U-shaped average total cost curve. In the long run, all costs are variable and economies of scale can cause long run average costs to decrease with larger output, though diseconomies of scale may later cause costs to rise, forming the characteristic U-shape of the long run average cost curve.

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Umamaheswari Rajan
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Short Run Cost Output Relationship

Fixed cost curve is a horizontal line which is parallel to the ‘X’ axis. This cost is constant with
respect to output in the short run. Fixed cost does not change with output. It must be paid even if
‘0’ units of output are produced. For example: if you have purchased a building for the business
you have invested capital on building even if there is no production.
Total fixed cost (TFC) consists of various costs incurred on the building, machinery, land, etc..
For example if you have spent Rs. 2 Lakhs and bought machinery and building which is used to
produce more than one batch of commodity, then the same cost of Rs. 2 Lakhs is fixed cost for
all batches. The total variable costs vary according to the output. Whenever the output increases
the firm has to buy more raw materials, use more electricity, labour and other sources
therefore the TVC curve is upward sloping. The total cost consists of fixed (TFC) and
variable costs (TVC). The TFC of Rs. 2 Lakhs is included with the variable cost throughout
the production schedule so the total cost (TC) is above the TVC line.

Graph – Total Cost Curves

Graph – Average Cost Curves

The above set of graphs indicates clearly that the average variable cost curve looks like a boat.
Average fixed cost curve declines as output increases and it is a hyperbola to the origin. The
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Marginal cost curve slopes like a tick mark which declines up to an extent then it starts
increasing along with the output. Let us see and understand the nature of each and every
curve with an example. The table and graphs shown below indicates the total costs curves and
average cost curves at various output level.

Table - Cost Schedule

(Rupees in thousands ‘000)


Output TC TFC TVC AFC ATC AVC MC

0 v1200 300 - - - - -

1 1800 300 1500 300 1800 1500 600

2 2000 300 1700 150 1000 850 200

3 2100 300 1800 100 700 600 100

4 2250 300 1950 75 562.5 487.5 150

5 2600 300 2300 60 520 460 350

6 3300 300 3000 50 550 500 700

Graph – Average Cost Curves

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Graph – Total Cost Curves

From the above table and set of graphs we can understand that capital is the fixed factor of
production and the total fixed cost will be the same Rs. 300,000. The total variable cost will
increase as more and more goods are produced. So the total variable cost TVC of producing 1
unit is Rs.1500 000, for 2 units 1700 000 and so on.

Total cost = TFC + TVC for 1 unit TC = 300 + 1500 = 1800.

The marginal cost of producing an extra unit is calculated based on the


difference in total cost.

MCn = TCn – TCn-1


MC2 = TC2 – TC 2-1 = 2000 – 1800 = 200

MC for 5th unit = TC of 5th unit minus TC of 4th unit,


in our example 2600 – 2250 = 350.

AVC also is calculated in the same manner TVC / output = 2600 / 5 = 460
AFC = TFC / output = 300 / 5 = 60.

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Cost Output Relationship In The Long Run

In the long run costs fall as output increases due to economies of scale, consequently the
average cost AC of production falls. Some firms experience diseconomies of scale if the
average cost begins to increase. This fall and rise derives a U shaped or boat shaped average
cost curve in the long run which is denoted as LAC. The minimum point of the curve is said to
be the optimum output in the long run. It is explained graphically in the chart given below.
Graph – Long Run Average Cost Curve

In the long run all factors are variable and the average cost may fall or increase to A, B
respectively but all these costs are above the long run cost average cost. LAC is the lower
envelope of all the short run average cost curves because it contains them all. At point ‘E’ the
SAC1 and SMC1 intersects each other, in case the organization increases its output from OM to
OM1 they have to spend OC1 amount. In case the organization purchases one more machine
(increase in fixed cost) then they will get a new set of cost curves SAC2, and SMC2. But the
new average cost curve reduces the cost of production from OC1 to OC2.That means they can
save the difference of C1C2 which is nothing but AB. Therefore in the long run due to business
expansion a firm can reduce their cost of production. During their business life they will meet
many combinations of optimum production and minimum cost in different short periods. In the
long run due to law of diminishing returns the long run average cost curve LAC also slopes like
boat shape.

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