Cost

Meaning of cost
• In economics, cost refers to the value of what must be given
up to obtain something. It represents the trade-off involved in
making economic decisions, such as the production of goods
and services or consumption choices.
• The cost of production means the total expenses that are
associated with the production of a good or service.
 Explicit cost and Implicit cost
Basic Explicit cost Implicit cost
difference
Meaning These are direct, out-of-pocket These are indirect, non-monetary costs that represent
expenses that a firm incurs in the the opportunity cost of using resources owned by the
production process. firm.
These costs involve actual
monetary transactions.
Nature Involves actual cash payments. No direct cash payments;

Example Wages paid to employees. Use of company-owned property without charging rent.
Rent for office space. • if a business owner uses their own capital or their own
Payments for raw materials. time to run a business, the implicit cost is what they
could have earned elsewhere with that time or capital.
measurement Easily measurable in monetary terms Requires estimation based on the value of the forgone
(invoices, receipts). alternative.
Actual cost and opportunity cost
Basic difference Actual cost Opportunity cost

Meaning The actual, out-of-pocket expenses incurred The value of the next best alternative
in the production or acquisition of goods and that is foregone when a choice is made.
services.
nature Tangible, involves real financial payments. Intangible, represents potential benefits
or earnings lost.
Example Wages paid to employees. The income you give up by choosing to
Rent paid for office space. study instead of working.
Profits lost by choosing to produce
product A instead of product B.

Measurement Easily measurable in monetary terms. Requires estimation and depends on the
value of the forgone alternative.

Recording in account Recorded in financial statements and reports. Not recorded in accounting books, but
considered in decision-making.
Economic Cost and Accounting cost
Basic Economic cost Accounting cost
difference
concept total cost, including both explicit and implicit costs Only explicit, recorded costs incurred in
(opportunity cost) production or operation.
scope Broader; includes all costs of resources, including forgone Narrower; only includes out-of-pocket
opportunities. (actual) expenses.
Components Explicit costs (e.g., wages, rent, materials) Only explicit costs (e.g., wages, rent,
Implicit costs (e.g., opportunity cost of using owned materials).
resources like capital and time).
purpose Used for economic decision-making to measure the true cost Used for financial reporting and tax
of choosing one alternative over another. purposes, to record actual expenditures.
example Cost of using your own building (implicit rent you could Rent paid for a building.
earn). Wages paid to employees.
Salary you forego by working on your own business.

focus Focuses on both monetary and non-monetary (opportunity) Focuses only on monetary, out-of-pocket
costs. expenses.
Used by Economists and business owners for decision-making. accountants for financial statements and tax
filing.
Cost Concept in Production
• In the context of production, costs represent the expenses a firm
incurs to produce goods and services. These costs are key to
determining the pricing, profitability, and efficiency of production.
• Total Cost (TC): The total expenditure incurred in the production of a given
level of output. It includes both fixed and variable costs.
Fixed Costs (FC): Costs that do not change with the level of production.
• Examples: rent, salaries, and insurance. These costs are incurred even if
no production takes place.
Variable Costs (VC): Costs that vary directly with the level of production.
Examples: raw materials, direct labor, and energy usage. These costs
increase as production increases.
MC (Marginal Cost):
• Marginal cost refers to the additional cost incurred from producing one
more unit of a good or service.
• MC= TCn- TCn-1
Or
• MC= ΔTC/ΔQ
AC (Average Cost):
• Average cost is the total cost per unit of output produced. It is the total
cost divided by the quantity of output produced.
• AC= TC/Q
 Short-run cost and long-run cost analysis
Short-Run Costs:
Short run: The period during which at least one factor of production is fixed (typically capital, like machinery or
buildings), while other inputs (like labor) can vary.
• In the short run, some inputs are fixed, and costs are divided into fixed and variable.
Characteristics:
1. Firms can change output by adjusting variable inputs like labor or raw materials.
2. Fixed Costs (supplementary cost)(FC): Costs that do not change with the level of output (e.g., rent,
equipment costs).
3. Variable Costs (VC) (prime cost): Costs that vary directly with the level of output (e.g., wages, materials).
4. Total Cost (TC): Sum of fixed and variable costs
• TC= FC+ VC
• 5. average cost:
average total cost (ATC)= TC/Q
Average fixed cost(AFC)= FC/Q
Average variable cost(AVC)= VC/Q
6. Marginal Cost (MC): The additional cost of producing one more unit of output.
• In the short run, firms face diminishing returns, meaning that as more variable inputs are added to fixed inputs,
the additional output generated from each new input declines, which can increase marginal costs
• Long-Run Costs:
• Long-run, the period when all inputs, including capital, are variable, meaning the firm
can adjust all factors of production.
• Characteristics:
1.There are no fixed costs; all costs are variable.

2. Firms can adjust their scale of operation by expanding or contracting all inputs.

3. Economies of Scale: In the long run, firms may experience lower average costs as
production scales up due to factors like specialization and more efficient use of resources.

4. Diseconomies of Scale: Beyond a certain point, further increases in production may lead
to higher average costs due to factors like management inefficiencies or overcrowding of
facilities.
5. Long-Run Average Cost (LRAC): A curve that shows the lowest possible
cost at which a firm can produce any given level of output when all inputs
are variable.
6. Returns to Scale:
• Increasing Returns to Scale: Doubling inputs results in more than double the output.
• Constant Returns to Scale: Doubling inputs results in exactly double the output.
• Decreasing Returns to Scale: Doubling inputs results in less than double the output.

• In the long run, all inputs are variable, and firms can take advantage of economies or
suffer from diseconomies of scale.
Firm’s short run costs (Rs.)
Total cost curves FC curve is a flat line at the level of fixed costs. The total
fixed costs are incurred even when output is zero. as fixed
costs do not change with production levels.

The VC curve starts at the origin (0 output) and increases as

output increases.

TC curve starts at the level of fixed

costs (100) and increases as
output rises, representing the sum
of fixed and variable costs.
The slope of the TC curve reflects
the Marginal Cost of production,
which can vary based on the level
of output due to diminishing
returns.

TC=FC+VC
 Average Variable Cost (AVC):Shape: U-shaped curve. AVC decreases
Short run average and marginal initially as output increases due to the spreading of variable costs over more
cost curves units of output. However, it eventually increases as diminishing returns set
in.

Average Fixed Cost (AFC):Shape: Decreasing curve. AFC continuously

declines as output increases because fixed costs are spread over a larger
number of units. It never touches the x-axis.

Marginal Cost (MC):Shape: U-shaped curve. Initially decreases as output

increases due to increasing efficiency, then rises due to diminishing returns.
The MC curve intersects the AVC and AC curves at their minimum points.

Average Cost (AC):Shape: U-shaped curve.Relationship: The AC curve is

derived from the sum of AFC and AVC. It follows a similar U-shape, declining
at first and then increasing. The AC curve is minimized where it intersects the
MC curve.

AC = AFC + AVC The average cost is the sum of average fixed

and average variable costs
MC intersects AVC and AC at their minimum points

X-axis: Quantity of output

Y-axis: Cost
Shapes of cost curves in shortrun
Capital Labour Output( TFC TVC(PL= TC AFC= AVC=VC AC MC
(Fixed (variable Q) (Pk= Rs. Rs.10) FC/Q /Q
factor) factor) 5)
1 1 2 5 10 15 2.5 5 7.5 -
1 2 5 5 20 25 1 4 5
1 3 9 5 30 35 0.55 3.3 3.85
1 4 12 5 40 45 0.42 3.3 3.72
1 5 14 5 50 55 0.36 3.57 3.93
1 6 15 5 60 65 0.33 4 4.33
 Long-Run Cost Curve
• The long-run cost curve represents the minimum cost of producing different levels of output when a
firm can adjust all of its inputs. Unlike the short run, where at least one input is fixed, in the long
run, all inputs (like labor, capital, etc.) are variable, allowing firms to achieve the most efficient
scale of production.
• Key Characteristics of the Long-Run Cost Curve:
1.U-Shape: The long-run average cost (LRAC) curve is typically U-shaped, reflecting economies of
scale, constant returns to scale, and diseconomies of scale:
1. Economies of Scale: When increasing production leads to a decrease in average costs due to factors like
specialization, bulk purchasing, and more efficient use of capital.
2. Constant Returns to Scale: When increasing production results in proportionate changes in costs.
3. Diseconomies of Scale: When further increases in production lead to higher average costs due to coordination
challenges, management inefficiencies, etc.
2.Envelope Curve: The LRAC is often called an envelope curve because it is derived from the lowest
points of a series of short-run average cost (SRAC) curves, each corresponding to a specific level of
fixed inputs. As firms expand, they move along the LRAC, choosing the most cost-efficient level of
fixed inputs for each level of production.
3.Minimum Efficient Scale (MES): This is the point where the firm has exploited all possible
economies of scale, and further expansion does not lower the average cost. Beyond this point, the
firm achieves constant returns to scale, or if it expands too much, it might face diseconomies of
scale.
 LRTC (long-run total cost curve)

• The LRTC(longrun total cost curve) curve

begins at the origin (0,0) because, in the
long run, when there is no production
(output = 0), the total cost is also zero.
• This assumes that the firm does not
incur any fixed costs when it is not
producing.
 • The long run cost curve is also called

Longrun AC cost curve planning curve because it helps the firm in

future decision-making process.
• The long-run average cost curve (LRAC) is
derived from short run average cost curves
(SRAC).
• Envelope curve (as it envelopes short run
average cost curves).
• The envelope curve is a graphical
representation that outlines the lowest points
of a set of curves, providing a boundary for
those curves. In the context of cost curves, the
LRAC curve acts as the envelope for the
various SRAC curves.
• The LRAC curve is derived from the lowest
points of each SRAC curve. At any given
level of output, the LRAC is the lowest
average cost achievable by adjusting all
inputs.
• The LRAC curve is typically U-shaped,
reflecting economies of scale, and
diseconomies of scale.
• Downward Sloping Portion: Represents economies of scale, where
average costs decrease as production increases due to increased
efficiency and specialization.
• Flat Section: Indicates constant returns to scale, where average
costs remain stable as output increases.
• Upward Sloping Portion: Represents diseconomies of scale, where
average costs start to rise due to inefficiencies associated with
larger production levels.
• The long run cost curve is also called planning curve because it helps the firm
in future decision-making process.
• The long run average cost curve (LRAC) is derived from short run average
cost curves (SRAC).
• Envelope curve (as it envelopes short run average cost curves).
• The envelope curve is a graphical representation that outlines the lowest
points of a set of curves, providing a boundary for those curves. In the context
of cost curves, the LRAC curve acts as the envelope for the various SRAC
curves.
• The LRAC curve is derived from the lowest points of each SRAC curve. At
any given level of output, the LRAC is the lowest average cost achievable by
adjusting all inputs.
• The LRAC curve is typically U-shaped, reflecting economies of scale, and
diseconomies of scale.
• The SRAC curve shows the average cost per unit of output when at least
one input is fixed (e.g., capital, land). Firms can only vary variable inputs
(e.g., labor, materials) in the short run.
• Long-Run Average Cost (LRAC):The LRAC curve represents the average
cost per unit of output when all inputs can be varied. In the long run, firms
can adjust all resources to minimize costs.
• The LRAC curve (the envelope curve) will touch the lowest points of the
SRAC curves but will not cross them, encapsulating the optimal average
costs for various output levels.