Lecture-15

Cost analysis
Learning Objective : Short term cost concepts such as fixed cost, variable cost
total cost Average cost concepts and relationships
SHORT RUN COSTS: Short run costs are classified as fixed and variable costs.
Total Fixed Cost (TFC)
All costs associated with the fixed inputs. These costs do not vary with the level of
production. They remain invariant in the short run, but in long run there are no fixed
costs. These are also called overhead or sunk costs. Since total fixed cost remains
constant irrespective of the level of output, the total fixed cost curve is parallel to the Xaxis (Fig. 1).

Fig. 1
Incur even if the resource is not used.
Does not change as the level of production changes (in the short run)
Exist only in the short run.
Not under the control of the manager in the short run.
The only way to avoid fixed cost is to sell the item.
Examples: insurance, depreciation, mortgage, interest, etc.
Average Fixed Cost (AFC)

Cost per unit of output is called as average fixed cost. Since fixed cost is constant,
as more output is produced, average fixed cost fall continuously, but at a decreasing rate.
Therefore, AFC curve slopes downward throughout its length. Mathematically speaking,
AFC curve becomes asymptotic to both the axes (Fig. 2).
TFC
Output

AFC =

Fig. 2
Variable Cost (VC)
Variable costs (VC) are the costs that vary or change with the change in output.
Variable costs are also known as operating costs, prime costs, on costs and direct costs.
The variable costs vary directly with the level of output. Some of the characteristics of
the variable costs are as under.
Can be increased or decreased by the manager.
VC = (the quantity of the input) (price of the inputs.)
Increases as production increases.
Total Variable cost (TVC) is the summation of the individual variable
costs.
Variable costs exist in the short-run as well as in long-run.
In fact, all costs are considered to be variable in the long run.

Some examples of variable versus fixed costs:

Fertilizer is a variable cost until it has been purchased and applied.
Labour and cash rent contracts have to be considered fixed costs during
the duration of the contract.
Irrigation water is generally variable, but can have a fixed component.
Total Variable Cost (TVC)

All costs associated with the variable inputs.

TVC = Px * X,
Where,
Px

= cost of a variable input

= variable input

The nature of the total variable cost is shown in Fig. 3.

Fig. 3
The total variable cost curve rises upward as the level of output increases. This
shows that as the output is increased the total variable cost also increases. Total
variable cost curve starts from the origin which implies that when the output is
zero the total variable cost is also zero.
Average Variable Cost (AVC)

 Average variable cost is the cost per unit of output i.e. total cost divided by the
number of units of output produced (Fig. 4). Thus average variable cost (AVC) is
variable cost per unit of output.

Fig. 4
AVC =

TVC
Output

The AVC curve is linked with the Average Production (AP) curve of the variable input.
TVC
Y

AVC =

AVC =

Px * X
Y

(Because TVC = Px * X)
Px
Y/X

But Y/X is average product (AP) of variable input X. Thus,

AVC =

Px
AP

 This shows that there is inverse relationship between AP and AVC. So as when
AP is increasing AVC is decreasing, and when AP is decreasing, AVC is
increasing. When AP is at maximum AVC is at its minimum (Fig. 5).

Fig. 5
Total Cost (TC)
As the name implies, the sum of total fixed cost (TFC) and total variable cost
(TVC) is called the total cost (TC) as shown in Fig. 6.
TC = TFC + TVC
= K + Px * X

Fig. 6
In the short run TC will increase as only the TVC increases, since TFC is constant
or fixed. TVC rises with the increase in output because the output can be
increased only by the increase in the amount of variable input. So as output
increases with the increase in the TVC, the TC must also rise, i.e. the TC is a
function of output. Total cost curve is obtained by adding vertically TFC and
TVC curves. Thus the vertical difference between TVC and TC curve is nothing
but the TFC (Fig. 7). Thus we summarize;
TFC is constant and unaffected by output level.
TVC is always increasing:
First at a decreasing rate.
Then at an increasing rate.
TC is parallel to TVC:
TC is higher than TVC by a distance equal to TFC.

Fig. 7
Average Total Cost (ATC)
Average total cost refers to the average of all costs per unit of output i.e.,
ATC = AFC + AVC

or
TC
Output

ATC =

TFC + TVC
Y

Average total cost (ATC) or average cost (AC) is also known as unit cost, since it
is the cost per unit of output produced (Fig. 8). ATC or AC reaches at a low point
but at a higher output than AVC curve. The AC falls over a greater range of
output than AVC because of the flattening/ lowering influence of AFC. For a
range beyond the minimum of AVC curve, AFC falls at a faster rate than the
increase in AVC and this causes AC to continue to fall beyond the minimum of
AVC curve. The ATC curve starts rising when the rate of decrease of AFC curve
is less than the rate of increase of AVC curve.

Fig. 8
Marginal Cost (MC)
Marginal cost (MC) (Fig. 9) is the cost of producing an additional unit of output.

Fig. 9

Marginal Cost =

MC =

Change in the total costs

Change in the output
TC
Q

Marginal cost is independent of fixed cost.

MCn = TCn TCn-1

or

= (TVCn + TFCn) - (TVCn-1 + TFCn-1)

or
= TVCn TVCn-1
(Because TFCn and TFCn-1 are same as the fixed cost is constant
Hence marginal cost is the addition to the total variable cost when output is increased
from n-1 units to n units of output.

Marginal cost is inversely related to

marginal product (MP) of the variable input (Fig. 10).

Mathematically,
TC
Y

MC =

Or
MC =

TVC
Y

Fig. 10

Px*X
MC =

(Because TVC = Px *X)

or
MC =

Px
Y/X

MC =

(Because Y/X = MP)

Px
MP

TYPICAL AVERAGE AND MARGINAL COST CURVES AND THEIR

SELECTED ATRIBUTES

Fig. 11
AFC is always declining at a decreasing rate.
ATC and AVC decline at first, reach a minimum, and then increase at higher
levels of output.
The difference between ATC and AVC is equal to AFC.
MC crosses ATC and AVC at their minimum points.
If MC is below the average cost value; Average cost value will be decreasing.
If MC is above the average cost value; Average cost value will be increasing.
RELATIONSHIP BETWEEN AVERAGE AND MARGINAL COST
If MC < AC, then AC is falling
If MC > AC, then AC is rising
If MC = AC, then AC is constant

Fig. 12
Mathematically, these relationships can be worked out as follow.

TC
Y

MC =

ATC*Y
Y

(Be cause TC = ATC * Y)

=Y*

AC
Y

ATC
Y

+ AC

is the slope of the Average cost curve.

If

AC
Y

MC < AC
< 0 then

AC
Y

If

> 0 then

MC > AC
and
AC
Y

If

= 0 then

MC = AC

PRODUCTION RULES FOR THE SHORT RUN

Case 1:

If expected selling price > minimum ATC (which implies total revenue
(TR) > TC): A profit can be made.

Maximize profit by producing where,

MR = MC

Case 2:
If expected selling price < minimum ATC but > minimum AVC: (Which implies
TR > TVC but < TC), then;

A loss cannot be avoided.

Minimize loss by producing where,

MR = MC

Case 3:
If expected selling price < minimum AVC (which

A loss cannot be avoided.

implies TR < TVC) then;

Minimize loss by not producing.

The loss will be equal to total fixed cost (TFC).

Questions
1. Costs which do not vary with the level of production are called
a) Variable cost
b) Fixed cost
c) Average total cost
d) Average variable cost
2. When average is minimum, average productivity is
a) Minimum
b) Maximum
c) Zero
d) None of the above
3. The difference between ATC and AVC is equal to
a) MC
b) AFC
c) Both a and b
d) None of the above
4. The marginal cost curve above the intersection of average cost curve is
a) Demand curve
b) Consumption curve
c) Supply curve
d) None of the above
5. When marginal cost is greater than average cost then AC is
a)
b)
c)
d)

rising
constant
falling
None of the above

Answers
1 .b)
2. b)
3.b)
4c)
5a)