Economics

Theory of Production
Cost Analysis

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 Agenda
Cost of Production and its Classification

Short Run Analysis for Costs

Long Run Analysis for Costs

Marginal Cost

Relationship b/w Marginal Cost to AVC and ATC

Practice Questions

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 Cost of Production
It is all of the payments or expenditures necessary to obtain the factors of production
of land, labor, capital and management required to produce a commodity. It
represents money costs which we want to incur in order to acquire the factors of
production

The following elements are included in the cost of production:

(a) Purchase of raw machinery,

(b) Installation of plant and machinery,
(c) Wages of labor,
(d) Rent of Building,
(e) Interest on capital,
(f) Wear and tear of the machinery and building
(g) Advertisement expenses
(h) Insurance charges
 Cost of Production

Normal Profit

The profit which he must earn so that it is equivalent to his income from any other
profession
Classification of Costs
 Another Classification of Costs

Explicit Cost

Implicit Cost

Real Cost

Opportunity Cost
 Another Classification of Costs
Explicit Cost: Explicit cost is also called money cost or accounting cost. Explicit cost represents all
such expenditure which are incurred by an entrepreneur to pay for the hired services of factors of
production and in buying goods and services directly. In other words, we can say that they are the
expenses which the business manager must take into account of because they must actually be paid by
the firm

Example: The explicit cost includes wages and salary payments, expenses on the purchase of raw
material, light, fuel, advertisements, transportation, taxes and depreciation charges.

Implicit Cost: Expenses that an entrepreneur does not have to pay out of his own pocket but are costs
to the firm because they represent an opportunity cost.

Example: For instance, if a person is working as a manager in his own firm or has invested his own capital
or has built the factory at his own land, then though he is not paying for the same but still the cost for the
same must be accounted for
 Another Classification of Costs
Real Cost: Real costs are the pains and inconveniences experienced by labor to
produce a commodity

Example: The pains borne by labour while working in harsh weather constitutes real cost

Opportunity Cost: The value of a resource in its next best use. It is the amount of
income or yield that could have been earned by investing in the next best alternative

Example:

Owner spending his own time in managing the company where as he could have earned 1 lakh in salary
working in a job

A labor being given 100 per hour must be equal to his opportunity cost otherwise he would leave and join
elsewhere
 Agenda
Cost of Production and its Classification

Short Run Analysis for Costs

Long Run Analysis for Costs

Long Run Analysis

Marginal Cost

Relationship b/w Marginal Cost to AVC and ATC

Practice Questions

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Cost Analysis in Short Run and Long Run
Short run is a period of time over which only some factors of production can vary

Short run, then, is a period of time over which output can be changed by adjusting the quantities of
resources such as labor, raw material, fuel but the size or scale of the firm remains fixed.

In the long run there is no fixed resource. All the factors of production are variable. A firm can change
everything from number of Labors to Buying a new machinery but the speed of change depends on type
of business the company is in

For example, a balloon making firm can change the size of firm more quickly than a car manufacturing
firm.
Types of Costs in Short Run

Total Fixed Cost

Total Variable Cost

Total Cost
 Types of Costs in Short Run

Total Fixed Cost

Total fixed cost occur only in the short run

Fixed Cost are the one’ which remains constant in short run irrespective of scale of production

Fixed cost is to be incurred even if the output of the firm is zero

For Example: If firm is producing 100 units using the machine, then the cost of machine
remains the same even if they start producing 1000 units or say 10 units
 Types of Costs in Short Run

Total Variable Cost

Total variable cost is linked with the level of output

When output is zero, variable cost is zero. When output increases, variable cost also increases and it
decreases with the decrease in output

For example, wages paid to the labor engaged in production, prices of raw material which a firm. incurs on
the production of output are variable costs

A firm can reduce its variable cost by lowering output but it cannot decrease its fixed cost
 Types of Costs in Short Run

Total Cost

Total cost is the sum of fixed cost and variable cost incurred at each level of output.

TC = TFC + TVC
Explanation of Short run
Total Fixed Cost

The short run cost data of the firm shows that total fixed
cost TFC (column 2) remains constant at $1000/-
regardless of the level of output
Total Variable Cost

In the figure (13.2), the total variable cost curve (TVC)

increases with the higher level of output.

It starts from the origin and then first increases slowly at a

up to the 4th units of output. It then begins to rise at an
increasing rate.
Total Cost Curve

The total variable cost curve and the total cost curve begin
to rise more rapidly as production is increased.

The reason for this is that after a certain output, the

business has passed its most efficient use of its fixed
costs machinery, building etc., and its diminishing return
begins to set in.
 Average Cost
Many of the times have seen that people are equally concerned in knowing the
cost per unit of the product.

Average Fixed Cost

Average Variable Cost

Average Total Cost

 Average Cost
Average Fixed Cost

Average fixed cost refers to fixed cost per unit of output. Average fixed Cost is found out by dividing the
total fixed cost by the corresponding output.

AFC = TFC/Output

For instance, if the total fixed cost of a shoes factory is $5,000 and it produces 500 pairs of shoes, then the
average fixed cost is equal to $10 per unit.

If it produces 1,000 pairs of shoes, the average fixed cost is $5 and if the total output is 5,000 pairs of shoes,
then the average fixed cost is $1 pair of shoe
 Average Cost
Average Fixed Cost

The concept of average fixed cost can be explained with the help
of the curve, in the diagram (13.4) the average fixed cost curve
gradually falls from left to right showing the level of output.

The larger the level of output, the lower is the average fixed cost

Smaller the level of output, the greater is the average fixed cost.
The AFC never becomes zero.
 Average Cost
Average Variable Cost

Average variable cost refers to the variable expenses per unit of output Average variable cost is obtained
by dividing the total variable cost by the total output.

AVC = TVC/Output

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 Average Cost
Average Variable Cost

When a firm increases its output, the average variable

cost decreases in the beginning, reaches a minimum and
then increases

When you first increase production, up to a point till the

plant works to its full capacity the variable cost will
decrease. But post that if you try to increase production
the inefficiency will creep in and the variable cost will
increase

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 Average Cost
Average Total Cost

Average total cost refers to cost (both fixed and variable) per unit of output

ATC = Total Cost/Output

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 Average Cost
Average Total Cost

As the output of a firm increases, average total cost like the

average variable cost decreases in the beginning reaches a
minimum and then it increases

Average total cost will continue falling so long average variable

cost does not rise

Even if average variable cost continues rising, it is not necessary

that the average total cost will rise. It can be due to the fact
that the increase in average variable cost is less than the fall in
average fixed cost

If the rise in the average variable cost is greater than the fall in
average fixed cost, then the average total cost will rise
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 Agenda
Cost of Production and its Classification

Short Run Analysis for Costs

Long Run Analysis for Costs

Long Run Analysis

Marginal Cost

Relationship b/w Marginal Cost to AVC and ATC

Practice Questions

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Short Run and Long Run Average Cost Curves

The LAC is U-shaped but is flatter than tile short run cost
curves. Mathematically expressed, the long-run average
cost curve is the envelope of the SAC curves

The long-run average cost curve of the firm is lowest at

point C. CM is the minimum cost at which optimum output
OM can be, obtained.

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 Agenda
Cost of Production and its Classification

Short Run Analysis for Costs

Long Run Analysis for Costs

Long Run Analysis

Marginal Cost

Relationship b/w Marginal Cost to AVC and ATC

Practice Questions

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 Marginal Cost
Marginal Cost is an increase in total cost that results from a one unit increase in output

For example, the total cost of producing one pen is $5 and the total cost of producing two pens is $9, then
the marginal cost of producing second unit is $4 only (9 - 5 = 4).

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 Marginal Cost

The marginal cost curve in fig. (13.8) decreases sharply with

smaller Q output and reaches a minimum. As production is
expanded to a higher level, it begins to rise at a rapid rate.

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 Agenda
Cost of Production and its Classification

Short Run Analysis for Costs

Long Run Analysis for Costs

Long Run Analysis

Marginal Cost

Relationship b/w Marginal Cost to AVC and ATC

Practice Questions

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Relationship Between Average Variable Cost and Average Total
Cost to Marginal Cost
1. When Average Variable cost
starts increasing, the Average
Total cost is still decreasing
because change in decrease in
average fixed cost is more than
change in average variable cost

2. Average Variable cost reaches

its lowest point before the
average Total cost

3. Marginal Cost starts increasing

as soon as total variable cost
starts to increase at increasing
rate

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1) When average cost is falling, the marginal cost is
always lower than the average cost.

(2) When average cost is rising, marginal cost lies

above AC and rises faster than AC.

(3) The marginal cost curve must cut the average

cost curve at the minimum point of AC.

D – MC
C – ATC
B – AVC
A - AFC
 Agenda
Cost of Production and its Classification

Short Run Analysis for Costs

Long Run Analysis for Costs

Long Run Analysis

Marginal Cost

Relationship b/w Marginal Cost to AVC and ATC

Practice Questions

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Practice Questions

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Practice Questions

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