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Cost Analysis
Cost Analysis
What is cost?
• In producing a commodity a firm has to
employ an aggregate of various factors of
production such as land, labour, capital and
entrepreneurship.
• These factors are to be compensated by the
firm for their contribution in producing the
commodity.
• This compensation (factor price) is the cost.
Various concepts of Cost
• 1. Real Cost
• 2. Opportunity or Alternative Cost
• 3. Money Cost – Explicit & Implicit Costs
• 4. Accounting & Economic Costs
• 5. Fixed and Variable Costs
Cost concepts
• 6. Production Costs –
• Total Cost (TC)
• Total Fixed Cost (TFC)
• Total Variable Cost (TVC)
• Average Fixed Cost (AFC)
• Average Variable Cost (AVC)
• Average Total Cost (ATC) and
• Marginal Cost (MC)
Real Cost
• The ‘real cost of production’ refers to the
physical quantities of various factors used
in producing a commodity.
• Real cost signifies the aggregate of real
productive resources absorbed in the
production of a commodity (or a service).
Opportunity Cost
• The concept of opportunity cost is based on the
scarcity and alternative applicability
characteristics of productive resources.
• The real cost of production of something using
a given resource if the benefit forgone (or
opportunity lost) of some other thing by not
using that resource in its best alternative use.
• An opportunity cost or alternative cost is the
value of a resource in a foregone employment.
Economists’ Money Costs
• Economists wish to include imputed value of all
the inputs provided by the producer himself in
addition to outright money transactions between
the firm and other parties from whom inputs are
purchased for carrying out production.
• Thus money costs in economic terms or
• Economic cost = explicit or Accounting costs +
implicit costs.
Sunk Costs
AVC
COST
AFC
OUTPUT
Average Fixed Cost, Average Variable Cost and
Average Total cost of the Firm
Output Average Average Average
(Units) Fixed Cost Variable Cost Total Cost
TFC ÷ Q TVC÷ Q TC÷ Q
1 240 1 = 240 1 1 = 120 360 1 = 360
2 240 2 = 120 160 2 = 80 400 2 = 200
3 240 3 = 80 180 3 = 60 420 3 = 140
4 240 4 = 60 212 4 = 53 452 4 = 113
5 240 5 = 48 280 5 = 56 520 5 = 104
6 240 6 = 40 420 6 = 70 660 6 = 110
Calculation of Marginal Cost
Output Total Cost Total Variable Marginal Cost
(units) (Rupees) Cost(Rupees) (Rupees)
0 240 0 --
1 360 120 120
2 400 160 40
3 420 180 20
4 452 212 32
5 520 280 68
6 660 420 140
Output TFC TVC TC AFC AVC ATC MC
(units) (TFC/Q) (TVC/Q) (TC/Q)
(1) (2) (3) (4) (5) (6) (7) (8)
0 100 0 100 -- -- -- --
1 100 25 125 100 25 125 25 (125-100)
MC
AC
COST
A M P
B
NN
C
O L Q
OUTPUT
Esimation of Cost Functions
Relationship between cost and output is
expressed by cost function.
TC = f(Q)
TC = Total Cost Q = Quantity of output
Three variants of Short-run Cost function
1.Linear Cost function
1. Linear function: TC = a + bQ
(TFC + TVC) (TFC) (AVCxQ)
TVC
ATC = TC/Q = TFC/Q + TVC/Q = a/Q + b
TC=a + bQ
MC = δΤC = b
δQ
cost
Illustration:
TFC
TC = 100 + 0.5Q (Q=10)
∴ΤFC = 100 ; TVC = 0.5Q output
At Q = 10, TVC = 0.5 x 10 = 5 and TC = 100 + 5 = 105
ATC = a/Q + b = 100/10 + 0.5 = 10.5
∴ΜC = b = 0.5
Explanation of Linear Cost function
The firm has fixed costs which must be met irrespective of the quantity of
output produced. This is represented by a in the equation TC=a+bQ
The firm must pay proportional amount for rawmaterials, labour and other
inputs, which is the TVC represented by bQ in the equation.
The equation for Total Cost = Total Fixed Cost + Total Variable Cost
Will thus be given as TC = a + bQ.
At Zero output TC = a + bxo = a =TFC
Average Total Cost = TC ÷ Output Q = a/Q + b
Average Fixed Cost = a/Q and Average variable cost = b
Since in the shortrun, TFC is the same irrespective of output, all increases
(differentials) in cost due to increase (differentials) in output will be
the Marginal Cost MC = b