Program - MBA

Course – ‘Managerial Economics’

Lecture – 17, 18, 19, 23 (Unit 3)
Cost Concepts & Cost Output Relationship in
the Short-Run
By
Sadananda Prusty, PhD
Professor & Dean-Academics
Jaipuria Institute of Management, Ghaziabad
 Content
• Importance of Knowledge of Cost

• Types of Costs

• Cost Output Relationship in the Short-Run

 Importance of Knowledge of Cost
• The analysis of cost of production guides the firms in determining what
to produce, how much to produce and sell. Thus, cost determines the
supply of any commodity, and the theory of cost is
mostly a restatement of the theory of production in
monetary terms.
• Cost function of the firm is a mathematical relationship
between costs of factor inputs and activity (i.e., output)
• The same level of output can be produced with the
help of different cost combinations
• The total cost function gives the least cost
combinations for the production of different levels of output
 Types of Costs
• The out-of-pocket costs (or, actual cost) on tuition fee and teaching materials are
the explicit costs that a student incurs while pursuing MBA. However, the
income that he would have earned if he had employed
his labour resource on a job rather than spending them
in studying different courses in MBA is known as
implicit cost (or, opportunity cost) of pursuing MBA
• One accounting procedure for valuing assets on the
balance sheet is acquisition cost minus depreciation.
This is faulty as the true current market value of an
asset may differ from its book value
• Thus, in addition to explicit costs, the business
economist uses implicit or imputed cost in evaluating a decision
 Types of Costs
• Private costs are those that accrue directly to the firms engaged in relevant
activity (e.g., cost on labour, raw materials, machine). Social costs (or, external
costs) are passed on to persons not involved in the
activity in any direct way (e.g., water and air pollution)
• Fixed costs are those costs which in total do not
vary with changes in output (e.g., interest on borrowed
capital, rental payments, a portion of depreciation
charges on equipment and buildings). Variable costs
are those costs which increase with the level of
output (e.g., payment of raw materials, charges
on fuel and electricity, depreciation charges
associated with wear and tear of assets)
 Types of Costs
• Accounting profits are the firm’s total revenue less its explicit
costs. Economic profits are the firm’s total revenue less its explicit
and implicit costs
• If a firm’s total receipts exceed all its economic
costs (explicit plus implicit costs), the residual
accruing to the entrepreneur is called an economic
or pure profit. Thus, an economic profit is a return
in excess of the normal profit required to retain
the entrepreneur in a particular line of production
 Types of Costs
• In economic analysis, the following types of costs are considered in
studying cost data of a firm

• Total Cost (TC)

• Total Fixed Cost (TFC)
• Total Variable Cost (TVC)
• Average Total Cost (ATC)
• Average Fixed Cost (AFC)
• Average Variable Cost (AVC)
• Marginal Cost (MC)
 Costs in Short-Run
• The short-run is a period during which one of the factors of
production is considered to be constant (usually it is assumed that
capital is the fixed factor in the short-run)

• Thus, the short-run cost function has two

important components: One is a variable
component that depends on the level of
output (Q) of the firm and the other one
is a fixed component that does not depend
on the level of output (Q)
 Costs in Short-Run
• TC (Total Cost) = TFC (Total Fixed Cost) + TVC (Total Variable Cost)
Table 7.1: Calculation of Total Cost

Number of workers Total output Fixed cost Variable cost Total cost
employed (baby dolls) (Rs.) (Rs.) (Rs.)
0 0 300 0 300
1 5 300 200 500
2 10 300 400 700
3 22 300 600 900
4 22 300 800 1100
5 20 300 1000 1300

• Dividing both sides of the equation by Q, we have TC/Q = TFC/Q + TVC/Q,

i.e. AC or ATC (Average Cost or Average Total Cost) = AFC (Average Fixed
Cost) + AVC (Average Variable Cost)
• Marginal Cost (MC) is defined as the additional cost the firm relating to each
successive unit-wise increment in total output. It is measured on the ratio of
change in total cost to one unit change in total output
 Short-Run Total Cost Curves
• The following are the shapes of short-run total cost curves
 Short-Run Average Cost Curves
• The following are the shapes of short-run average cost curves (SAC) and
marginal cost curve. U shaped indicating declining SAC in the beginning,
then remaining constant for a while and then rising
 Relationship of STC, TVC, TFC, SMC, SAC,
AVC, AFC & SAC
STC
STC  TVC  TFC  PL L  PK K TVC = PLL

• The minimum short-run marginal

cost occurs where TFC and TVC
have the least slope
TFC= PKK
 Minimum average variable cost
occurs when AVC = SMC

 Minimum short-run average cost

occurs when SAC = SMC
 Cost Output Relationship in the Short-Run
• Relationship of Average Product of Labour (APL) and
Average Variable Cost (AVC) 8
12

Average Variable Cost ($)

7
10 6
Average Product (Q/L)

5
8
4
6 3
2
4
1
2 0
0 0 10 40 50 54 56

0 2 4 5 6 7 Production Output (Q)

Input L

If the average productivity of the variable input increases there will be a corresponding
drop in the average variable cost
 L  PL
AVC    P L 
Q  AP L
 Cost Output Relationship in the Short-Run
• Relationship of Marginal Product of Labour (MPL) and Short-Run Marginal Cost
(SMC)

If the marginal productivity of the variable input increases there will be a corresponding
drop in the short-run marginal cost
 L  PL  1 
ArcSMC L    PL  Similarly using calculus SMC    PL
 Q  ArcMP L  MP L 
THANK YOU