Cost Concepts

in Economics
Dr Monika Jain

1
 Definition of Cost
A cost is relevant if it is affected by a
management decision.
Historical cost is incurred at the time of
procurement
Replacement cost is necessary to replace
inventory

2
 Definition of Cost
There are two types of cost associated with
economic analysis
Opportunity cost is the value that is
forgone in choosing one activity over the
next best alternative
Out-of-pocket cost is actual transfer of
value that occur

3
 Opportunity Cost
The income that would have been received if
the input had been used in its most profitable
alternative use.
The value of the product not produced because
an input was used for another purpose.
An “economic concept” not an “accounting
concept.”
As economic decision-makers, we assume
costs include opportunity costs.

4
 Accounting versus Economic
Cost
An accountant’s notion of costs involves only
the firm’s explicit costs:
Explicit costs: the firm’s actual cash payments for
its inputs or the Accounting cost
An economist includes the firm’s implicit costs:
Implicit costs: the opportunity costs of
nonpurchased inputs.
 Economic cost: the sum of explicit and implicit costs.

5
Accounting versus Economic
Cost
Accounting versus Economic Cost
Accounting Economic
Approach Approach
Explicit Cost (purchased inputs) $60,000 $60,000
Implicit: opportunity cost of
30,000
entrepreneur’s time
Implicit: opportunity cost of funds 10,000
______ ______
Total Cost $60,000 $100,000

6
 Costs
Total fixed costs (TFC)
Average fixed costs (AFC)
Total variable costs (TVC)
Average variable cost (AVC)
Total cost (TC)
Average total cost (ATC)
Marginal cost (MC)

7
 Short-run versus Long-run
Decisions
Short run: a period of time during which
at least one factor of production remains
fixed. In the short run, a firm decides how
much output to produce in the current
facility.
Long run: the time it takes for a firm to
build a production facility and start
producing output. In the long run, a firm
decides what size and type of facility to
build.

8
 Fixed Costs
Result from owning a fixed input or
resource.
Incurred even if the resource isn’t used.
Don’t 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 costs is to
sell the item.

9
 Fixed Costs

1. Depreciation
2. Interest
3. Rent
4. Taxes
(property)
5. Insurance

10
 Important Fixed Costs
Total fixed cost (TFC):
All costs associated with the fixed
input.
Average fixed cost per unit of output:

AFC = TFC
Output

11
 Variable Costs
Can be increased or decreased by the
manager.
Variable costs will increase as
production increases.
Total Variable cost (TVC) is the
summation of the individual variable
costs.
VC = (the quantity of the input) X
(the input’s price).

12
 Variable Costs
 Variable costs exist in the short-run and long-run:
In fact, all costs are considered to be variable costs in
the long run.
 Variable versus Fixed, some examples:
Fertilizer is a variable cost until it has been
purchased and applied.
Labor 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.

13
 Important Variable
Costs
Total variable cost (TVC):
All costs associated with the variable input.
Average variable cost per unit of output:

AVC = TVC
Output

14
 Total Cost
The sum of total fixed costs
and total variable costs:

TC = TFC + TVC

In the short run TC will only

increase as TVC increases.
15
 Output TFC
(Q) (£)
Total costs for
100
0 12
firm X
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40

20

0
0fig 1 2 3 4 5 6 7 8
 Output TFC
(Q) (£)
Total costs for
100
0 12
firm X
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Output TFC TVC
(Q) (£) (£)
Total costs for
100
0 12 0
firm X
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Output TFC TVC
(Q) (£) (£)
Total costs for
100
0 12 0
firm X TVC
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Total costs for
100
firm X TVC
80

Diminishing marginal
60
returns set in here

40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Output TFC TVC
(Q) (£) (£)
Total costs for
100
0 12 0
firm X TVC
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Output TFC TVC
(Q) (£) (£)
Total costs for
TC
(£)
100
0 12 0
firm X
12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Output TFC TVC
(Q) (£) (£)
Total costs for
TC
(£) TC
100
0 12 0
firm X
12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Total costs for
TC
100
firm X TVC
80

Diminishing marginal
60
returns set in here

40

20

TFC
0
0fig 1 2 3 4 5 6 7 8
 Typical Total Cost
Curves

25
 Average Total Cost
Average total cost per unit of output:

AFC + AVC

ATC = TC
Output

26
 Short-run Average Total Cost
 Short-run average total cost measures total cost per unit
of output produced.

TFC TVC
SATC  
Q Q
Short-
run Fixed Variable
Average = Cost + Cost per
Total per Unit Unit
SATC  AFC  SAVC
Cost

27
 Short-run Average Total Cost
 Short-run average total cost measures total cost per unit
of output produced.

TFC TVC
SATC  
Q Q
Short-
run Fixed Variable
Average = Cost + Cost per
Total per Unit Unit
SATC  AFC  SAVC
Cost

28
 Marginal Cost
The additional cost incurred from
producing an additional unit of output:

MC =  TC
 Output
MC =  TVC
 Output

29
Costs (£) Q TVC AVC
35 0 0 -
1 10 10
30 2 16 8
3 21 7
25 4 28 7
5 40 8
20 6 60 10
7 91 13
15

10

5
AFC
0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TVC AVC
35 0 0 -
1 10 10
30 2 16 8
3 21 7
25 4 28 7
5 40 8
20 6 60 10
3 13
7 91
15

10 AVC

5
AFC
0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TC AC
35 0 12
1 22 22
30 2 28 14
3 33 11
25 4 40 10
5 52 10.4
20 6 72 12
7 103 14.7
15

10 AVC

5
AFC
0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TC AC
35 0 12
1 22 22
30 2 28 14
3 33 11
25 4 40 10
5 52 10.4
20 6 72 12
7 103 14.7
15
AC

10 AVC

5
AFC
0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TC MC
35 0 12
10
1 22
6
30 2 28
5
3 33
7
25 4 40
12
5 52
20
20 6 72
31
7 103
15

10

0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TC MC
35 0 12
10 MC
1 22
6
30 2 28
5
3 33
7
25 4 40
12
5 52
20
20 6 72
31
7 103
15

10

0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TC MC AC
35 0 12 -
10 MC
1 22 22
6
30 2 28 14
5
3 33 11
7
25 4 40 10
12
5 52 10.4
20
20 6 72 12
31
7 103 14.7
15

10

0
0 1 2 3 4 5 6 7
Q
Costs (£) Q TC MC AC
35 0 12 -
10 MC
1 22 22
6
30 2 28 14
5
3 33 11
7
25 4 40 10
12
5 52 10.4
20
20 6 72 12
31
7 103 14.7
15
AC

10

0
0 1 2 3 4 5 6 7
Q
 Average and marginal
MC costs
AC

AVC
Costs (£)

x
AFC

fig
Output (Q)
 Typical Average &
Marginal Cost Curves

39
 Short-run Average Total Cost
(SATC)
 The AC curve is U-
shaped because of the
behavior of its two
components as output
produced increases.
AFC decreases as
output increases.
AVC increases as
output increases.

40
 Relationship between Short-run
Marginal and Average Cost
Curves
As long as AC is
declining, marginal
cost lies below it.
 When AC rises, SMC
is greater than SATC.

 At point m, AC=MC.

41
 Farm Size in the Short-
Run

42
 Long-run Average Cost
Long-run average cost (LAC) is total cost
divided by the quantity of output when the
firm can choose a production facility of any
size.
The LAC curve describes the behavior of
average cost as the plant size expands.
Initially, the curve is negatively sloped, then
beyond some point, it becomes horizontal.

43
 Alternative long-run average cost
curves

Economies of Scale
Costs

LRAC

O Output
fig
 Alternative long-run average cost
curves

LRAC
Diseconomies of Scale
Costs

O Output
fig
 Alternative long-run average cost
curves

Constant costs
Costs

LRAC

O Output
fig
 A typical long-run average
cost curve

LRAC
Costs

O Output
fig
 A typical long-run average
cost curve

Economies Constant Diseconomies LRAC

of scale costs of scale
Costs

O Output
fig
 Possible Size-Cost
Relations

49
 Economies of Size
 Increasing returns to size.
 LRAC curve is decreasing.
 Economies of size result from:
Full utilization of labor, machinery,
buildings.
Ability to afford specialized labor and
machinery and new technology.
Price discounts for volume purchasing of
inputs.
Price advantages when selling large
amounts of output.

50
 Long-Run Average Cost
Curve
(Economies of Size)

51
 Diseconomies of Size
Decreasing returns to size.
LRAC curve begins to increase.
Diseconomies of size result from:
Lack of sufficient managerial skill.
Need to hire, train, supervise, and
coordinate larger labor force.
Dispersion over a larger geographical
area.
Disease control, waste disposal.

52
 Long-Run Average Cost
Curve
(Diseconomies of size)

53
 Reduction in costs when the scale of
production increases is called

ECONOMIES
OF SCALE

INTERNAL EXTERNAL
ECONOMIES ECONOMIES

54
 INTERNAL ECONOMIES

Technological Large scale production provides

opportunities for technological
advances
Advantages
Economies in
Production
Large scale production workers of
Advantages of varying skills & qualifications are
divisions employed which facilitates division of
of labour labour as per specialization
&
Specialization
.. Large scale selling of
firms own products

.. Large scale purchase

of raw materials & Improves the overall
Economies in performance of the firm
other inputs
Marketing
.. Advertising cost
.. Large
scale distribution
55
 .. Specialization in
managerial activities

Managerial .. Improves managerial

Economies efficiency
.. Mechanization of
managerial functions

.. Efficient management
of the transport
function
.. Helps in reducing
Transport
transportation and
&
storage costs
Storage
Economies
.. Proper utilization of
storage facilities

56
 CAUSES OF EXTERNAL ECONOMIES
Advantages Common Pool of
Knowledge
CONCENTRATION of of locality
locality Reduced transportation
cost

The benefits which

companies derive from
trade publications and
Knowledge technical journals
INFORMATION
sharing By virtue of location,
common pool of research
can be created and
benefits can be shared

Breaking up of processes
Breaking up which can be handled by
DISINTEGRATIO
N specialist firms
57 processes
 ADVANTAGES AND DISADVANTAGES OF LARGE SCALE
PRODUCTION

Specialization Rent

Economy of Overhead
labour charges

Economics of
buying and
selling

58
 Economies of Scale
 Economies of scale: a situation in which an
increase in the quantity produced decreases the long-
run average cost of production.
 Economies of scale refer to cost savings associated
with spreading the cost of indivisible inputs and input
specialization.
 When economies of scale are present, the LAC curve
will be negatively sloped.

59
 Economies of Scale
 Economies of scale are said to exist if by
increasing your output of a single good by one
more unit, your average cost deceases.
The opposite of economies of scale is
diseconomies of scale.
This comes from initially spreading fixed
costs across more units of output.

60
 Minimum Efficient Scale

 The minimum efficient scale describes the

output at which economies of scale are
exhausted and the long-run average cost curve
becomes horizontal.
 Once the minimum efficient scale has been
reached, an increase in output no longer
decreases the long-run average cost.

61
 Diseconomies of Scale

 A firm experiences diseconomies of scale

when an increase in output leads to an
increase in long-run average cost—the LAC
curve becomes positively sloped.
 Diseconomies of scale may arise for two
reasons:
Coordination problems
Increasing input costs

62
 Economies of scope
 Economies of scope is a term that refers to the
reduction of per-unit costs through the
production of a wider variety of goods or
services
 Economies of scope are said to exist if when
the firm increases the variety of goods it sells,
it achieves a savings in total cost in
comparison to two firms producing the two
variety of goods separately.

63
 Economies of Scope
 Economies of Scope Concept
Scope economies are cost advantages that
stem from producing multiple outputs.
Big scope economies explain the popularity
of multi-product firms.
Without scope economies, firms specialize.
 Exploiting Scope Economies
Scope economics often shape competitive
strategy for new products.

64
 Economies of Scope

 Economies of scope are comparable to

economies of scale but imply efficiency gains
resulting from expansion of scope, or number
of different output types, rather than from an
increase in the volume of total output.

65
 How It Works/Example
 
Let's assume Company XYZ strictly manufactures vacuum
cleaners.
 if the company decided to branch out into brooms?
Adding brooms to the product line would allow XYZ to
spread certain fixed costs over a larger number of units.
 Thus, the company could reach more customers with its
advertising budget, its sales force could be used to sell
both products, brooms could be stored and shipped from
the firm's existing vacuum warehouse, and the
company's factory could turn leftover broom bristles into
cleaning brushes for its vacuums.
 Furthermore, XYZ could then market itself as a "cleaning
products" company rather than just a "vacuum"
company.

66
 How It Works/Example
 In this example, XYZ increased the variety of
items produced rather than increasing the
number of vacuum cleaners produced.
 As a result, the company's advertising, selling,
and distribution costs may generally remain the
same, but its number of products sold will
increase.
 The cost of producing multiple products
simultaneously is often less than the costs
associated with producing each product line
independently.

67
 Why It Matters
 Similar to economies of scale, economies of scope
provide companies with a means to generate operational
efficiencies.
 However, economies of scope are often obtained by
producing small batches of many items (as opposed to
producing large batches of just a few items).
 Because they frequently involve marketing and
distribution efficiencies, economies of scope are more
dependent upon demand than economies of scale.
 This is often what motivates manufacturers to bundle
products or to create a whole line of products under one
brand.

68
 Diseconomies of scope.
Although economies of scope are often an
incentive to expand product lines, the
creation of new products is often less
efficient than expected.
 The need for additional managerial
expertise or personnel, higher raw materials
costs, a reduction in competitive focus, and
the need for additional facilities can actually
increase a company's per-unit costs. When
this happens, it is often referred to as
diseconomies of scope.
69
 Conclusion
Nevertheless, when done correctly,
economies of scope can help companies
gain a significant competitive advantage.
Not only do they trim expenses on a per-unit
basis and improve profitability, but they can
also force less cost-efficient competitors out
of the industry or discourage would-be
rivals from even entering the market

70