COST ANALYSIS

INTRODUCTION

 Determinants of Cost Function: C=f (S,O,P,T,M)

 The cost of production may be defined as the aggregate of expenditure
incurred by the producer in the process of production. Cost, is therefore, the
valuation placed on the use of resources.
 Several concepts of costs such as; Fixed Cost, Variable Cost, Total Cost
Average Cost, Marginal Cost, Money Cost, Real Cost, Implicit Cost,
Explicit Cost, Private Cost, Social Cost, Historical Cost, Replacement Cost
And Opportunity Cost.
 Fixed costs are those costs which remain fixed, irrespective of the output.
They have to be incurred on equipment, building etc and they are incurred
even when the output is zero. Fixed costs are also called Supplementary
costs or Overheads or Indirect costs.
 Variable costs are those costs which vary with the output. For example the
cost of raw materials, electricity, gas, fuel etc. the Variable costs are also
called Prime costs, Direct costs or Operating costs.
 TC
MC 
MC= TCn- TCn-1 Q
TVC
MC 
=(TVCn + TFC) – (TVCn-1 + TFC) Q
L
MC  w *
=TVCn + TFC- TVCn-1– TFC Q
Q
MP 
MC = TVCn – TVCn-1 L
1 L

MP Q
w
MC 
MP
 THREE POINTS THAT EMERGE ARE

 Marginal cost changes due to variable cost and hence is

independent of fixed cost.
 Secondly the shape of Marginal Cost is determined by the
law of variable proportions.
 Price of a factor input remains constant is a vital
assumption.
 The difference between the short-run and long run
production function is based on the distinction between
fixed and variable costs. In the short-run production
function, the output is increased only by employing more
units of variable factors; other factors of production
remaining fixed. In the long run all factors are variable and
thus all costs are variable.
 Marginal Product and Marginal Cost: when Marginal
Product is increasing Marginal Cost is decreasing and
when Marginal Product is decreasing MC is increasing.
MC increases in the range where production faces a
diminishing returns.
Total cost Average cost and Marginal Cost
 Total cost is the aggregate (sum-total) cost of
producing all the units of output. It is the summation of
total fixed cost and total variable cost. Thus,
TC = TFC + TVC

 The Total Fixed Cost curve is a horizontal

straight line, parallel to the X-axis.
The total variable cost curve slopes upwards as
output increases. The total cost curve is parallel to
the total variable cost curve as it is the lateral
summation of total fixed cost and total variable
cost curves.
 Average Cost: The Average Cost is the cost per
unit of output produced. Thus, the Average Cost
is obtained by dividing the total cost by the total
output. AC = TC

 TC = TFC and QTVC.

 AC can be rewritten as

AC = TFC + TVC
Q
 Therefore AC= AFC+AVC
The Average Fixed Cost is the fixed cost per unit of output. i.e. AFC = TFC
Q

Now, if the output goes on increasing, the AFC will go on falling because the
total fixed cost will be thinly spread over the number of units of output.
AVC = TVC
Q
1. In the starting the average variable cost
is rather high.
2. When more and more units of output are
produced, the firm starts enjoying
several advantages in the form of
transport, commercial and marketing
economies and thus the average variable
cost goes on falling.
3. Any further effort to increase the output
brings about disadvantages in marketing
and other processes involved in
production, mainly associated with the
employment of variable factors and thus
the average variable cost begins to rise.
 The Average Cost Curve in the Short-Run
The AC curve is the lateral summation of the
average fixed and variable cost curves.
AC = AFC + AVC
 The average fixed cost curve slopes downwards
from left to right (AFC curve) and average
variable cost curve first goes downwards and then
bends upwards (AVC curve).
 Each point of AC curve can be plotted as the sum
of AFC and AVC.
The U-Shape of Average Cost Curve is explained in two
ways :

 i) The Geometrical explanation: The shape of AC curve

depends on the slopes of AFC And AVC curves.
Therefore, the AC curve acquires U-shape.

 ii) The Theoretical explanation :Economies of Scale

TC  AC.Q
d (TC )
MC  1.When AC is falling, the
dQ
MC lies below it
d ( AC.Q)
MC  2. Secondly MC cuts the
dQ
AC at the lowest point of
d ( AC ) AC curve
MC  Q  AC
dQ
3. when AC curves begin
d ( AC ) to rise, the marginal cost
measures  slope  of
dQ curve will be above the
AC AC curve
d ( AC )
 0, MC  AC
dQ
d ( AC )
 0, MC  AC
dQ
d ( AC )
 0, MC  AC
dQ
i) When AC is falling, the MC lies below it.
ii) Secondly MC cuts the AC at the lowest point of AC curve.
iii) Thirdly, when AC curves begin to rise, the marginal cost curve will be above
the AC curve showing that MC rises faster than the AC curve.
 Long- Run Average Cost Curve : Long- Run
Average Cost Curve will envelope the related series of
all short-run AC curves.
 In case of short-run since some factors are
“Indivisible” the producer has to remain contented by
making best use of the given plant; whereas in the
long run the scale of operation can be altered and the
producer will choose the most feasible plant. There
will be a new short run average cost each time the
scale is revised.