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Cost and Cost Curves
Cost and Cost Curves
Cost and Cost Curves
Cost function
• It shows the relationship between cost and output
• It depends on production conditions and price of the factors of
production
• Costs of production are a major force deciding the supply of the
product
Types of Cost
• Opportunity cost- of a producing a good / service is all that has been forgone
to produce that good
Opportunity cost = explicit cost + implicit cost
• Explicit cost and Implicit cost
• Explicit costs---- contractual cash payments to other factor owners for
purchasing or hiring the various factors- actual or business costs entered in
the books of accounts eg payments on account of wages, salaries, utility
expenses, interest, rent, purchase of materials, license fee, insurance
premium and depreciation charges
• Implicit / imputed cost ----there are certain other costs which do not take the
form of cash outlays nor do they appear in the accounting system. eg return
on money capital invested by entrepreneur – wages or salary forgone
• Accounting cost and Economic cost
Accounting cost are explicit concept
Economic cost = Accounting cost + Implicit cost
Economic profit = Total Revenue – Total Economic Costs
Accounting profit = Total Revenue – Accounting costs
Eg. An owner of a drug store had the following information about her
receipts and expenditures per year:
Income= $10,00,000 , Wages = $3,00,000
Utilities = $20,000 , Raw materials =$ 5,00,000
She could work elsewhere earning $2,00,000. Find her accounting
profit? What would you advise her ?
• Accounting cost = 3,00,000 + 20,000 + 5,00,000 = 8,20,000
Implicit cost = 2,00,000
Accounting profit = 10,00,000 – 8,20,000 = 1,80,000
Economic costs = 8,20,000 + 2,00,000 = 10,20,000
Economic Profit = 10,00,000 – 10,20,000 = - 20, 000
loss, Advice ?
• Fixed / Overhead cost – cost of fixed factors – do not change with
output – cannot be altered in short run- Fixed costs include interest
on borrowed capital, rent for equipment or factory building,
depreciation charges on machinery, and salaries of permanent
employees
• Variable cost – cost of variable factors eg raw material, labour–
change with change in the level of output- are nil at zero level of
output – can be altered in short run
• Semi variable cost – have elements of both fixed and variable costs-
they are fixed for a certain level of production and become variable
after this level is exceeded eg. Cost of electricity telephone bill, costs
of operating certain equipments or vehicles, ( air crafts on lease by
air lines, cranes, road rollers etc)
0 50 0 50
1 50 20 70
2 50 35 85
3 50 60 110
4 50 100 150
5 50 145 195 50
6 50 190 240
7 50 237 287
8 50 292 342
Short Run Average Cost Curves
• Average fixed Cost : AFC =
• Average Variable Cost : AVC =
• Average total Cost : ATC = AC = AFC + AVC
AC =
• Marginal cost : MC = = = ( = 0)
(fixed costs do not change in the short run)
Units of TFC TVC TC AFC AVC ATC MC
output
0 50 0 50 -- --- --- --
1 50 20 70 50 20 70
20
2 50 35 85 25 17.50 42.50
15
3 50 60 110 16.67 20 36.67
25
4 50 100 150 12.50 25 37.50
5 50 145 195 10 29 39 40
6 50 190 240 8.33 31.67 40 45
7 50 237 287 7.14 33.86 41 45
8 50 292 342 6.25 36.50 42.75 47
55
Cost curves in the short run
Relation between MC and ATC, AVC
MC intersects ATC and AVC at their lowest
points
When MC < AVC , AVC falls
When MC > AVC , AVC rises
When MC = AVC , AVC is minimum
J
When MC < ATC , ATC falls
A
D When MC > ATC , ATC rises
H When MC = ATC , ATC is minimum
K
Vertical distance between ATC and AVC = the
vertical distance between AFC and x axis
B M N
F
The “U” shape of ATC, AVC, SMC is due to the
G E Law of Diminishing Marginal Returns
A’
Relationship between cost and productivity
• Relation between AVC and • Relation between MC and
Average Product Marginal Product
AVC = = MC = =
( Q = AP L ) ( TFC = 0 , = w L )
AVC = = MC = =
AVC = w() ( MPL = )
MC = w()
Find FC, VC, MC, AVC, AFC, ATC/AC
Per unit