Principles of Economics

EGMC001
Cost Analysis: Unit 5

Learning Objective:
Comprehend the cost-output relationship in the short run
Exemplify the cost-output relationship in the long run
Identify the reasons for the emergence of economies of scale and scope
 Cost Concepts

Inputs Cost (Rs.)

Inputs hired  
Cloth 95000
Labour 32500
Sewing Machine 60000
Electricity 45500
Miscellaneous 10000
Sub Total 243000
Inputs owned  
  135000
Managerial ability
Building 70000
Total 448000
 Short Run: Cost Concepts
 Total Cost Functions
 Total Fixed cost TFC
 For fixed resources
 Total Variable Cost TVC
 For variable resources
Total Cost TC = TFC + TVC
 Per unit Cost Functions
 Average Variable Cost AVC = TVC/Q
 Average Fixed Cost AFC = TFC/Q
 Short Run Average Cost SAC = TC/Q
 Short Run Marginal cost
 SMC = ∆TC/∆Q
 Change in TC to produce one more unit
of output
Cost-Output relationship in Short
Run
Quantity TFC TVC TC AFC AVC SAC SMC

0 120 0 120 - - - -
1 120 40 160 120 40 160 40
2 120 60 180 60 30 90 20
3 120 90 210 40 30 70 30
4 120 160 280 30 40 70 70
5 120 270 390 24 54 78 110
 Short Run Cost Curves
400 _
TC
Costs TC is the vertical sum of TFC and TVC
300 _ TFC
J
TVC
200 _ TVC starts from origin; increases slowly at first due to
* G diminishing returns and higher levels of output increases
TVC
100 _ TFC rapidly
G *
* H
0 | | | | | | SAC, SMC and AVC: initially decline, reach minimum, then
_ 2 4 6 Output
160 rise
Costs Q 3 > Q2 > Q1
120 _
SMC AFC falls continuously as more output is produced
80 _ SAC
AFC
•When AVC(SAC) is falling then SMC lies below SAC
40 _ AVC •When AVC(SAC) is rising then SMC lies above SAC
H
’
G’* AFC •When AVC (SAC) is at its minimum then MC = AVC (SAC)
0 | | | | | |
1 Q1 2 Q2 3 Q3 4 5 6
Output
 AP A
MP B

Relationship between AP
SAC and SMC MP
with Labour
Average Product (AP)
and Marginal Product
(MP) SMC SMC SAC
SAC

B’
A’
O Output
Cost-Output relationship in Long Run
Production Total LTC LAC LMC
scale Product (Q)
A 10 50 5.00 5
B 20 90 4.50 4
C 30 120 4.00 3
D 40 150 3.75 3
E 50 200 4.00 5
F 60 260 4.33 6
Long Run Cost Curves
LTC
300 _

LTC
200 _

100 _ A B

0 | | |
20 40 60 Total Product

6_ LMC
*
* * LAC
4_ *
*
* *
2_ Economies Diseconomies
of scale of scale

0 | | | Total Product
20 40 60
Long Run Cost Curves

LAC (a) LAC (b)

LMC LAC LMC

LMC
LAC = LMC
P A LAC
LMC
Q
O Q O
Many Short-Run ATC Curves Form
a Firm’s LRAC Curve, or
Planning Curve
ATC1 ATC10
ATC9
ATC2 Long-run
Rs.5 b average cost
a ATC8
Cost per unit

ATC3 ATC7
c ATC4 ATC6
ATC5

0 10 q’ 40 Output per period

Each point of tangency represents the least cost way of producing that level of output
A Firm’s Long-Run Average Cost
Curve

Long-run

Cost per unit

average cost

0 A B Output per period

Economies Constant Diseconomies

of scale average cost of scale
Economies of Scale-
Due to Large Plant

A.1 SPECIALISATION B.1. SAVES ON COST OF

A.2. INDIVISIBILITY OF CAPITAL TRANSPORT, DISTRIBUTION &
PROCUREMENT
B.2. QUANTITY DISCOUNTS,
FUNDS RAISING
B.3. ADVERTISING COST &
SALES PROMOTION
B.4. INNOVATION
B.5. MANAGEMENT
A 1, 2 TECHNICAL ECONOMIES
B1 COMMERCIAL ECONOMIES
B2 FINANCIAL ECONOMIES
B3 MARKETING ECONOMIES
B4 RISK BEARING ECONOMIES
B5 MANAGERIAL ECONOMIES
THANKS!