COST CURVES

INTRODUCTION
DEFINITION: Cost may be defined as a sacrifice or
foregoing which has already occurred or has potential
to occur in future with an objective to achieve a
specific purpose measured in monetary terms.
Cost results in current or future decrease in cash or
other assets, or a current or future increase in liability.
Determinants of Cost:
o Price of inputs
o Productivity of inputs
o Technology
o Level of Output
 TYPES OF COSTS
1. ACCOUNTING COSTS: An accounting cost is recorded in the ledgers of a
business, so the cost appears in an entity's financial statements.
Examples:
 Cost of raw materials
 Wages and Salary
 Interest on Loan

2. REAL COSTS: Real costs are more or less social and psychological in nature and
non-quantifiable in money terms. The modern concept of compensation packages is
strongly driven by the real cost component of total cost, as besides normal salary
employers try to compensate for leisure, social and family needs, etc.

3. IMPLICIT COSTS: These are the costs that do not involve actual payment or cash
outflowor reduction in the assets.
These arise when a firm makes use of its own resources which include :
 Own Building
 Costs of self - owned or self - employed resources
 Own Land
4. OPPORTUNITY COSTS:
 Opportunity cost is the benefit forgone from the next best
alternative that is not selected.
 Individuals or firms give up an opportunity to use or enjoy
something in order to select something else.
 For example: In case of choices: you may be working in
your hometown and suppose you have got another job
opportunity in a city far away from your hometown. Now if
you select the new job, you would be forgoing the benefits of
staying at home. This would be your opportunity cost of the
new job.

5. EXPLICIT COSTS:
 Also known as out of pocket costs or accounting costs.
 These are the costs that are entered in the Trading and Profit
and Loss Account.
 For Example: Interest on Loan, Office expenses, Salaries, etc
6. SOCIAL COSTS: Social costs of the firms are those that society in
general has to bear because of the firm’s activities.
 For Example: Pollution caused by industrial wastes and emissions.
 It has 2 components: A) Private costs of the firm, B) Social costs paid
by the society.

7. SUNK COSTS: A sunk cost is a cost that has already been incurred
and cannot be recovered.
 For Example: A) Your rent, marketing campaign expenses or money
spent on new equipment can be considered sunk costs.
B) Cost incurred in constructing a Factory.

8. IMPUTED COSTS: An imputed cost is a cost that is incurred by

virtue of using an asset instead of investing it or undertaking an
alternative course of action.
 For example, if a firm occupies a building that it owns, it forgoes the o
pportunity of renting it out for some other use.
 TYPES OF COST CURVES

I. SHORT
RUN

3.
1. TOTAL 2. AVERAGE
MARGINAL
COST COST
COST

Fixed Variable Fixed Variable

II. LONG
RUN
3.
1. Total 2. Average
Marginal
Cost Cost
Cost
 SHORT RUN COST FUNCTION
 In the short-run, the firm cannot change or modify fixed
factors such as plant, equipment and scale of its organization.
 In this the output can be increased or decreased by changing
the variable inputs like labor, raw materials, etc.

 TOTAL FIXED COSTS (TFC)

• These are the Costs that DO NOT vary with the output.
• These costs are NOT affected by the changes in volume of
production.
• It included:
o Property Tax
o Rent
o Depreciation
 TOTAL VARIABLE COSTS (TVC)
• These are the costs that vary with the output and are
incurred in getting more and more inputs.
• Variable costs are equal to zero if there is no output.
• Includes:
o Cost of raw material
o Wages

Total Cost = Total Fixed Cost + Total Variable

Cost
 AVERAGE FIXED COST(AFC)
AFC is the fixed cost per unit of output and thus,
Average Fixed Cost = Total Fixed Cost
Unit Output
As the number of units of output is
Increased, fixed cost remaining same,
AFC falls steeply at first and then gently.
 AVERAGE VARIABLE COST (AVC)
AVC is variable cost per unit of output and thus,
Average Variable Cost = Total Variable Cost
Unit Output
 Relationship between Total Cost, Fixed
Cost and Variable Cost
 TFC curve is a horizontal straight
line parallel to X-axis as it remains
constant at all levels of output.
 TC and TVC curves are inversely S-
shaped because they rise initially at a
decreasing rate, then at a constant
rate and finally, at an increasing rate.
This shape is determined by the law
of variable proportions.
 At zero output, TC = TFC because
there is no variable cost as zero level
output.
 So, TC and TVC curves start from
the same point, which is above the
 MARGINAL COST (MC)
Marginal Cost refers to the addition to total cost when one
more unit of output is produced.
MCn = TCn – TCn-1

Where, n is the number of units produced

Thus, Marginal Cost (MC) = △TC
△Q
Relationship between Average and Marginal Cost Curves
As output increases, the gap between AC and
AVC falls.
As output increases, the gap between AC and
AFC increases.
AVC never intersects AC due to the gap of AFC,
AFC needs to be zero so as to make AVC intersect
AC.
MC intersects AC and AVC at their lowest points.
 COSTS IN LONG RUN
 All costs are variable in the long run since factors of production, size of
plant, machinery and technology are all variable.
 It is often referred to as the “Planning Cost Function” and the Long
Run Average Cost (LAC) curve is also known as “Planning Curve” or
“Envelope curve”.

 LONG RUN AVERAGE COST

• The long-run average cost curve is the relationship between the lowest
attainable average total cost and the output when both the plant size
and labor are varied.
 Different Shapes of Long Run Average Cost
Curves

1. The Curve LAC in the Panel ’a’ suggests early

economies of scale, followed by diseconomies of scale
beyond a least cost plant size.

2. The Curve LAC in Panel ‘b’ happens when

economies of scale offset diseconomies over a broad
range of output. It has a prolonged downward slope till
a very large level of output and thereafter, an upward
curve.

3. The Curve LAC in Panel ‘c” represents the situation

in which a firm initially experiences economies of scale
when it expands, represented by the downward sloping
portion of LAC curve.
 LONG RUN TOTAL COST
• Long run Total Cost (LTC) refers to the minimum cost at
which given level of output can be produced.
• LTC is always less than or equal to short run total cost, but
it is never more than short run cost.
 LONG RUN MARGINAL COST
 Long run Marginal Cost (LMC) is defined as added cost of
producing an additional unit of a commodity when all inputs are
variable.
 This cost is derived from short run marginal cost.

 If perpendiculars are drawn from point A, B, and C,

respectively; then they would intersect SMC curves at P, Q, and
R respectively. By joining P, Q, and R, the LMC curve would
be drawn.
 It should be noted that LMC equals to SMC, when LMC is
tangent to the LAC.
 CONCLUSION

The short run cost curves of a firm are the SAVC

curve, the AFC curve, the SAC curve and SMC curve.
AC Falls when MC < AC.
AC is minimum when MC = AC.
AC rises when MC > AC.
THANK YOU!