Cost ConceptsCost Concepts

Cost Concept:Cost Concept: It is used for analyzing the cost It is used for analyzing the cost

of a project in short and long of a project in short and long run. run.

Types of Cost:Types of Cost: Total fixed costs (TFC)Total fixed costs (TFC) Average fixed costs (AFC)Average fixed costs (AFC) Total variable costs (TVC)Total variable costs (TVC) Average variable cost (AVC)Average variable cost (AVC) Total cost (TC)Total cost (TC) Average total cost (ATC)Average total cost (ATC) Marginal cost (MC)Marginal cost (MC)

Fixed Costs(FC)Fixed Costs(FC)Fixed Cost denotes the costs which do Fixed Cost denotes the costs which do

not vary with the level of production. not vary with the level of production. FC is independent of output.FC is independent of output.

Eg:Eg: Depreciation, Interest Rate, Rent, Taxes Depreciation, Interest Rate, Rent, Taxes

Total fixed cost (TFC):Total fixed cost (TFC): All costs associated with the fixed input.All costs associated with the fixed input.

Average fixed cost Average fixed cost per unit of output:per unit of output: AFC = TFC /OutputAFC = TFC /Output

Variable Costs(VC)Variable Costs(VC)

Variable Costs is the rest of total cost, the part Variable Costs is the rest of total cost, the part that varies as you produce more or less. It that varies as you produce more or less. It depends on Output.depends on Output.

Eg: Increase of output with labour.Eg: Increase of output with labour.

Total variable cost (TVC):Total variable cost (TVC):

All costs associated with the All costs associated with the variable input.variable input.

Average variable costAverage variable cost- cost per unit of output:- cost per unit of output:

AVC = TVC/ OutputAVC = TVC/ Output

Total costs(TC)Total costs(TC) The sum of total fixed costs and The sum of total fixed costs and

total variable costs:total variable costs:

TC = TC = TFC + TVCTFC + TVC

Average Total CostAverage Total Cost

Average total cost per unit of output:Average total cost per unit of output:

ATC =AFC + AVCATC =AFC + AVC

ATC = TC/ OutputATC = TC/ Output

Marginal CostsMarginal Costs

The additional cost incurred from The additional cost incurred from producing an additional unit of producing an additional unit of output:output:

MC = MC = TC TC OutputOutput

MC = MC = TVC TVC OutputOutput

Typical Total Cost CurvesTypical Total Cost Curves

TVC,TC is always increasing:TVC,TC is always increasing: First at a decreasing rate.First at a decreasing rate. Then at an increasing rateThen at an increasing rate

Typical Average & Marginal Cost Typical Average & Marginal Cost CurvesCurves

AFC is always AFC is always declining at a declining at a decreasing rate.decreasing rate.

ATC and AVC ATC and AVC decline at first, decline at first, reach a minimum, reach a minimum, then increase at then increase at higher levels of higher levels of output.output.

The difference The difference between ATC and between ATC and AVC is equal to AVC is equal to AFC.AFC.

MC is generally MC is generally increasing.increasing.

MC crosses ATC and MC crosses ATC and AVC at their AVC at their minimum point.minimum point.

If MC is below the If MC is below the average value:average value: Average value will be Average value will be

decreasing.decreasing. If MC is above the If MC is above the

average value:average value: Average value will be Average value will be

increasing.increasing.

Production Rules for the Short-Production Rules for the Short-RunRun1.If expected selling price < minimum AVC (which 1.If expected selling price < minimum AVC (which

implies TR < TVC):implies TR < TVC): A loss cannot be avoided.A loss cannot be avoided. Minimize loss by Minimize loss by not producingnot producing.. The loss will be equal to TFC.The loss will be equal to TFC.

2.If expected selling price < minimum ATC but > 2.If expected selling price < minimum ATC but > minimum AVC:minimum AVC:

(which implies TR > TVC but < TC)(which implies TR > TVC but < TC) A loss cannot be avoided.A loss cannot be avoided. Minimize loss by producing where MR = MC.Minimize loss by producing where MR = MC. The loss will be between 0 and TFC.The loss will be between 0 and TFC.

Contd…Contd…3.If expected selling price > minimum ATC 3.If expected selling price > minimum ATC

(which implies TR > TC):(which implies TR > TC): A profit can be made.A profit can be made.

Maximize profit by producing where: Maximize profit by producing where: MR = MCMR = MC

Short Run Production DecisionsShort Run Production Decisions

SPSPSP

Long Run Costs Curve:Long Run Costs Curve:

All costs are variable in the long run.All costs are variable in the long run. There is only AVCThere is only AVC in LR, since in LR, since

all factors are variable. all factors are variable. It is also called as Planning Curve or It is also called as Planning Curve or

Envelope or scale curve.Envelope or scale curve.

Production Rules for the Long-RunProduction Rules for the Long-Run

1.If selling price > ATC (or TR > TC):1.If selling price > ATC (or TR > TC): Continue to produce.Continue to produce. Maximize profit by producing where Maximize profit by producing where

MR = MC.MR = MC.

2.If selling price < ATC (or TR < TC):2.If selling price < ATC (or TR < TC): There will be a continual loss.There will be a continual loss. Sell the fixed assets to eliminate fixed Sell the fixed assets to eliminate fixed

costs.costs. Reinvest money is a more profitable Reinvest money is a more profitable

alternative.alternative.

Long Run Cost CurveLong Run Cost Curve

M-optimum level of productionM-optimum level of production

MMEconomies of scale Diseconomies of scale

Economies of Scale:Economies of Scale: Economies of scaleEconomies of scale are the cost  are the cost

advantages that a firm obtains due advantages that a firm obtains due to expansion. to expansion. DiseconomiesDiseconomies is the is the opposite.opposite.

Two types:Two types:

1. Pecuniary Economies of Scale:1. Pecuniary Economies of Scale:

Paying low prices because of Paying low prices because of buying in large Quantity.buying in large Quantity.

2.Real Economies of Scale:2.Real Economies of Scale:

Refers to reduction in physical Refers to reduction in physical quantities of input , per unit of output when quantities of input , per unit of output when the size of the firm increases, as a result the size of the firm increases, as a result input cost minimized.input cost minimized.

Diseconomies:Diseconomies:

1.Internal Economies: It is a condition which 1.Internal Economies: It is a condition which brings about a decrease in LRAC of the firm brings about a decrease in LRAC of the firm because of changes happening within the firm.because of changes happening within the firm.

e.g.As a company's scope increases, it may have to e.g.As a company's scope increases, it may have to distribute its goods and services in progressively distribute its goods and services in progressively more dispersed areas. This can actually increase more dispersed areas. This can actually increase average costs resulting in diseconomies of scale.  average costs resulting in diseconomies of scale. 

2.External Economies:2.External Economies:

It is a condition which brings It is a condition which brings about a decrease in LRAC of the firm about a decrease in LRAC of the firm because of changes happening because of changes happening outside the firm.outside the firm.

E.g. Taxation policies of Gov…E.g. Taxation policies of Gov…