Theory of Cost

• Concepts of Cost
• cost concepts can be classified as: (i) accounting cost
concepts, (ii) analytical cost concepts and (iii) policy related
cost concepts
(i) Accounting Cost Concepts: Actual and Opportunity Costs
• Actual costs are the expenditures which are actually incurred
by the and recorded in the books of accounts for all practical
purposes.
• Opportunity cost is the loss of income due to opportunity
foregone. Opportunity cost is also called alternative or
economic cost. It arises because of scarcity and alternative
uses of resources. The foregone benefit is called opportunity
cost of the gains from the chosen use of the resources.
• The opportunity cost is the expected returns from the
second best use of the resources foregone to avail the gains
of their best use.
• Business and Full Costs
• Business costs include all the expenses which are incurred in
carrying out the business. used in calculating actual profits
and losses in the business.
• The concept of full costs includes opportunity cost and normal
profit.
• Opportunity cost: foregone benefit
• Normal profit is a necessary minimum earning which a firm
must get to remain in its present occupation. Practically,
normal profit is the rate of profit earned by most of the firms
in the industry.
• Explicit and Implicit Costs
• Explicit costs are those which are actually
incurred by the business firms and are entered
in the books of accounts.
• implicit or imputed costs are certain other costs
which do not take the form of cash outlays, nor
do they appear in the accounting system.
• Although implicit costs are not taken into
account while calculating the loss or gain of
the business, these costs do figure in business
decisions.
• Implicit costs are similar to opportunity cost.
• Analytical Cost Concepts :Total, Average, and
Marginal Costs
• Total cost (TC) represents the cost of the total
resources used in the production of goods and
services. If refers to the total outlays of money
expenditure on the resources used to produce a given
output. The total cost for a given output is obtained
from the cost function.
• Average cost (AC) is of statistical nature, rather than
being an actual cost: the total cost (TC) / the total
output (Q), i.e., TC/Q = average cost.
• Marginal cost (MC) is the addition to the total cost on
account of producing one additional unit of product.
Or, marginal cost is the cost of marginal unit produced.
• Fixed and Variable Costs
• Fixed costs are the costs which are fixed in amount
for a certain level of output.
• Fixed cost includes cost of (i) managerial and
administrative staff; (ii) depreciation of machinery,
building and other fixed assets and (iii) maintenance
of land. The concept of fixed cost is associated with
short run.
• Variable costs are those which vary with the
variation in the total output. Variable costs include
direct labour cost, cost of raw materials, and running
cost of fixed capital, such as fuel, ordinary repairs,
routine maintenance expenditure and the costs of all
other inputs that vary with output
Short-run and Long-run Costs
• Long-run costs are the costs incurred in the long run. In
the long run, there is no fixed cost. All the costs are
variable cost. It implies that even the costs incurred on
fixed assets, like plant, building, machinery and so on
become the variable costs.
• Short-run costs include fixed cost and the variable cost,
i.e., the costs which vary with the variation in the
output.
Policy Related Cost Concepts: Private and Social Costs
• Private Cost: Private costs are those which are
actually incurred or provided for by an individual or
a firm on the purchase of goods and services from
the market.
• Private costs are internalized in the sense that ‘the
firm must compensate the resource owner in order
to acquire the right to use the resource.

• Social Cost: Social costs are the broader costs to

society that result from a business's activities. These
include private costs (what the business pays) and
external costs, which are not paid by the business
but by society.
• The money value of inputs is called cost of production
and the money value of output is referred to as sales
revenue—the value of output sold.
• The theory of cost deals with the cost–output
relationship.
• Theory of cost analyzes the relationship between
cost and output; how costs of production changes
with changes in production.
• The relationship between cost and output is called
cost function.
• There are four major inputs :land, labour, capital
and entrepreneurship. The costs attached with each
are; rent, wages, interest and profits respectively.
 SHORT-RUN COST CURVES
• A short-run cost curve shows the minimum cost
impact of output changes for a specific plant
size and in a given operating environment.
• From cost theory point of view, short run refers
to a period during which some costs remain
fixed and some costs are variable
• Short-run Cost Measures
the total short-run cost (TC) consists of fixed cost and
variable cost.
• TC = TFC + TVC,

Averages total cost = TC/Q OR TFC/Q+TVC/Q

• AC = AFC + AVC

MC = TCn − TCn−1 or ∆ TC/ ∆ Q or ∆TFC+ ∆ TVC/Q

As ∆ TFC=0; ∆ TC= ∆ TVC, MC= ∆ TVC

n denotes the total number of units produced at a point of time

• The theory of short-run cost behaviour can be
stated as the cost of production increases with
the increase in production and vice versa.
• In fact, it is the rate of increase in output that
determines the rate of increase in the cost of
production.

• the short-run theory of production, i.e., the

laws of returns to variable input, or the law of
diminishing returns
• given the cost of labour (the wage rate), as
long as output increases at increasing rate,
the cost of production increases at
decreasing rate and when output increases at
decreasing rate, cost of production increases
at increasing rate.

• It is this kind of cost–output relationship that

forms the basis of the short-run theory of
cost
• Total Fixed Cost:
• Total fixed cost includes those costs, which do
not vary with the level of output.
• Total Variable Cost
• varies with the level of output. As output increases, the total
variable cost also increases the total variable cost curve is shown
as inverse S-shaped curve.
• This is due to the law of diminishing returns:
• (i) When the output is zero, the total variable cost is also zero.
• (ii) As output increases, the total variable cost also increases.
• According to the law as more and more units of the variable
factor are applied to a given amount of the fixed factors, the
output will initially increase at an increasing rate. This implies
that total variable costs will initially increase at a decreasing
rate.
• (iii) when additional units of the variable factor are added to a
given quantity of the fixed factors, the output of a good will
increase at a decreasing rate. This implies that total variable
costs will increase at an increasing rate
• Stages of the TVC Curve:
• Zero Output (TVC = 0):
– Explanation: When the firm produces no output, its variable costs are zero because no
resources (like labor or materials) are being used.
• Increasing Output with Decreasing Rate of TVC Increase:
– Explanation: As the firm starts increasing output, the TVC begins to rise. However, in the
initial stages, as more units of the variable factor (like labor) are added to a fixed factor (like
machinery), output increases at an increasing rate. This means that the TVC increases, but at
a slower pace.
• Increasing Output with Increasing Rate of TVC Increase:
– Explanation: After a certain point (denoted as X∗X^*X∗), adding more units of the variable
factor leads to smaller and smaller increases in output. This is due to the law of diminishing
returns, which states that as more of a variable input is added to a fixed input, the additional
output produced by each additional unit of the variable input will eventually decrease. As a
result, TVC starts to increase more rapidly.
• Law of Diminishing Returns: This law is central to understanding the shape of the
TVC curve. Initially, adding more variable inputs (like labor) increases output
efficiently, leading to slower increases in TVC. But as more input is added beyond a
certain point, the efficiency drops, leading to faster increases in TVC.
• In summary, the TVC curve reflects how variable costs behave as production levels
change, starting with slow increases in cost when output is low, and then
accelerating as production continues to rise beyond an efficient point due to the law
of diminishing returns.
• Total Cost
• Total cost is obtained by adding total fixed cost and
total variable cost.
• The total cost curve is also an inverse S-shaped curve
like the total variable cost curve and is everywhere
higher than the total variable cost curve by the same
amount as the total fixed cost.
• Average Cost
• the average cost curve is shown as U shaped. Initially, it falls,
then reaches a minimum and starts rising. As output increases,
these fixed costs per unit decrease significantly, pulling down
the average cost.
• Decreasing Average Costs:
• Initial Decline: When a firm starts producing, it
spreads its fixed costs (like rent, machinery)
over more units of output. As output increases,
these fixed costs per unit decrease significantly,
pulling down the average cost.
• Variable Costs: At low levels of production,
increasing returns to scale can also occur, where
the variable costs (like labour and materials) are
used more efficiently, further reducing the AC.
• Shape: The curve slopes downward in this phase,
reflecting lower average costs as output rises.
• b. Minimum Point (Optimal Scale):
• Bottom of the U: Eventually, the firm reaches a
point where the average cost is at its lowest. This
point represents the optimal scale of production
where the firm is operating most efficiently,
balancing fixed and variable costs.
• Characteristics: At this minimum point, any
additional increase in output doesn’t lead to
further cost savings. Ap is maximum.
• c. Increasing Average Costs:
• Rising Costs: As the firm continues to increase
production beyond the optimal level, it may
encounter inefficiencies. These could include
overuse of resources, management
challenges, or bottlenecks in production.
• Fixed Costs: Even though fixed costs per unit
are low, the increase in variable costs (due to
inefficiencies) causes the average cost to rise.
• Shape: The curve begins to slope upward
again, representing increasing average costs
as output continues to grow.
• Average Variable Cost
• Average cost can be obtained from the total variable
cost.
• Average Variable Cost = Total Variable Cost/ Output
the average variable cost curve is shown as U
shaped.
• Downward Slope: At low levels of output, AVC
decreases due to increasing efficiency.
• Minimum Point: AVC is at its lowest when the
variable inputs are used most efficiently.
• Upward Slope: At higher levels of output, AVC
increases due to diminishing returns.
• Average Fixed Cost
• the average fixed cost curve is shown as a rectangular
hyperbola because as the level of output increases,
the fixed cost per unit decreases.
Continuous Decline:
• As output increases, AFC decreases because the total
fixed cost is being divided by a larger and larger
number of output units.
• The AFC curve will never touch the x-axis, as fixed
costs can never be reduced to zero, no matter how
much output is produced.
• Similarly, it approaches but never touches the y-axis,
as there's always some fixed cost per unit, even at
very low levels of output.
• the hyperbolic shape of the AFC curve comes
from the fact that no matter how much you
produce, the total fixed cost remains the
same, and this constancy is reflected in the
curve's smooth, continuous decline.
• Constant Area: The area under the AFC curve
(which represents TFC) remains constant,
regardless of the level of output. This property
gives the AFC curve its hyperbolic shape.
• Marginal Cost
• Marginal cost is the change in the total cost or total variable
cost due to a unit change in the level of output.
• the marginal cost curve is shown as U shaped. Initially, it falls
as the variable factor is used more efficiently and then starts
rising.
• reflecting decreasing costs as output increases.
• At a certain level of output, the firm reaches the most
efficient use of its inputs. The cost of producing an additional
unit is at its lowest. This point represents the minimum of the
MC curve.
• As production continues to increase, the firm begins to
experience diminishing returns to the variable input. Each
additional unit of input produces less output than the
previous one, leading to higher costs for each additional unit
produced.
• Downward Slope: At low levels of output, MC
decreases due to increasing efficiency in
production.
• Minimum Point: MC is at its lowest when the
firm is using its inputs most efficiently.
• Upward Slope: Beyond this point, MC increases
due to diminishing returns to the variable input

• The MC curve shows the change in total cost

when output changes by one unit. It reflects
the immediate cost impact of producing an
additional unit.
• Some Relationships Between the Short-run Cost Curves
• AC and AVC:
• The average variable cost curve and average cost curve are
both U shaped due to the law of variable proportions.
However, average variable cost curve reaches its minimum
point before the average cost curve.

• because AVC is influenced only by variable costs, while AC

includes both fixed and variable costs. The fixed costs'
continuous spread helps the AC curve stay lower for a longer
period, delaying its minimum point compared to AVC.
• AC & MC:
• Both the average cost curve and the marginal
cost curve are U shaped.
• when average cost is falling, marginal cost is
also falling and is below it.
• when average cost is rising, marginal cost is
also rising and is above it.
• when average cost is at its minimum point,
marginal cost is equal to average cost or the
marginal cost curve intersects the average cost
curve.
• LONG-RUN COST ANALYSIS
• In the long run, the supply of most of the
factors of production is elastic. No factors are
fixed in the long run. Thus, all the factors of
production can be changed in the long run.

• It is important to understand that the long-run

cost curves are formed by the short-run cost
curves.
• The long-run average cost (LAC) is the average
per unit cost of production when all the factors of
production are variable in the long run.
• The long-run average cost curve can be derived
from the short-run average cost curves.
• To start with it is assumed that given the
technology, only three methods are available to
the firm to produce the output. These three
methods can be represented by three different
plants each with a different scale of operations.
• SAC1 is the short-run average cost of the small size of plant,
• SAC2 is the short-run average cost of the medium size of plant,
• SAC3 is the short-run average cost of the large size of plant.
• To produce an output of OX1 per unit costs are lowest on plant
SAC1. Similarly, for an output of OX2 per unit costs are lowest on
plant SAC2 and for an output of OX3, they are lowest on plant
SAC3. If one examines the reality, there are infinite number of
such plants each represented by an SAC.
• The long-run average cost curve is derived from the SAC’s as the
minimum per-unit cost of producing each level of the output.
• It shows the least cost of producing each level of the output. The
long-run average cost curve is called the envelope curve as it
envelops the SAC’s.
• The long-run average cost curve is U shaped because
of the law of returns to scale:
(i) Initially, the long-run average costs fall as a firm
experiences increasing returns to scale because of
economies of scale.
(ii) When the economies of scale have reached their
limit while diseconomies of scale have not yet
appeared, the long-run average cost curve reaches its
optimum plant producing the optimum output.
(iii) When a firm increases its output beyond its
optimum capacity by changing its scale of operations,
the disadvantages that it experiences are called the
diseconomies of scale.
• Long-run Marginal Cost
• The long-run marginal cost curve can be derived
from the short-run marginal cost curves as in Figure
9.10.
• The long-run marginal cost curve (LMC) is derived
from the short-run marginal cost curve (SMCS).
• The process of derivation of LMC curve is exactly the
same as the process of deriving the LAC curve.
• SMC curves are drawn corresponding to each SAC. To
derive the LMC, consider the points of tangency
between SAC curves and the LAC, i.e., points A, B and
C for the long-run production planning.
• Relationship Between Long-run Average Cost and Long-run
Marginal Cost Figure
• (i) When long-run average cost is falling, long-run marginal
cost is also falling and is below it.
• (ii) When long-run average cost is rising, long-run marginal
cost is also rising and is above it.
• (iii) When long-run average cost is at its minimum point, long-
run marginal cost is equal to long-run average cost, or the
long-run marginal cost curve intersects the long-run average
cost curve.
• Also, at this point Long-run Average Cost = Short-run Average
Cost = Short-run Marginal Cost = Long-run Marginal Cost
• Or
• LAC = SAC = SMC = LMC
• Long-run Total Cost
• The long-run total cost curve is the minimum total cost of producing different
levels of output from different plant sizes.
• the long-run total cost curve is derived from the short-run total cost curves
taking the point which represents the optimum size of the plant.
• The short-run total cost curve begins from the level of the fixed costs while
the long-run total cost curve begins from the origin since in the long run
there are no fixed costs.
• The long-run total cost curve is inverse S shaped because of the law of
returns to scale.
• The long-run average cost curve is U shaped because of the law of returns to
scale.
• The long-run marginal cost curve can be derived from the short-run marginal
cost curves.
• When long-run average cost is at its minimum point, long-run marginal cost
is equal to long-run average cost. Also at this point, LAC = SAC = SMC = LMC.
• The long-run total cost curve is derived from the short-run total cost curves
taking the point which represents the optimum size of the plant.
• Cost-output relationship facilitates many
managerial relationships such as :
• (a) Formulating the standards of operations.
• (b) Formulating the rational policy on plant
size.
• (c) Formulating a policy of profit prediction.
• (d) Formulating a policy of pricing fixation.
• (e) Formulating a policy of promotion
methods.
• (f) Formulating a policy of expenses control.