Module II

Production Function:
Cost Function

1
 Cost Function
“In Economic term cost means scarifies done by individual or by
firm to acquire a given input”.

Cost of input= Input used in production * respective prices.

Important of Cost-
1. Determines the Profit Margins.
2. Finding the optimum output level.
3. Locating the weak point in the production management.

Economics cost are distinct from accounting cost

 Short-run Production Cost
TOTAL COST (TC)
✓ The sum of cost of all inputs used to produce goods and services.
✓ Total cost (TC ) also defined as total fixed cost (TFC) plus
total variable cost (TVC).

TC = TFC + TVC

TOTAL FIXED COST (TFC) TOTAL VARIABLE COST (TVC)

✓ The cost of inputs that are ✓ The cost of inputs that changes
independent of output. with output.
✓ Examples: Factory, machinery ✓ Example: Raw materials, labours,
and etc. etc.
 Short-run Production Cost

AVERAGE TOTAL COST (ATC)

✓ The total cost per unit of output.
✓ The formula for average total cost (ATC) is the total cost
(TC) divided by the output (Q).

ATC = TC
Q

TC = TVC + TFC
 Short-run Production Cost
Average Fixed Cost (AFC)
Total fixed cost (TFC) divided by total output:
AFC = TFC
Q

Average Variable Cost (AVC)

Total variable cost (TVC) divided by total output:
AVC = TVC
Q
Marginal Cost (MC)
The change in total cost that results from a change in output;
the extra cost incurred to produce another unit of output:
MC = TC
Q
 Cost Function
 Cost Analysis:

 Given the employment of fixed factor (capital)

when more and more variable units are
employed the cost from the additional
input may initially decrease but eventually
increase”.
 Short-run Cost Curves

TOTAL COST (TC)

COST
TC The sum of cost of all inputs used to produce goods
and services.
Also defined as TFC plus TVC

TVC TC = TVC + TFC

TOTAL VARIABLE COST (TVC)

The cost of inputs that changes with output.

TFC
TOTAL FIXED COST (TFC)
The cost of inputs that is independent of output.

QUANTITY
 Short-run Cost Curves

MARGINAL COST (MC)

COST Change in total cost that results from a change in output

MC = TC
MC ATC Q

AVERAGE TOTAL COST (ATC)

Total cost per output

AVC ATC = TC ATC = AFC + AVC

Q

AVERAGE VARIABLE COST (AVC)

Total variable cost (TVC) divided by total output
AVC = TVC
Q

AVERAGE FIXED COST (AFC)

Total fixed cost (TFC) divided by total output

AFC = TFC
Q
AFC
QUANTITY
 The Shapes of Cost Curves
 The variable and total cost curves have the same shape
 Increasing output increases VC and TC

• The fixed cost curve is always constant

• Increasing output doesn’t change FC
• The average fixed cost curve is downward sloping
• Increasing output decreases AFC

• The marginal cost, average variable cost, and average total

cost curves are U-shaped
• Increasing output initially leads to a decrease in MC, AVC,
and ATC but eventually they increase

12-9
 The Shapes of Cost Curves
• The U-shape of ATC and AVC curves is due to:

• When output is increased in the short run, it can only be

done by increasing the variable input.

• The law of diminishing productivity causes marginal

and average productivities to fall.

• As average and marginal productivities fall, average

and marginal costs rise.

• The marginal cost curve goes through the minimum

points of the ATC and AVC curves .
12-10
 The Relationship Between
Marginal Productivity and Marginal Costs
Costs
per unit
MC
AVC

If marginal productivity is rising,

marginal costs are falling
Q
Output If average productivity is falling, average
per worker
costs are rising

AP of workers
MP of workers
Q
12-11
 Cost Function
 Some Important cost relationship-
 When MC falls -- AC follows.
 But the rate of fall in MC is greater than AC.
 Reason MC decreasing cost is attributed to single
marginal unit.
 In case of AC, decreasing marginal cost is distributed
over entire out put.
 When MC increases AC also increases but at a lower rate
for the same reason.
 MC intersects ATC at its minimum point.
 That is output optimization point.
 MC=AC
 Cost Analysis
Q FC VC TC AFC AVC AC MC
0 20 0 20 - - - -
1 20 15 35 - - - -
2 20 25 45 - - - -
3 20 30 50 - - - -
4 20 35 55 - - - -
5 20 45 65 - - - -
6 20 65 85 - - - -
7 20 90 110 - - - -
 Cost Analysis
Q FC VC TC AFC AVC AC MC
0 20 0 20 - - - -
1 20 15 35 20.0 15.0 35.0 15
2 20 25 45 10.0 12.5 22.5 10
3 20 30 50 6.7 10.0 16.7 5
4 20 35 55 5.0 8.8 13.8 5
5 20 45 65 4.0 9.0 13.0 10
6 20 65 85 3.3 10.8 14.2 20
7 20 90 110 2.9 12.9 15.7 25
 Cost Analysis
Q FC VC TC AFC AVC AC MC
0 20 0 20 - - - -
1 20 15 35 20.0 15.0 35.0 15
2 20 25 45 10.0 12.5 22.5 10
3 20 30 50 6.7 10.0 16.7 5
4 20 35 55 5.0 8.8 13.8 5
5 20 45 65 4.0 9.0 13.0 10
6 20 65 85 3.3 10.8 14.2 20
7 20 90 110 2.9 12.9 15.7 25

MC intersects AC at its minimum point.

That is output optimization point.
MC=ATC
 Cost Function
 TC = a + bQ.
 Here:
 TC = Total cost.

 a = Total fixed cost

 b = Coefficient.
 Q = Quantity Output.

 Example:
 TC= 200+5Q+2Q2
 Cost Curves In The Long Run
 Long Run Average Cost Curve (LRAC)

 Long run is a period where all factors of inputs are

variables.
 Long run total cost (LRTC) starts from origin because
of the absence of total fixed cost.
 Long Run Average Cost Curve (LRAC)

 Shows the minimum cost of producing any given output

when all of the inputs are variable.
 LONG-RUN PRODUCTION COST
LRAC curve are derived by a series of short run average cost curves

COST
SRAC1
SRAC5

SRAC2 SRAC4 LRAC

SRAC3

Tangential point of the SAC

are joined and made up the LRAC.

QUANTITY
 Long-run Production Cost
 Long run average cost curve (LRAC) is “U–Shaped” due to
the Law of Returns to Scale.
 Law of Returns to Scale states that as the firm expand its
size or scale of production, its long run average cost
(LRAC) will decrease and increase at later stage.
Cost
LRAC

Increasing Constant Decreasing

Return to Return to Return to
Scale Scale Scale

Quantity
 Long-run Production Cost
ECONOMIES OF SCALE
➢ Advantages and benefits of a firm as it becomes larger and
larger.
➢ Reduce long run average cost (LRAC).
➢ Marketing economies, financial economies, labour economies,
technical economies, managerial economics.

DISECONOMIES OF SCALE
➢ Problems faced by a firm as it becomes larger and larger.
➢ Mismanagement, competition, labour diseconomies.
 Cost Concept
A. Accounting Cost Concepts
1. Opportunity cost and Actual cost

2. Business cost and Full costs

3. Actual /Explicit cost and Implicit cost

4. Out-of-pocket and Book costs

 Cost Concept
B. Analytical Cost Concepts
1. Fixed cost and Variable costs

2. Total , Average and Marginal cots

3. Short-Run costs and Long-Run costs

4. Incremental cost and Sunk costs

5. Historical cost and Social costs

6. Private cost and Social costs

 Cost Function
 Opportunity cost & Actual Cost:-

 Opportunity cost may be defined as the expected

returns from the second best use of resources which are
forgone due to the scarcity of resources.

 It is also called as Alternative cost, Implicit or Imputed

costs.

 Actual cost are those which are actually incurred by the firm
in payment for labour, material, plant building etc.

 This cost reflect in the book of a/c of firm.

 Also called as Explicit Cost.

 Cost Function
 Marginal Cost & Incremental Cost:-

 Marginal cost is increase in the total cost due to

increasing production by one unit.
 Incremental cost can be defined as the arise in
cost due to a business decision to expand the business
unit. For ex. Cost arise due to adding new plant.
 Incremental cost includes both fixed cost &
variable cost.
 Cost Function
 Sunk Cost & Replacement cost:-

 The sunk costs are those which cannot be

altered , increase or decreased by varying
the rate of output.

 Replacement cost refers to the outlay which has to

made for replacing an old asset.
 Cost Function
 Private Cost & Social Costs:-
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.
Social costs on the other hand refer to the total cost
borne by the society due to production of a commodity.
 Cost Function

 Some basic costs & Cost concept.

 Fixed cost:-
Fixed costs those which are fixed in volume for
a certain given output. Fixed cost does not vary with
variation in the output between zero & certain level of
output.

Variable Cost
Variable costs are those which vary with the variation
in the total output.
 Economies Of Scale
Economies of scale are benefits and advantages
of a firm as it expands its production.
• Reduce the average cost.

INTERNAL
Internal economies happen inside an organization

Labour Economies
Economies of Government Action
Managerial Economies

Marketing Economies Economies of Concentration

Technical Economies
Economies of Information
Financial Economies

Risk Bearing Economies Economies of Marketing

Transport and Storage

Economies
 Economies Of Scale

Diseconomies of scale are problems and disadvantages

faced by a firm when it expands production.
• Increase the average cost.

INTERNAL
Raise the cost of production of a firm as
the firm expands

Labour Diseconomies Scarcity of Raw Material

Wage Differential
Management Problem

Concentration Problem
Technical Difficulties