Cost Concepts

detailed explanation of cost concepts in micro economics....

1. Cost ConceptsCost Concepts

2. Cost Concept:Cost Concept:
 It is used for analyzing the cost of a It is used for analyzing the cost of a
project in short and long run. project in short and long run.

3. 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)

4. Fixed Costs(FC)Fixed Costs(FC)
Fixed Cost denotes the costs which do not Fixed Cost denotes the costs which do not
vary with the level of production. FC is vary with the level of production. FC is
independent of output.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

5. Variable Costs(VC)Variable Costs(VC)
Variable Costs is the rest of total cost, the part that Variable Costs is the rest of total cost, the part that
varies as you produce more or less. It depends varies as you produce more or less. It depends
on Output.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 variable All costs associated with the variable
input.input.
Average variable costAverage variable cost- cost per unit of output:- cost per unit of output:
AVC = TVC/ OutputAVC = TVC/ Output

6. 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 = TFC + TC = TFC +
TVCTVC
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

7. Marginal CostsMarginal Costs
The additional cost incurred from The additional cost incurred from
producing an additional unit of output:producing an additional unit of output:
MC = MC = DD TC TC
DD OutputOutput
MC = MC = DD TVC TVC
DD OutputOutput

8. 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

9. Typical Average & Marginal Cost Typical Average & Marginal Cost
CurvesCurves

10. AFC is always AFC is always
declining at a declining at a
decreasing rate.decreasing rate.
ATC and AVC decline ATC and AVC decline
at first, reach a at first, reach a
minimum, then minimum, then
increase at higher increase at higher
levels of output.levels of output.
The difference The difference
between ATC and AVC between ATC and AVC
is equal to AFC.is equal to AFC.
MC is generally MC is generally
increasing.increasing.
MC crosses ATC and MC crosses ATC and
AVC at their minimum AVC at their minimum
point.point.
If MC is below the average If MC is below the average
value:value:
Average value will be Average value will be
decreasing.decreasing.
If MC is above the average If MC is above the average
value:value:
Average value will be Average value will be
increasing.increasing.

11. Production Rules for the Short-RunProduction Rules for the Short-Run
1.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.

12. Contd…Contd…
3.If expected selling price > minimum ATC (which 3.If expected selling price > minimum ATC (which
implies TR > TC):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

13. Short Run Production DecisionsShort Run Production Decisions
SPSPSP

14. :
LongRunCostsCurve
:
LongRunCostsCurve
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 all factors in LR, since all factors
are variable. 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.

15. 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 costs.Sell the fixed assets to eliminate fixed costs.
Reinvest money is a more profitable Reinvest money is a more profitable
alternative.alternative.

16. Long Run Cost CurveLong Run Cost Curve
M-optimum level of productionM-optimum level of production
MM
Economies of scale Diseconomies of scale

17. Economies of Scale:Economies of Scale:
Economies of scaleEconomies of scale are the cost are the cost
advantages that a firm obtains due to advantages that a firm obtains due to
expansion. expansion. DiseconomiesDiseconomies is the opposite. is the opposite.
Two types:Two types:
1. Pecuniary Economies of Scale:1. Pecuniary Economies of Scale:
Paying low prices because of buying Paying low prices because of buying
in large Quantity.in large Quantity.

18. 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 quantities of input , per unit of output
when the size of the firm increases, as a when the size of the firm increases, as a
result input cost minimized.result input cost minimized.

19. Diseconomies:Diseconomies:
1.Internal Economies: It is a condition 1.Internal Economies: It is a condition
which brings about a decrease in LRAC of which brings about a decrease in LRAC of
the firm because of changes happening the firm because of changes happening
within the firm.within the firm.
e.g.As a company's scope increases, it may e.g.As a company's scope increases, it may
have to distribute its goods and services in have to distribute its goods and services in
progressively more dispersed areas. This progressively more dispersed areas. This
can actually increase average costs can actually increase average costs
resulting in diseconomies of scale. resulting in diseconomies of scale.

20. 2.External Economies:2.External Economies:
It is a condition which brings about a It is a condition which brings about a
decrease in LRAC of the firm because of decrease in LRAC of the firm because of
changes happening outside the firm.changes happening outside the firm.
E.g. Taxation policies of Gov…E.g. Taxation policies of Gov…