Description Case 1 Case 2 Case 3

Total Revenue (TR) 1000 1100 900

Explicit Costs (accounting Costs) (750) (750) (750)
Accounting Profit 250 350 150
Implicit Costs (Say normal Return on Capital employed (250) (250) (250)
by the Entrepreneur & salary foregone)
Economic Profit 0 100 (100)
Note ; Economic profit will be always less than Normal Profit Super normal Subnormal
Accounting Profit Or Zero profit, Profit
Economic Profit Abnormal
/ Min.ROI profit
❖A product; ❖Service
❖Process ❖Sales territory
❖Machine ❖Customer class
❖Dept.
❖Plant
 1. Explicit Cost 1. Implicit Cost
2. Accounting Cost 2. Economic Cost
3. Outlay Cost 3. Opportunity Cost
4.Historical Cost 4.Replacement Cost
5. Incremental cost 5. Sunk Cost
6. Private Cost 6. Social Cost
7.Direct Cost 7.Indirect Cost
8. Fixed Cost 8. Variable cost
 Mathematical Cost per Output
Price of Input Factor;
relationship (Total Cost  Dependent
Independent Size of output,
Technology, Level of Total Output
capacity utilisation Units)
 SHORT-RUN
❖ Short-run does not relate to any particular❖ Short-run production function shows the
point of time - like weeks, months, year etc. It max output qty that can be produced by a set
is based on variability of fixed factors and of inputs, assuming that the Amount of at
variable factors. least one input used remains unchanged
❖ During short-run, time is “too short” that no during the period.
new fixed factor say capital equipment can❖ Since the capital is kept constant and other
be installed to increase production factors varied , this gives variable proportions
❖ In other words, capital being a fixed factor, is of input (K is fixed & L is varied)
kept constant in Short-run ❖ Hence the name law of Variable Proportions /
❖ Thus in short-run, amount of capital (fixed Law of Returns to variable inputs
factor) is kept constant while amount of
other factors are varied (labour, raw material
etc.)
 FIXED COST
❖ TFC remains constant throughout the period
❖ TFC has no bearing with the output – whether O/P or or zero, TFC remains
constant; even if the firm is temp. shut down , still there will be f.cost

Output Units F.Cost Total Fixed Cost Curve

2,000

0 1,000 1,800
1,600

Total Fixed Cost

1 1,000 1,400
1,200
TFC
2 1,000 1,000
800
600
3 1,000 400
200

4 1,000 0
0 1 2 3 4 5 6

5 1,000 Output

❖ TFC Line will be horizontal to X-axis

❖ It will never start from zero, because even if the production is zero, TFC will be
constant
 Variable cost
• V.C change with change in O/P, eg. Wages, RM price, power etc.
• If firm is temp. shut down – no V.Cost
• So at zero O/P, V.Cost curve starts from Zero

Output Units V.Cost Completely Variable Cost

0 0
VC
1 10 Total
Variable
2 20 Cost

3 30

Output qty

The above line was drawn under the assumption that variable cost vary
linearly with change in output. This is purely theoretical - but we shall learn
going forward that VC curve is not linear in actual situations.
 Semi Variable Cost (SVC)
• S.V.C are neither absolutely fixed nor perfectly variable.
• Up to certain levels SVC behaves like F.Cost. After that behaves like V.Cost
• Therefore SVC consist of both Fixed cost and variable cost; E.G Auto fare

Output F.Cost V.Cost Total Semi Variable Cost

Units portion portion Cost
of SVC of SVC TC
Total SV
0 100 0 100 Cost
Variable Cost of Production
1 100 10 110 FC
2 100 20 120
3 100 30 130
Output
 Stair-step Variable Cost

Output Units V. Cost Stair Step Variable Cost

0 -30 2000
4 vC
31-60 4000 Total SV
Cost 3
61-90 6000 2
91-120 8000 1

Output
Eg. (i) Passenger Van – One van can accommodate say max 30 pax. (ii) Salary
of foremen. When production crosses a particular limit, additional foreman is
appointed.
 Total Cost

Output F.Cost V.Cost Total Total Cost

Units Cost
0 1000 0 1000 TC
Total
Cost VC
1 1000 10 1010
2 1000 20 1020
1000 FC
3 1000 30 1030

Output qty

Here it is assumed that V.Cost curve is linier. I.e V.cost increases in proportion
to or proportionately with out put. This is a theoretical assumption.
 TFC,TVC,TC CURVES
• TFC Curve – Total Fixed Cost Curve 100

• Never Starts at Zero

Output TFC TVC TC 90
TC
• Remains Constant throughout 0 20 0 20 80

• Parallel to X axis 1 20 13 33 70
TVC
• TVC Curve- Total Variable cost Curve 60
2 20 16 36
• Starts at Zero 50

• Upward slopping curve 3 20 18 38

Cost
40

• Initially Convex outwards – Stage of 4 20 20 40 30

increasing returns TFC

5 20 26 46 20

• Then convex inwardly – Stage of 10

Diminishing Returns 6 20 40 60
0
• Then steeply climbs upwards – Stage of 7 20 70 90 0 1 2 3 4 5 6 7 8

TFC TVC TC
negative returns
Qty
• TC Curve – Total Cost Curve
• TC = TFC + TVC
• Starts from TFC point, never starts at zero
• Will go parallel to TVC curve at all levels of o/p
• “The vertical” (not the distance) between these two curves will be equal and is equal to Fixed Cost
 Fixed Qty of TP AP MP Remarks
Factor (K) Labr. (L)
1 1 100 100.0 100
1 2 210 105.0 110 AP MP > AP
1 3 330 110.0 120
1 4 440 110.0 110 AP = Max; MP = AP
1 5 520 104.0 80
1 6 600 100.0 80
1 7 670 95.7 70 AP MP < AP
1 8 720 90.0 50
1 9 750 83.3 30
1 10 750 75.0 0
1 11 740 67.3 -10

TP = Total Product = Total output Qty

AP = Average Product = TP/No. of units of V.Factor
MP = Marginal Product = Change in product per unit change in the qty of V.Factor; MPn = TPn – TP (n-1)
 30
0
-10

Average Fixed Cost (AFC) = TFC/Q = Fixed cost per Unit output
 • Average Fixed Cost (AFC) = Fixed cost per Unit of
output ; AFC = TFC/Q
• Since TFC is constant while Q is increasing, AFC
will steadily fall as output increases.
• Therefore AFC cure will slope downwards throughout
its length
• But will not touch the x axis as AFC cannot be Zero.

Cost
30
0
-10 AFC

O/P Qty
 • Average Variable Cost (AVC) = T.VC/Q = V.cost per
Unit of output
• From Zero to normal capacity AVC falls (Stage of
increasing Returns)
• Beyond the normal capacity AVC will rise steeply
(Stage of diminishing Returns)
• Therefore AVC curve will first fall, then reach a
minimum and then steeply rise
AVC

30
0
-10

O/P Qty
 Point of inflexion TP
M
TP
AP Stage I Stage II Stage III
MP

AP = max

INPUT QTY - L
 • Average Total Cost (ATC) = AFC +AVC
• Or = TC / Q
• Behaviour of ATC curve is a result of the behaviour
of AFC Curve and AVC curve.
• In the beginning both AVC and AFC curves will fall
hence ATC will fall sharply
• When AVC curve begins to rise , AFC continues to
fall steeply, ATC continues to fall.
• Thereafter AVC sharply rises, hence ATC will also
rise.
• Therefore ATC curve is ‘’U‘’ shaped
ATC
AVC
30
0
-10

AFC

O/P Qty
 Marginal Cost (MC)= Addition to total cost due to
production of an additional unit
MC = ∆TC/∆Q; ∆TC = Change in Total Cost, ∆Q =
change in output
Or MC(n) = TC(n) – TC (n-1)
MC Curve falls as output increases in the
beginning.
It starts rising after a level of output (Law of
variable proportions)
When ATC is decreasing MC is below ATC; When
ATC is increasing MC is above ATC
Inflection The MC curve becomes minimum corresponding to
Point 30 point of inflexion on the ATC.
At minimum Average Total Cost , ATC = MC
0
MC curve also is “U” shape
-10
Output corresponding to the point where ATC is
minimum is optimum output (or were MC = ATC)
(Where to enter in Stage II of short run production
cycle is now solved )
 LONG-RUN
❖ Long-run does not relate to any particular points of time like weeks, months, year etc. It is
based on variability of fixed factors and variable factors.
❖ This is the planning horizon and the firm will be able to install new fixed factors viz.
machines, plants, capital equipment, as well increase variable factors of production.
❖ In other words, all input factors are variable in long-run
❖ Thus in Long-run, both the amount of capital (fixed factor) as well amount of other factors
(variable factors) are varied
❖ Long-run production function shows the least possible cost of producing any given level of
output when all individual factors are variable.
❖ Since all factors varied , it is called Returns to Scale – Both K & L are varied in the same
proportion.
❖ Hence the name law of Returns to scale
❖ It should be kept in mind that once the firm has built a particular scale of production, its
production takes place in short-run. The firm actually operates in short run and plans for
long run.
• But, practical evidence shows modern firms
face ‘L-shaped’ cost curve over a considerable
quantity of output.
• The L-shaped long run cost curve implies that
initially when the output is increased due to
increase in the size of plant (and associated
variable factors), per unit cost falls rapidly
due to economies of scale.
• The long-run average cost curve does not
increase even after a sufficiently large scale
of output as it continues to enjoy economies of
scale.
 Economies Dis-economies

Benefits / Advantages Suffer/ Disadvantages

Due to expansion That a firm has grown so
Why ? Large scale of large beyond its optimum
production shall reduce size, that it becomes
costs of production 1 difficult to manage ,
Economies & coordinate and assure
Diseconomies cooperation.

Internal External
 Internal Eco/ D.Eco External Eco /D.Eco

• Within the Firm • From outside the firm

• Due to its own efforts • Due to expansion in the output of
• (Endogenous Factors – due to efficiency of the the whole industry
entrepreneur, or his managerial talents or the type of • Available to each member of the
machinery used or the marketing strategy adopted ) industry
• Are available exclusively to the • Non-dependent on the output level
expanding firm of the individual firm
• Dependent on the output level of the firm

Eg. Coaching center & Pandemic

 Kinds of Internal Eco/ D.Eco Kinds of External Eco /D.Eco

1. Technical E/D 1. RM & Cap Equip

2. Technological
2. Managerial E/D 3. Skilled Labor
3. Commercial E/D 4. Ancillary industries
5. Transportation & marketing
4. Financial E/D facilities
5. Risk bearing E/D 6. Information
(TMCFR) (ARTIST)
 Kinds Economies Dis-economies

Technological 1. Superior technology Equip. & Machines. 1. Max utilization of all factors, nothing
2. Composite Technology 1 more to improve, beyond optimum levels
3. Vertical Integration 2 2. Machines overrun , wear & tire, B. downs
4. Division of Labour & Specialization of 3. Poor control & co-operation
labour

Managerial 1. (reduction of Managerial Cost) 1. Scale of production exceeds optimal limit

2. Departmentalization D.E sets in
3. Specialization & Division of labour of 2. Difficulty in communication and delay
managers in decision implementation
4. Decentralization of decision making 3. Poor control & co-operation
4. Bureaucracy, Red tapism

Commercial 1. Qty discounts – lower price of RM 1. D/E due to exceeding opt. sacle
2. Efficient marketing – better utilization of 2. Eg. Higher cost of advt.
salesmen & low per unit advt.costs
3. Able to sell at lower price – competitive price
advantage
 Kinds Economies Dis-economies

Financial 1. Ability to get cheap and easy loans 1. Higher dependency on borrowed funds
2. Due to goodwill shares can be readily sold 2. Higher cost of capital , low profits

Risk bearing 1. Large firms can better withstand Ups & 1. Large scale diversification may lead to
downs of economy D/E
 Kinds Economies

Cheaper RM & 1. Exploration new & cheaper Growth of 1. Growth of ancillary services for
Cap. Equip resources of RM & Cap. Equip Ancillary Services supply of RM, machinery, tools,
2. Availability of cheaper & spares Repair Services
better RM and Cap.Equip. 2. New units for processing &
3. Consequently reduction in recycling of waste
cost of output

Technological 1. Discovery of new & better Better 1. Development of efficient

technology Transportation & Transportation and Marketing
2. Improved machinery & process marketing facilities
3. Above Enhances each firms’ Facilities 2. Hence outsourcing cuts cost
productivity and reduce cost 3. Speedy communication facilities

Development of 1. Pool of Trained & Skilled

skilled labour labourers are created Information 1. Publication of information
(Bengaluru the IT hub) booklet and bulletins by
2. This has favourable effect to industry associations or by
individual firms Govt. in public interest
 SUMMARY
 Cost analysis refers to the study of behaviour of cost in relation to one or more production
criteria. It is concerned with the financial aspects of production.
• Accounting costs are explicit costs and includes all the payments and charges made
by the entrepreneur to the suppliers of various productive factors.
• Economic costs take into account explicit costs as well as implicit costs. A firm has to
cover its economic cost if it wants to earn normal profits.
• Outlay costs involve actual expenditure of funds.
• Opportunity cost is concerned with the cost of the next best alternative opportunity
which was foregone in order to pursue a certain action.
• Direct costs are those which have direct relationship with a component of operation. They
are readily identified and are traceable to a particular product, operation or plant.
SUMMARY
• Indirect costs are those which cannot be easily and definitely identifiable in
relation to a plant, product, process or department. They not visibly traceable to any
specific goods, services, processes, departments or operations.
• Incremental cost refers to the additional cost incurred by a firm as a result of a
business decision.
• Sunk costs are already incurred once and for all, and cannot be recovered.
• Historical cost refers to the cost incurred in the past on the acquisition of a
productive asset.
• Replacement cost is the money expenditure that has to be incurred for replacing an
old asset.
• Private costs are costs actually incurred or provided for by firms and are either
explicit or implicit.
• Social cost, on the other hand, refers to the total cost borne by the society on
account of a business activity and includes private cost and external cost.
 SUMMARY
• The cost function refers to the mathematical relation between cost and the various determinants of cost. It expresses
the relationship between cost and output.
• Economists are generally interested in two types of cost functions; the short run cost function and the long run cost
function.
• Short-run cost functions are
• Fixed or constant costs which are not a function of output. These are inescapable or uncontrollable.
• Variable costs are a function of output in the production period.
• Short run is a period of time in which output can be increased or decreased by changing only the amount of
variable factors such as, labour, raw material, etc. ,
• Long run is a period of time in which the quantities of all factors may be varied. In other words, all factors become
variable in the long run.
• Semi-variable costs are neither perfectly variable, nor absolutely fixed in relation to the changes in the size of
output.
• Stair-step costs remain fixed over certain range of output; but suddenly jump to a new higher level when output
goes beyond a given limit.
• Total cost of a business is defined as the actual cost that must be incurred for producing a given quantity of
output.
• AFC is obtained by dividing the total fixed cost by the number of units of output produced.
• Average variable cost is found out by dividing the total variable cost by the number of units of output produced.
• Average total cost is the sum of average fixed cost and average variable cost.
• Marginal cost is the addition made to the total cost by the production of an additional unit of output.
 SUMMARY
• Long run cost of production is the least possible cost of producing any given level of output when all individual factors
are variable.
• A long run cost curve depicts the functional relationship between output and the long run cost of production.
• The long run average cost curve, often called a planning curve, is so drawn as to be tangent to each of the short
run average cost curves.
• LAC curve is not tangent to the minimum points of the SAC curves.
• Empirical evidence shows that the state of technology changes in the long-run. Therefore, modern firms face ‘L-
shaped’ cost curve over a considerable quantity of output.
• Economies of scale are of two kinds - external economies of scale and internal economies of scale.
• External economies of scale accrue to a firm due to factors which are external to a firm.
• Internal economies of scale accrue to a firm when it engages in large scale production.
• Increase in scale, beyond the optimum level, results in diseconomies of scale.