Short run cost:

Short run is a period of time in which the firm can change its
output by varying only the amount of variable factors, such as
labour, raw materials, fuel etc. In the short run, fixed factors,
such as capital technology, management, etc. cannot be
changed to change the level of output. The short run costs are
incurred purchases of labour, raw materials, fuel, etc. which
vary with the change in the level of output. In the short run, if
the firm wants to increase output, it can do so only by over
working in the existing plant by hiring workers and by buying
more raw materials. It cannot increase its output in short run
by enlarging the size of the existing plant.
Long run cost:
Long run is a period of time in which all factors of production
are variable. Thus, in the long run, output can be increased by
increasing capital equipment or by increasing the size of
existing plant or by building a new plant.
Cost function:
Cost function shows that relationship between cost of
production and the level of production. Cost of production is
influenced by various variables like level of output, price of
inputs, technology, etc. The cost function can be expressed as
C= f (Q, Pf, T ...) --------- (i)
Where, C = Cost of production
T = Technology
 Pf = Price of inputs or factors of production
Q = Quantity of output
Although, cost of production is influenced by various factors,
for simplicity, we assume that cost of production is the function
of level of output. It is expressed as: C = f (Q)
Derivation of Short run Cost Curves
1. Total Fixed Cost (TFC): Total fixed cost is defined as the
total expenses incurred by fixed factors production. Fixed
factors are those factors, which cannot be changed in
short run. The fixed cost remains unchanged, whatever be
the level of output. Even there is no output at a time; this
cost will have to be incurred. Fixed cost included rent of
factory, salaries payment of permanent employees,
interest on capital, insurance premium, license fee, etc.
Average fixed cost (AFC): AFC is defined as the total fixed
cost divided by the quantity of output. i.e.
AFC = TFC/Q

Fixed cost is explained with the help of following figure.

In Figure X-axis represents quantity of output and Y-axis
represents cost. TFC is the total fixed cost curve. It is parallel to
the X-axis. It means that TFC remains constant whatever be the
level of output. TFC starts somewhere above the origin,
because the firm has to bear fixed cost when output is zero.
AFC is derived from TFC curve. It is downward sloping because
as output increases it goes on decreasing and takes rectangular
hyperbola shape.
2. Total Variable Cost (TVC): Total variable cost is defined as
the total expenses incurred by variable factors of
production. Variable factors are the factors, which change
with output. Thus, variable cost is that cost which changes
with the change in output. Variable cost includes the cost
of raw materials, wages of labour, cost of fuel etc. If the
output increases, the total variable cost will increase. If
the output decreases, the total variable cost will decrease.
If the output is zero, the variable cost will also be zero.
TVC is upward slopping inverse S shaped, because it
follows the law of variable proportion.
Average variable cost: AVC is defined as the total variable
cost divided by the quantity of output. i.e. AVC = TVC/Q.
the curve of AVC represents the slope of the line drawn
from the origin to the TVC. It can be shown by the
following figure:
In fig. As output increases TVC rises at decreasing rate, but
after a certain level of output it increases at an increasing rate.
AVC at each level of output is derived from the slope of the line
drawn from the origin to the point on the TVC. The slope of ray
line through the origin declines continuously until the ray
becomes tangent to the TVC at point c, the right of c the slope
of ray increasing. Thus AVC falls initially as productivity of
variable factor increases and reaches minimum, when optimal
point is reached and then rises. AVC takes the U shaped curve.
3. Total Cost: Total cost refers to all monetary expenditures
incurred in the production of a commodity. It is the sum of total
fixed cost and total variable cost. i.e. TC= TFC + TVC
When output is zero total cost will be equal to total fixed cost.
TC also follows the shape of TVC i.e. it also follows the law of
variable proportion. However it starts at the point where the
TFC starts and maintains the vertical distance with the TVC.
Average cost: AC is defined as the total cost divided by the
quantity of output. It is also obtained by summing up AFC and
AVC. i.e.
AC = TC/Q = TFC + TVC/Q
=TFC/Q + TVC/Q
= AFC+ AVC.
The slope of the line drawn from the origin on the total cost
curve gives the SATC (AC).it can be shown by the following
figure.

In fig. the different slope of the line made from origin to the TC
curve. These slope lines help to derive the SAC curve. Initially
AC falls reaches the minimum at the level of optimal operation
of plant and rises again. The U shaped of both AVC and AC
reflects the law of variable proportion.
Marginal Cost (MC): MC is defined as the change in total cost
caused by a unit change in output. MC is the addition to the
total cost when one more unit is produced. Graphically the MC
curve is the slope of the TC. Slope of a curve is given by a
tangent at that point of the curve. The slope of TC declines until
it reaches a tangent that is parallel to the x axis and then it
starts to rise. It is shown by the following figure.
In fig. the tangent of TC curve is parallel to x axis at point B, in
lower figure this is the place where MC is minimum. Thus MC
also takes U shaped.
The traditional cost theory says that short run costs are U
shaped reflecting the law of variable proportions. Initially there
is a phase of decreasing cost (increasing productivity), then
there is a point where cost is minimum i.e. plant is optimally
utilized, we have gained the optimal combination between the
fixed and variable factors of production. Short run costs curves
are shown by the following figure.

Relationship between AC and AVC

  Since AC = AFC + AVC, AC falls so long as AFC and AVC fall
 When AFC falls but AVC increases the change in AC
depends on the rate of change in AFC and AVC on the
following pattern
 If decrease in AFC > increase in AVC, AC falls.
 If decrease in AFC = increase in AVC, AC remains constant.
 If decrease in AFC < increase in AVC, AC rises.
Relationship between AC and MC

MC = ∂TC/ ∂Q
MC = ∂ (AC.Q)/∂Q
MC = Q. ∂ (AC)/∂Q + AC. ∂Q/∂Q
MC = Q .∂AC/∂Q + AC
MC = Q. slope of AC + AC
MC = AC + Q (slope of AC)
There may be three possibilities:
1. When AC is falling, the slope of AC is negative
MC = AC + Q (-ve)
= AC – Q (any value). Thus when AC is falling, MC is
lower than AC. i.e. if slope of AC < 0  MC < AC.
2. If AC is rising, the slope of AC is positive
MC = AC + Q (+ve)
 MC = AC + Q (any value). Thus when AC is rising MC is
greater than AC. i.e if slope of AC > 0 MC > AC.
3. If AC reaches its minimum point, the slope of AC is zero.
MC = AC + Q (zero)
MC = AC. Thus when AC reaches its minimum, MC is equal
to AC. i.e if slope of AC = 0 MC = AC.
Why MC is independent to fixed cost?
MC = TCn-TCn-1---------- (1)
= (TFC + TVCn) – (TFC + TVCn-1)
= TFC + TVCn -TFC - TVCn-1
= TVCn -TVCn-1. Therefore MC is the rate of change in
total variable cost.
Derivation of Cost curve from production function
There is exactly inverse relationship between AP and AC. When the law
of increasing returns operates in the production, AP increases and
becomes maximum, but the AC falls and reaches its minimum. But
when the law of diminishing returns operates in production, AP
decreases and AC rises. Therefore the shape of AC curve follows the law
of variable proportion. This is shown above figure. Similarly a
mathematical expression showing the relationship between volume of
output and its total cost function is called cost function.
 Linear cost function: TC = a + b Q --------(1)
Where, TC = total cost
a = intercept
b = slope
Q = quantity of output
b Q = total variable cost
AC = TC/ Q = a + b Q/Q = a/Q + b Q/Q = a/Q + b
MC = ∂TC/∂Q = ∂ (a + b Q)/∂Q = b
b = MC remains constant in the case of linear cost function.

 Quadratic cost function: TC = a + bQ + cQ2-------(II)

 Where, a, b, c = constant
a = total fixed cost
b Q + cQ2 = total variable cost
AC = TC/Q = a+ b Q + cQ2/Q = a/Q + b + c Q
MC = ∂TC/∂Q = ∂ (a + b Q + cQ2)/∂Q
= b + 2cQ
AFC = TFC/Q = a/Q
AVC = TVC/Q = b Q + cQ2/Q = b + c Q

 Cubic cost function: TC = a + b Q – cQ2 + Q3

Where, a, b, c = parametric constant
a = total fixed cost
b Q – cQ2 + Q3 = total variable cost
AC = TC/Q = a + b Q – cQ2 + Q3/Q = a/Q + b – c Q+ Q2
MC =∂TC/∂Q = ∂ (a + b Q – cQ2 + Q3)/∂Q
= b – 2cQ + 3Q2
AFC = TFC/Q = a/Q
AVC = TVC/Q = b Q – cQ2 + Q3/Q = b- c Q+ Q2
Long run cost Curves: In the long run all factors are variable. i.e.
the firm can change all inputs accordingly. Thus, long run cost
curves are essentially planning curves. They help the producer for
deciding on the optimal level of output to be produced and
expansion of output. Long run cost curves are derived from the
short run cost curves.
To see how the cost curves help in output decisions, we take
a look at the short run cost curves. Suppose the firm has
choice of three Plant sizes.
SAC1 - Showing the small Plant size
SAC2 - showing the medium Plant size
SAC3 - showing the large Plant size
The firm’s decision of expansion of plant size depends on
the cost curves. However the ultimate decision is on the
demand that the firm faces in the market.
 In fig. the optimal quantity of small Plant is oq. Now
supposing demand increases oq1, the firm has two options
either to remain the small plant size or to expand the medium
plant size. The ultimate decision of the Plant size is made on
the basis of anticipated market demand. If the firm
anticipates an increase in its market demand, then it would be
better for the firm to expand the medium plant size. Similarly
the optimum output level yielding minimum cost for the firm
is given by q2 in the medium size plant. If demand increases
to q2, than the firm makes its decision whether or not to
expand to the large plant size based on the market demand.
Due to economies of scale when the plant size of the firm is
increased, its cost of production declines.
Long run Average Cost (LAC): LAC is derived from short
run cost curves. It is derived by joining all the points that are
tangent to the short run cost curves. The enveloping nature of
LAC can be shown by the following figure.
This fig shows five short run cost curves. The curve joining all the
points of tangency of the SAC curves is long run cost curve.
The various SAC are U Shaped as they reflect the law of
variable Proportions. The LAC is U shaped as it reflects the returns
to scale. In the long run at the initial stage the firm faces
increasing return to scale. Due to this the cost is also decreasing.
Thus the SAC curves are also tangent in their falling part.
Similarly at the rising part, the firm faces decreasing returns to
scale. Thus the cost is increasing at this part it is due to that all
SAC curves are also tangent in their rising part to the LAC
curve.
The optimal production level occurs at point N. Here LAC is
also reaches its minimum and is tangent to SAC3’s minimum
point. Output less than OQ implies that there is still more
capacity to be utilized and output more than OQ implies over
utilization of production capacity. Thus at output OQ the
firm’s production capacity is optimally utilized.

The LAC curve shows optimality i.e. each point at the LAC
curve represents the least cost for producing the
corresponding level of output. Any point above LAC
represents higher cost and point below LAC is desirable but
unattainable given the state of technology.
Derivation of the Long run Marginal Cost curve (LMC)
Long rum marginal cost curve is also derived from the short
run marginal cost curves but it doesn't envelope the SMC’s.
The LMC is derived from the points where the SMC’s
intersect with the vertical lines drawn from the point of
tangency of the SAC with the LAC. At the point where the
SAC's minimum point is tangent with the LAC, The SMC
and LMC curves intersect each other. It is shown by the
following figure.
The fig shows the LMC is derived with the help of SMC
curves. At Point A the LMC and SMC2 intersect each other.
The optimal plant size is that where the LAC curve at its
minimum. Like in the short run the LMC curve cuts the LAC
curve at its minimum point. To the left of the point A, LMC
is less than SMC and to the right of Point A, LMC > SMC.
This implies that at point A, LMC = SMC = LAC = SAC.
Modern Theory of Cost:
Traditional economists argued that AC and MC are always U
shaped. But in the 20th century there were growing dissatisfaction
among the economists regarding the shape of the cost. So the
modern economists (Stigler 1939) proposed that AVC has saucer or
flat stretch shape and LAC and LMC have L shaped. Many
economists have rejected U shaped cost curves on the basis
of theoretical and empirical evidence. They point out that U
shaped cost curve implies rigidity of a firm’s Production
Capacity. But in reality firm wants to become flexible to
adopt the changing market demand. This brings in the
concept of reserve capacity. Modem economists argue that
all firms have reserve capacity which makes flexible to adopt
the changing market demand. Like traditional economists
modern economists also divide the cost into short run and
long run.
The short run total cost is divided into fixed and variable
cost. i. e. ATC= AFC + AVC
Average fixed cost: AFC includes the following elements
  Salaries and expenses of administrative staffs.
 Depreciation expenses
 The expenses for maintenance of building and land.

Fixed factors determine the size of firm. The choice of

The firm's Plant size depends as degree of flexibility. The
producer will choose that size of plants which is slightly
larger than the size required to produce expected demand.
This is because to take advantage of cyclical and seasonal
fluctuation in demand. It is shown by the following fig.

In fig. ox2 level of output shows excess reserve capacity. Line k shows
last limit of firm. If firm uses small plant, the last limit is p line. Thus
here reserve capacity is x1x2. The firm can use this reserve capacity by
paying direct labour over time. Which increases AFC is shown by dotted
line ab.

Average variable cost: according to modern theory of cost AVC

includes direct labour cost, expenditure on raw materials and running
expenses on machinery. Under modern theory AVC is saucer shaped.

In fig. SAVC is short run average cost curve, which is saucer shaped. In
the beginning as output increases SAVC falls up to point A, and then it
remains constant up to point B, after B point it starts to increase. This
flat portion AB(x1x2) shows the reserve capacity of the firm.
SMC is short run marginal cost curve, which is overlapped at flat
portion with SAVC. To the left of flat portion MC lies below AVC and to
the right MC lies above AVC.

Average Cost Curve (SATC): in modern cost theory ATC does not have a
flat. This is because even though the AVC = MC for a flat, the AFC is
continuously falling. Thus ATC is a smooth curve. Diagrammatically,

In fig. ATC is continuously falling until the reserve capacity is fully

utilized at X2. After this as the AVC rises, ATC also rises. The MC
intersects the AC’s minimum point which lies to the right of AVC’s
minimum point. The falling portion of AVC shows better utilization of
production capacity while rising portion shows increased cost of hiring
labour and over utilization of machines resulting in frequent break
down.

Long run cost curve:

Under the modern theory of cost. The long run average cost
includes two elements.
(i) Production costs: cost associated to the technical
Production Process. Products cost falls due to technical
efficiencies achieved from economies of scale. Initially
production cost falls at an increasing rate and with an
optimal Production, the production costs fall gradually.
(ii) Managerial cost: Cost associated to management of large
Plant sizes are managerial cost. Managerial cost may arise
due to the complexities associated to managing large scale
firm. As output expands, managerial cost falls up to a certain
optimal point and then gradually rises.
The L shaped LAC and empirical evidence: The LAC is L
Shaped rather than U shaped under the modern theory,
because fall in the production cost is more than the rise in
managerial cost. The LAC curve can also be derived from
the SAC curves. But as the traditional theory LAC is not the
tangency points of SAC curves. Actually LAC intersects the
SAC at their typical load factor points.
In fig.LAC does not envelope the SAC curves.

Under modern theory the LMC always lies below the LAC. Before
optimal scale of production LMC below LAC when optimal scale is
reached it remains constant.
In fig. OQ is optimal scale of output, after this LAC = LMC.