Cost Concepts

Cost Concept:

It is used for analyzing the cost of a

project in short and long run.

Types of Cost:

Total fixed costs (TFC)

Average fixed costs (AFC)
Total variable costs (TVC)
Average variable cost (AVC)
Total cost (TC)
Average total cost (ATC)
Marginal cost (MC)

Fixed Costs(FC)
Fixed Cost denotes the costs which do not vary
with the level of production. FC is
independent of output.
Eg: Depreciation, Interest Rate, Rent, Taxes

Total fixed cost (TFC):

All costs associated with the fixed input.

Average fixed cost per unit of output:

AFC = TFC /Output

Variable Costs(VC)
Variable Costs is the rest of total cost, the part that
varies as you produce more or less. It depends on
Output.
Eg: Increase of output with labour.

Total variable cost (TVC):

All costs associated with the variable
input.
Average variable cost- cost per unit of output:
AVC = TVC/ Output

Total costs(TC)
The sum of total fixed costs and total
variable costs:
TC = TFC + TVC
Average Total Cost
Average total cost per unit of output:
ATC =AFC + AVC
ATC = TC/ Output

Marginal Costs

The additional cost incurred from

producing an additional unit of output:
MC = TC
Output
MC = TVC
Output

Typical Total Cost Curves

TVC,TC is always increasing:

First at a decreasing rate.

Then at an increasing rate

Typical Average & Marginal Cost

Curves

AFC is always
declining at a
decreasing rate.
ATC and AVC decline
at first, reach a
minimum, then
increase at higher
levels of output.
The difference
between ATC and AVC
is equal to AFC.

MC is generally
increasing.
MC crosses ATC and
AVC at their minimum
point.
If MC is below the average
value:
Average value will be
decreasing.
If MC is above the average
value:
Average value will be
increasing.

Production Rules for the Short-Run

1.If expected selling price < minimum AVC (which implies TR <
TVC):
A loss cannot be avoided.
Minimize loss by not producing.
The loss will be equal to TFC.
2.If expected selling price < minimum ATC but > minimum AVC:
(which implies TR > TVC but < TC)
A loss cannot be avoided.
Minimize loss by producing where MR = MC.
The loss will be between 0 and TFC.

Contd
3.If expected selling price > minimum ATC (which
implies TR > TC):
A profit can be made.
Maximize profit by producing where:
MR = MC

Short Run Production Decisions

SP

SP

Long Run Costs Curve:

All costs are variable in the long run.

There is only AVC in LR, since all factors
are variable.
It is also called as Planning Curve or
Envelope or scale curve.

Production Rules for the Long-Run

1.If selling price > ATC (or TR > TC):
Continue to produce.
Maximize profit by producing where
MR = MC.
2.If selling price < ATC (or TR < TC):
There will be a continual loss.
Sell the fixed assets to eliminate fixed costs.
Reinvest money is a more profitable
alternative.

Long Run Cost Curve

Economies of scale

Diseconomies of scale

M-optimum level of production

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

2.Real Economies of Scale:

Refers to reduction in physical quantities
of input , per unit of output when the size of the
firm increases, as a result input cost minimized.

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

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