Cost Theory and Cost Function

Microeconomics
Cost Theory
and
Cost Functions
Team-6
CONTENT
01 C OST C ONC E PTS
02 DIFFE R E NT TYPE S OF C OST CONCEPT
03 C OST FUNC TIONS

THEORY OF COST
What is cost?
Cost is the expenditure required to create and sell
products and services, or to acquire asset.
Determinants of cost
• Price of Inputs: There is a direct relationship between price
of inputs and cost. As the price of inputs rises, cost rises and
vice versa.
2.Level of Output: There is a direct relationship between
output level and cost. More the level of output, more
is the cost.
3.State of technology: More modern and upgraded the

technology implies lesser cost and vice versa.
4.Management and administrative efficiency: Efficiency

and cost are inversely related. More the efficiency in
management and administration better will be the product
and less will be the cost.
DIFFERENT TYPES OF COST
CONCEPT
COST CONCEPT
The concept of cost is central to business decision making.
To make effective business decisions, the business
manager needs to be aware of a number of cost concepts
and their respective uses.
Actual cost
Actual cost means the actual expenditure incurred on
producing goods and services.
Example:Value of raw material, wages, rent, salaries paid and

interest of borrowed capital etc.
Real cost
The real cost is a cost as measured by the physical labor and
materials consumed in production.
Explicit cost
An explicit cost is a cost that is directly incurred by the firm,

company or organization during the production. The explicit cost
is kept on record by the accountant of the firm. Salaries, wages,
rent, raw material are few example of the explicit cost. The
explicit cost is also known as out- pocket cost.
Implicit cost
The implicit cost is directly opposite to it, as it is the cost that is

not directly incurred by the firm or company. In implicit cost
outflow of cash doesn’t take place. It is not in the record and is
heard to be traced back. The interest on owner’s capital or the
salary of the owner are the prominent example of the implicit
cost. The implicit cost is also known as imputed cost.
Economic Cost
The economic cost is the total expenditure a firm faces when

using economic resources to produce goods and
services.Economic cost involves all the expenses a firm
faces, those it can manage, and those beyond the company's
control.
Opportunity Cost
The opportunity cost is measured in terms of the forgone benefits
from the next best alternative use of a given resource. For
example the inputs which are used to manufacture a car may also
be used in the productions of military equipment. Main points of
opportunity cost are:
A. The opportunity cost of any commodity is only the next

best alternative forgone.
B. The next best alternative commodity that could be

produced with the same value of the factors, which are
more or less the same.
C. It helps in determining relative prices of factor inputs at
different places
D. It helps in determining the remuneration to services
E. It helps the manager to decide what he should produce

in the factory.
Fixed Cost
Fixed cost are the amount spent by the firm on fixed inputs in
the short run. Fixed cost are thus, those costs which remain
constant, irrespective of the level of output. These costs
remain unchanged even if the output of the firmis nil. Fixed
costs therefore, are known as Supplementary costs or
Overhead costs. Y
Cost
X
0 Unit
Variable Costs
: Variable costs are those cost that change directly as the
volume of output changes. As the production increases
variable cost also increases, and as the product decreases
variable costs also decreases, and when the production stops
variable cost is zero.
Y VC (Variable cost)
Cost
0 X
Unit
Total cost
Total cost is the total expenditure incurred in the production
of goods and services.
Total cost (TC) = TFC + TVC
Quantity =
Q
Q TFC TVC TC
0 10 0 10
2 10 6 16
4 10 10 20
6 10 16 26
Average Cost
Average cost is not actual cost, It is obtained by dividing

the total cost by the total output.
AC= Total Cost/Units Produced
• Average fixed cost

• Average variable cost
Average fixed cost (AFC)= AFC/Units Produced
The average fixed cost (AFC) curve looks like a
Rectangular Hyperbola.AFC curve slope downwards
Average variable cost (AVC)= AVC/Units Produced
The AVC curve is a U-shaped curve because of the
application of the Law of Variable Returns to Factor. As the
quantity produced of a commodity increases, the average
variable costs diminish, reach a minimum and then start to
rise.
8.Marginal Cost:
marginal cost is the change in total production cost that comes
from making or producing one additional unit.The purpose of
analyzing marginal cost is to determine at what point an
organization can achieve economies of scale to optimize
production and overall operations.If the price comes out is more
than the per unit cost price than it wll be a loss to produce more
quantity.If the price is less than it will be profitable.
Change in Total Expenses
Marginal Cost =
Change in Quantity of Units
Produced
COST FUNCTIONS
The cost output relationship plays an important role in

determining the optimum level of production.The cost
function can be classified as:
• Short run
• Long run
SHORT RUN
COST
The short run is a concept that states that, within a certain
period in the future, at least one input is fixed while others are
variable. In economics, it expresses the idea that an economy
behaves differently depending on the length of time it has to
react to certain stimuli.
• In short run one input is fixed

2. In short run cost curves are
operating curve
Short-Run
Average Cost
The average cost is determined by dividing the total cost by
the number of units produced by a firm. The short-run average
cost (SRAC) of a firm refers to the per-unit cost of output. To
compute SRAC, the short-run total cost is divided by the
output
TFC/Q =Average Fixed Cost (AFC)
SRAC = SRTC/Q
TVC/Q =Average Variable Cost (AVC)
= TFC + TVC/Q
Therefore, SRAC = AFC + AVC
A firm’s SRAC is U-shaped. It begins to drop, reaches a
minimum, and then begins to rise.
SHORT RUN
MARGINAL COST
A firm’s SRAC is U-shaped. It begins to drop, reaches a
minimum, and then begins to rise.
QUANTITY FC TVC TC AC MC
10 5 8 13 1.3 0
11 5 15 20 1.8 7
12 5 5 10 0.8 10
13 5 2 7 0.5 13
LONG RUN
COST
Long run costs are accumulated when firms change
production levels over time in response to expected economic
profits. In the long run there are no fixed factors of production.
The land, labor, capital goods, and entrepreneurship all vary to
reach the the long run cost of producing a good or service.
• All inputs are variable
2.Cost curves are planning curves

LONG RUN
COST
Long run costs are accumulated when firms change
production levels over time in response to expected economic
profits. In the long run there are no fixed factors of production.
The land, labor, capital goods, and entrepreneurship all vary to
reach the the long run cost of producing a good or service.
• All inputs are variable
2.Cost curves are planning curves

Long Run
Marginal Cost
Long run marginal cost is defined at the additional cost of

producing an extra unit of the output in the long-run i.e. when
all inputs are variable. The LMC curve is derived by the points
of tangency between LAC and SAC.
Why is the LAC also called the envelope curve?
The LAC curve suggests the long run optimization problem of the firm.
The firm can choose a plant size to operate at in the long-run where all
inputs are variable. Thus, the firm shall choose that plant at which it can
minimize costs.
So, the LAC is derived by joining the minimum most points of all
possible SAC curves of the firm at different output levels. Since the LAC
thus obtained almost ‘envelopes’ the SAC curves faced by the firm, it is
called the envelope curve.
Long Run Average Cost Curves
Long-run average cost curves (LAC) show how much it costs a firm
to produce a given output level as the number of units of input
increases. The LAC curve is U-shaped, which means that as the
number of units of input increases, the average cost falls and then
rises. The fall in average cost is due to economies of scale, while the
rise is due to diminishing returns. Diminishing returns occur when
the marginal product of an input starts to fall as the level of that input
increases.
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Microeconomics

02 DIFFE R E NT TYPE S OF C OST CONCEPT

03 C OST FUNC TIONS

3.State of technology: More modern and upgraded the

4.Management and administrative efficiency: Efficiency

Example:Value of raw material, wages, rent, salaries paid and

An explicit cost is a cost that is directly incurred by the firm,

The implicit cost is directly opposite to it, as it is the cost that is

The economic cost is the total expenditure a firm faces when

A. The opportunity cost of any commodity is only the next

B. The next best alternative commodity that could be

D. It helps in determining the remuneration to services

E. It helps the manager to decide what he should produce

Average cost is not actual cost, It is obtained by dividing

AC= Total Cost/Units Produced

• Average fixed cost

The cost output relationship plays an important role in

• In short run one input is fixed

• All inputs are variable

2.Cost curves are planning curves

• All inputs are variable

2.Cost curves are planning curves

Long run marginal cost is defined at the additional cost of

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