Cost

When a firm produces any commodity, it incurs costs.

Cost Function

Cost function shows the relationship between cost of production and the quantity of output.

C=f(Q)
Where C is the total cost of production
And Q is the level of output

The total cost function is derived from the production function which shows the technology of the
producer.

Two types of total cost functions are:

Long run total cost function
Short run total cost function

In the long run, the producer chooses the least cost factor combination while in the short run some of
the factors are fixed.

Total Cost is the sum of the outlays on all inputs used in production. If K (capital) and L(labour) are two
factors of production and r and w are respective prices of K and L respectively. Hence, the cost equation
is given by

C = rK + wL

Opportunity Cost: It is defined as the cost of the best alternative foregone. However, in the books of
accounts, this cost is not recorded. Suppose, a particular plot yields 3 quintals of rice and 8 quintals of
wheat. Then the opportunity cost of 3 quintals of rice is 8 quintals of wheat and the opportunity cost of
8 quintals of wheat is 3 quintals of rice.

Short Run Total Cost (SRTC)

In the short run, some of the factors are fixed and some of the factors are variable.

Let us consider that capital (K) and labour (L) are two inputs of production function.
Further, w and r are per unit cost of input of K and L respectively.
Let K is the fixed factor and L is the variable factor.
Hence rK is the fixed cost and wL is the variable cost.
Since the variable factor L depends on the output quantity Q, the variable cost wL is a function of Q.
Total Cost = Total Fixed Cost + Total Variable Cost

TC= TFC + TVC

= rK + wL
= TFC + f(Q)

Since, TC is the summation of TFC and TVC, the shape of the

short run TC curve can be determined by the shapes of the
TFC and TVC curves.

Short Run Total Fixed Cost Curve (TFC)

The fixed cost which is also known as the overhead cost

does not depend on the level of output. The examples of
such costs are costs of factory building and premises, plant
and machinery and permanent employees. A fixed cost
exists even when the quantity of output is zero. At all level
of output, fixed cost remains same. If we measure TFC
vertically and the quantity of output i.e. Q horizontally then TFC curve will be a horizontal straight line
with a positive vertical intercept.

Short Run Total Variable Cost Curve (TVC Curve)

Variable costs are also known as the “prime cost”. The examples of such costs are the cost of raw
material, power and temporary or casual workers. Variable costs are those costs which vary with the
level of output.

TVC depends on the level of output. As output increases TVC also increases. When level of output is nil,
TVC is zero. Hence TVC curve will start from the origin. But the shape of the TVC curve will depend on
the law of variable proportion.

From the law of variable proportions, we know that if one input increases keeping the other input as
same, total output will first increase at an increasing rate. So, the quantity of variable input will increase
at a lower rate than output. If it is assumed that input price is fixed, then TVC will increase at a lower
rate than the level of output at initial stage.

However beyond a certain level of output, due to diminishing returns, total output will increase at a
lower rate than the variable input. So, in this case, total variable cost will increase at a higher rate than
the level of output.

For all of the above reasons, TVC curve is first concave and then convex to the horizontal axis.

We know that the Total product curve is first convex and then concave to the horizontal axis. So, when
the TP curve is convex, TVC curve is concave. Again, when the total product curve is concave, TVC is
convex.
Short Run Total Cost (SRTC)

TC= TFC + TVC

Now, by adding the TVC and TFC curves vertically, we get TC curve. Hence, TC curve will be of similar
shape of that of TVC curve.
However, when Q=0, TVC =0, so, TC=TFC.
Hence, when Q=0, TC curve starts from the same positive vertical intercept as that of TFC. After that
with increase in output, TC curve is upward rising and takes the shape of TVC curve which is ‘inverted S-
shaped.’

The parallel shift of TVC curve upward by TFC gives us the TC curve. The vertical distance between TC
and TVC curve is constant which is TFC.

Derivation of Average Fixed Curve

TC =TFC +TVC
SAC (AC) = TC/Q =TFC/Q + TVC/Q = AFC +AVC

It is the per unit total fixed cost.

AFC = TFC/Q

The shape of AFC depends on the characteristics of AFC.

1. AFC is negatively sloped
Since, AFC = TFC/Q

Therefore, increase in output or Q means decrease in AFC. This inverse relationship indicates
that AFC curve must be negatively sloped.

d(AFC)/dQ = (d/dQ)(F/Q)
= F(d/dQ)(1/Q)
=F(-Q2)
=-(F/Q2) < 0

Since the slope or first order differentiation is negative, AFC curve should be negatively sloped.
2. AFC curve must be convex to the origin

For the convexity, the second order differentiation must be positive.

i.e. d2(AFC)/dQ2 = (d/dQ)[d(AFC)/dQ]

= (d/dQ)(-F/Q2)
= (2F/Q3) > 0

Hence, AFC curve must be convex to the origin.

 Since, AFC = (TFC/Q) = Constant/Q

As Q increases, AFC decreases. For very high

values of Q, the value of AFC must be minimum
but still positive but cannot be zero. AFC may be
close to zero but never touch the horizontal axis.
Due to this, AFC curve is asymptotic to both the
axis.

All the rectangles drawn below the AFC curve are

of equal areas.

Since AFC = TFC/Q

Hence, AFC.Q = TFC =Constant

a) At point R,
AFC = OA1 ; Q = OQ1
So, TFC = AFC.Q = OA1. OQ1 = area OA1RQ1

b) At point S,
AFC = OA2 ; Q = OQ2
So, TFC = AFC.Q = OA2. OQ2 = area OA2SQ2
Since AFC is constant, therefore area OA1RQ1 = area OA2SQ2

Since, all the rectangles drawn below the AFC curve are of equal areas, the AFC curve is called the
“Rectangular Hyperbola”.

Shape of Short Run Average Variable Cost Curve

The shape of the AVC curve can be derived from the law of
variable proportion. Since the TVC initially rises at a lower
rate and then at a higher rate than the level of output, the
AVC at first decreases and reaches a minimum point and
then rises with the increase in output. In this case, the AVC
curve is U-shaped.

AVC = wL/Q = w/(Q/L) =w/APL

From the law of variable proportion, we know that APL

curve is ‘inverse U-shaped’. It increases, reaches the
maximum and then falls.

The shape of AVC depends on the shape of APL.

Since wage rate is constant,
When APL is rising, AVC is falling
When APL reaches maximum, AVC reaches minimum
When APL falls, AVC rises

Shape of Short Run Average Cost Curve

AC = AFC + AVC

The shape of the average cost curve is obtained by vertically adding the AVC curve and AFC curve.
AVC curve is U shaped and AFC curve is always negative with rectangular hyperbola shape.

 Both the AFC and AVC curves are initially falling, hence their sum total AC curve is also falling.
 As output increases, AVC falls and reaches a minimum and thereafter increases whole AFC falls
continuously.

 But initially the strength of the falling AFC is more than that of the strength of rising
AVC. Hence, due to this combined effect AVC will initially fall.
 But as output increases, the strength of the falling AFC decreases. As a result the rising
AVC will outweigh the falling AFC. Hence, beyond a certain point, AC will start rising.
Thus, the shape of the AC curve is also U.
 AC curve first decreases and then increases but it reaches a minimum point after the
AVC reaches its minimum.

Marginal Cost

It is the addition to total cost due to one unit increase in

output.

It is the derivative of total cost with respect to output .i.e. MC =

d(TC)/dQ =Change in Total Cost/Change in output.

The shape of the MC curve can be derived from the law of

variable proportion.
Initially, total cost increases at a diminishing rate due to which
TC curve is concave to the Q-axis. Since this rate, the slope of
the TC curve represents the marginal cost. Hence, MC will
initially falls. .,

After a point of inflection is reached, TC curve is concave to the

Q-axis. This means that MC curve will increase after reaching a minimum point.

So, MC curve is ‘U’ shaped.

Again, TC = wL +rK
Now, MC = d(TC)/dQ = w(dL/dQ) (Since, K is fixed)

So, MC = w/MPL
From the law of variable proportion, we know that MPL is Inverted U shaped. IF wage rate or w is fixed,
then, with the increase in the amount of labour, MPL first increases, reaches its maximum and then falls.
Corresponding to this, MC curve first falls (When MPL rises), reaches its minimum (when MPL reaches its
maximum) and then rises (when MPL falls).
Hence, in the short run, MC curve is U-shaped.

Relation between Average and Marginal Cost

In the short run, both MC and AC curves are ‘U’ shaped.

The relationship actually developed on the basis of 3 steps:

1) When the AC curve is falling

 AC is negatively sloped
 d(AC)/dQ <0
2) When the AC curve is at its minimum point
 The value of AC is minimum
 d(AC)/dQ =0
3) When the AC curve is rising
 AC is positively sloped
 d(AC) /dQ>0

Where, d(AC)/dQ = slope of the AC curve

Now from the definition of AC, we know that it represents ‘per unit’ cost, i.e. AC = TC/Q.

1) When AC is falling, then (d/dQ)(AC) < 0.

Or, (Q.MC – TC)/Q2 < 0.

Or, (Q.MC – TC) < 0

Or, Q.MC < TC
Or, MC < TC/Q
Or, MC <AC

When AC falls, MC lies below AC.

2) When AC is minimum, then (d/dQ)(AC) = 0.

Or, (Q.MC – TC)/Q2 = 0.
Or, (Q.MC – TC) = 0
Or, Q.MC = TC
Or, MC = TC/Q
Or, MC =AC
When AC reaches minimum, MC curve cuts AC curve from below at the minimum point of AC. At that
point, AC = MC.

3) When AC is rising, then (d/dQ)(AC) > 0.

Or, (Q.MC – TC)/Q2 > 0.
Or, (Q.MC – TC) > 0
Or, Q.MC >TC
Or, MC >TC/Q
Or, MC >AC

When AC rises, MC lies above AC.

when AC is falling AC >MC

when AC reaches minimum AC =MC
when AC is rising AC <MC

Same relation holds between AVC and MC

when AVC is falling AVC >MC

when AVC reaches minimum AVC =MC
when AVC is rising AVC <MC
 Long Run Cost Curves

Long-run Total Cost Curve

It has been argued by different economists that a firm plans in the long run, but operates in the short
run. If we sum up different short runs, we get long run. Hence the shape of the long run total cost curve
(LRTC) can be derived from different short run total cost (SRTC) curve.

The long run is known as a ‘planning horizon’ and the LRTC is called a ‘planning curve’. A producer
chooses the overhead expenses in order to find out the most suitable factory set up for production.
Now, each amount of fixed cost/overhead cost is associated with a short run. In the long run, the firm
has the option to choose any one short-run cost out of various short run costs available to it. However,
since the objective of the producer is always to maximize profits, he will try to minimise the cost and
hence will choose that plant size which has the lowest cost in the short run and that plant size will be
the optimum one.( In the short run, plant size is fixed, i.e. for each plat size, there is a short run cost. But
in the long run, plant size is variable because there is different short run costs associated with different
plant size).

Graphically, it indicates that though the producer can only move along the SRTC curve in the short run.
The movement from one SRTC to another one is only possible in the long run.

If the producer wants to expand his output in future, then in that case LRTC curve serves as a guidance
to the producer.

Long Run Average Cost Curve (LRAC Curve)

LRAC is ‘U’ shaped, but the shape is flatter than SRAC.

The short run cost curves are derived on the basis of law of variable proportion, whereas the derivations
of long run average cost curves are based on the ‘returns to scale’.
LRAC is basically the envelope of all possible SAC curves. This is because LAC curve is the lower boundary
of all possible SAC curves and this boundary may not be on the minimum points. This means that It is
not necessary that the LRAC should go through the minimum points of SAC curves.

Summary (LRAC)

A LRAC curve is ‘U’ shaped, but it is flatter than any SRAC curve

LRAC is the envelope to the SRAC curves.

The shape of the LRAC can be explained by the returns to scale.

A LRAC will not be a kinked one. It is a smooth curve since for each level of output there exists one SRAC
curve.