Managerial Economics Unit 6

Unit 6 Cost Analysis

Structure:
6.1 Introduction
Case Let
Objectives
6.2 Types of Costs
6.3 Cost-Output Relationship: Cost Function
6.4 Cost-Output Relationships in the Short Run
6.5 Cost-Output Relationships in the Long Run
6.6 Summary
6.7 Glossary
6.8 Terminal Questions
6.9 Answers
6.10 Case Study
Reference/E-Reference

6.1 Introduction
In the previous unit, we learnt that output does not always increase
proportionately, with increase in the quantity of inputs employed in the
production process. We also learnt that certain tools exist to determine the
optimal combinations of inputs which can be employed to produce the
desired level of output. We saw that large scale production has some
advantages and disadvantages and, we also learnt about the various
economies that emerge with changes in internal and external conditions. As
production involves the use of inputs which are scarce, costs are incurred by
the business firm while producing and delivering a good or service. As the
primary objective of business firms is profit maximisation, costs need to be
controlled. In this unit, we shall explore topics in cost analysis and learn
about how firms can manage their costs. Costs are analysed from the
producer’s point of view. Cost estimates are made in terms of money. Cost
calculations are indispensable for management decisions.
In the production process, a producer employs different factor inputs. These
factor inputs are to be compensated by the producer for the services in the
production of a commodity. The compensation is the cost. The value of
inputs required in the production of a commodity determines the cost of

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output. Cost of production refers to the total monetary expenses (Both

explicit and implicit) incurred by the producer in the process of transforming
inputs into outputs. In short, it refers to total money expenses incurred to
produce a particular quantity of output by the producer. The knowledge of
various concepts of costs, cost-output relationship, etc. occupies a
prominent place in cost analysis.

Case Let (Continued from Unit 5)

In the previous unit, we learnt that Ramesh was asked to prepare a
production plan for the proposed expansion of production facilities of his
firm. Accordingly, Ramesh prepared the plan and submitted it to his
superior who browsed through the report. Subsequently, he called
Ramesh and told him that while the production plan had focused
adequately on technological issues and issues such as logistics, supply
chain for sourcing of inputs, etc, the report had missed out on the issue of
costs. Ramesh had completely overlooked the impact of increase in
production capacities and production quantities on the costs of
production. Ramesh replied that production costs would increase with
increase in production quantities. To this, Ramesh’s superior said that he
would be interested in knowing the impact of the proposals on the
average cost of production. Ramesh began exploring ways to assess the
impact of his proposals on costs of production.

Objectives:
After studying this unit, you should be able to:
 define concepts of production costs and assess their managerial
applications
 apply the short run and long run cost-output relationships in arriving at
the production decision
The case study is connected to the concepts of the said unit making the
reader in advance to understand the concepts and their relationship which
are to be covered.
Managerial uses of cost analysis
A detailed study of cost analysis is very useful for managerial decisions. It
helps the management to do the following:
1. Classify costs of production based on their nature

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2. Calculate the most profitable rate of operation of the firm

3. Prescribe the optimum quantity of output to be produced and supplied
4. Estimate in advance the cost of business operations
5. Apply methods of cost estimation
We will discuss the types of cost and its relationship with the output under
the influence of different factors, in the following sections.

6.2 Types of Costs

In this section we will discuss the types of costs. The types of costs are as
follows:
1. Money cost and real cost – When cost is expressed in terms of money,
it is called as money cost. It relates to money outlays by a firm on various
factor inputs to produce a commodity. In a monetary economy, all kinds of
cost estimations and calculations are made in terms of money only. Hence,
the knowledge of money cost is of great importance in economics. Exact
measurement of money cost is possible.
When cost is expressed in terms of physical or mental efforts put in by a
person in the making of a product, it is called as real cost. It refers to the
physical, mental or psychological efforts, the exertions, sacrifices, the pains,
the discomforts, displeasures and inconveniences which various members
of the society have to undergo to produce a commodity. It is a subjective
and relative concept and hence exact measurement is not possible.
2. Implicit or imputed costs and explicit costs – Explicit costs are those
costs which are in the nature of contractual payments and are paid by an
entrepreneur to the factors of production [excluding himself] in the form of
rent, wages, interest and profits, utility expenses, and payments for raw
materials, etc. They can be estimated and calculated exactly and recorded
in the books of accounts.
Implicit or imputed costs are implied costs. They do not take the form of
cash outlays and as such do not appear in the books of accounts. They are
the earnings of owner-employed resources. For example, the factor inputs
owned by the entrepreneur himself like capital that can be utilised by him or
can be supplied to others for a contractual sum. It is to be remembered that
the total cost is a sum of both implicit and explicit costs.

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3. Actual costs and opportunity costs – Actual costs are also called as
outlay costs, absolute costs and acquisition costs. They are those costs that
involve financial expenditures at some time and hence, are recorded in the
books of accounts. They are the actual expenses incurred for producing or
acquiring a commodity or service by a firm, for example, wages paid to
workers, expenses on raw materials, power, fuel and other types of inputs.
They can be exactly calculated and accounted without any difficulty.
Opportunity cost of a good or service is measured in terms of revenue which
could have been earned by employing that good or service in some other
alternative uses. In other words, opportunity cost of anything is the cost of
displaced alternatives or costs of sacrificed alternatives. It implies that
opportunity cost of anything is the alternative that has been foregone.
Hence, they are also called as alternative costs. Opportunity cost represents
only sacrificed alternatives. Hence, they can never be exactly measured and
recorded in the books of accounts.
The knowledge of opportunity cost is of great importance to managerial
decision-making. The concept of opportunity cost helps in taking decisions
to select the best alternative. While taking a decision among several
alternatives, a manager selects the best one which is more profitable or
beneficial by sacrificing other alternatives. For example, a firm may decide
to buy a computer which can do the work of 10 labourers. If the cost of
buying a computer is much lower than that of the total wages to be paid to
the workers over a period of time, it will be a wise decision. On the other
hand, if the total wage bill is much lower than that of the cost of the
computer, it is better to employ workers instead of buying a computer. Thus,
a firm has to take a number of decisions almost daily.
4. Direct costs and indirect costs – Direct costs are those costs which can
be specifically attributed to a particular product, a department, or a process
of production. For example, expenses on raw materials, fuel, wages to
workers, salary to a divisional manager, etc are direct costs. On the other
hand, indirect costs are those costs, which are not traceable to any one unit
of operation. They cannot be attributed to a product, a department or a
process. For example, expenses incurred on electricity bill, water bill,
telephone bill, administrative expenses, etc.

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5. Past and future costs – Past costs are those costs which are spent in
the previous periods. On the other hand, future costs are those which are to
be spent in the future.
6. Fixed costs and variable costs – Fixed costs are those costs which do
not vary with either expansion or contraction in output. They remain
constant irrespective of the level of output. They are positive even if there is
no production. They are also called as supplementary or overhead costs.
On the other hand, variable costs are those costs which directly and
proportionately increase or decrease with the level of output produced; they
are also called as prime costs or direct costs.
7. Marginal and incremental costs – Marginal cost refers to the cost
incurred on the production of another or one more unit. It implies the
additional cost incurred to produce an additional unit of output.
Incremental cost on the other hand refers to the costs involved in the
production of a batch or group of output. They are the added costs due to a
change in the level or nature of business activity. For example, cost involved
in the setting up of a new sales depot in another city or, cost involved in the
production of 100 extra units.
8. Accounting costs and economic costs – Accounting costs are those
costs which are already incurred on the production of a particular
commodity. It includes only the acquisition costs. They are the actual costs
involved in the making of a commodity. On the other hand, economic costs
are those costs that are to be incurred by an entrepreneur on various
alternative programmes. It involves the application of opportunity costs in
decision making.
Determinants of costs
Cost behaviour is the result of many factors and forces. But it is very difficult
to determine in general, the factors influencing costs, as they widely differ
from firm to firm and even industry to industry. However, economists have
given some factors considering them as general determinants of costs. They
have enough importance in modern businesses and decision making
processes. The following factors deserve our attention in this connection:
1. Technology – Modern technology leads to optimum utilisation of
resources, avoidance of all kinds of wastages, saving of time, reduction

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in production costs and results in higher output. On the other hand,

primitive technology would lead to higher production costs.
2. Rate of output (degree of utilisation of the plant and machinery) –
Complete and effective utilisation of all kinds of plants and equipments
would reduce production costs while, under-utilisation of existing plants
and equipments would lead to higher production costs.
3. Size of Plant and scale of production – Big companies with huge plant
and machineries organise production on large scale basis and enjoy
economies of scale which reduce the cost per unit.
4. Prices of factor inputs – Higher market prices of various factor inputs
result in higher cost of production and vice-versa.
5. Efficiency of factors of production and the management – Higher
productivity and efficiency of factors of production would lead to lower
production costs and vice-versa.
6. Stability of output – Stability in production would lead to optimum
utilisation of the existing capacity of plants and equipments. It also
brings savings of various kinds of hidden costs of interruption and
learning leading to higher output and reduction in production costs.
7. Law of returns – Increasing returns would reduce cost of production
and diminishing returns would increase costs.
8. Time period – In the short run, cost will be relatively high and in the
long run, it will be low as it is possible to undertake adjustments and
readjustments in production process.
Thus, many factors influence cost of production of a firm.

6.3 Cost-Output Relationship: Cost Function

In this section, we will discuss the cost-output relationship, i.e., the cost
function. Cost and output are correlated. Cost-output relations play an
important role in almost all business decisions. It throws light on cost
minimisation or profit maximisation and optimisation of output. The relation
between the cost and output is technically described as the “cost function”.
The significance of cost-output relationship is so great that in economic
analysis, the cost function usually refers to the relationship between cost
and rate of output alone and we assume that all other independent variables

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are kept constant. Mathematically speaking TC = f (Q) where TC = Total

cost and Q stands for output produced.
However, cost function depends on three important variables. These
variables are as follows:
1. Production function – If a firm is able to produce higher output with a
little quantity of inputs, in that case, the cost function becomes cheaper and
vice-versa.
2. The market prices of inputs – If market prices of different factor inputs
are high in that case, cost function becomes higher and vice-versa.
3. Period of time – Cost function becomes cheaper in the long run and it
would be relatively costlier in the short run.
These variables govern the behaviour of the cost function.
Types of cost functions
Generally speaking, there are two types of cost functions, namely, short run
cost function and long run cost function.

6.4 Cost-Output Relationships in the Short Run

In this section, we will discuss the cost-output relationship in the short run. It
is interesting to note that the relationship between the cost and output is
different at two different periods of time i.e. short-run and long run.
Generally speaking, cost of production will be relatively higher in the short-
run when compared to the long run. This is because a producer will get
enough time to make all kinds of adjustments in the productive process in
the long run than in the short run. When cost and output relationship is
represented with the help of diagrams, we get short run and long run cost
curves of the firm. Now we shall make a detailed study of cost output
relations both in the short-run as well as in the long run.
Meaning of short run
Short-run is a period of time in which only the variable factors can be varied
while fixed factors like plant, machinery, etc. remain constant. Hence, the
plant capacity is fixed in the short run. The total number of firms in an
industry will remain the same. Time is insufficient either for the entry of new
firms or exit of the old firms. If a firm wants to produce greater quantities of

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output, it can do so only by employing more units of variable factors or by

having additional shifts, or by having overtime work for the existing labour
force or by intensive utilisation of existing stock of capital assets, etc.
Hence, short run is defined as a period where adjustments to changed
conditions are only partial.
The short run cost function relates to the short run production function. It
implies two sets of input components: (a) fixed inputs and (b) variable
inputs. Fixed inputs are unalterable. They remain unchanged over a period
of time. On the other hand, variable factors are changed to vary the output
in the short run. Thus, in the short period, some inputs are fixed in amount
and a firm can expand or contract its output only by changing the amounts
of other variable inputs. The cost-output relationship in the short run refers
to a particular set of conditions where the scale of operations is limited by
the fixed plant and equipment. Hence, the costs of the firm in the short run
are divided into fixed cost and variable costs. We shall study these two
concepts of costs in some detail.
Fixed costs
These costs are incurred on fixed factors like land, buildings, equipments,
plants, superior type of labour, top management, etc. Fixed costs in the
short run remain constant because the firm does not change the size of
plant and the amount of fixed factors employed. Fixed costs do not vary with
either expansion or contraction in output. These costs are to be incurred by
a firm even if output is zero. Even if the firm closes down its operations for
some time temporarily in the short run, but remains in business, these costs
have to be borne by it. Hence, these costs are independent of output and
are referred to as unavoidable contractual cost.
Prof. Marshall called fixed costs as supplementary costs. They include items
such as contractual rent payment, interest on capital borrowed, insurance
premiums, depreciation and maintenance allowances, administrative
expenses like manager’s salary or salary of the permanent staff, property
and business taxes, license fees, etc. They are called as overhead costs
because these costs are to be incurred whether there is production or not.
These costs are to be distributed on each unit of output produced by a firm.
Hence, they are called as indirect costs.

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Variable costs
The costs corresponding to variable factors are discussed as variable costs.
These costs are incurred on raw materials, ordinary labour, transport,
power, fuel, water, etc, which directly vary in the short run. Variable costs
directly and proportionately increase or decrease with the level of output. If a
firm shuts down for some time in the short run; then it will not use the
variable factors of production and therefore, will not incur any variable costs.
Variable costs are incurred only when some amount of output is produced.
Total variable costs increase with increase in the level of production and
vice-versa. Prof. Marshall called variable costs as prime costs or direct costs
because the volume of output produced by a firm depends directly upon
them.
It is clear from the above description that production costs consist of both
fixed as well as variable costs. The difference between the two is
meaningful and relevant only in the short run. In the long run, all costs
become variable because all factors of production become adjustable and
variable in the long run.
However, the distinction between fixed and variable costs is very significant
in the short run because it influences the average cost behaviour of the firm.
In the short run, even if a firm wants to close down its operations but wants
to remain in business, it will have to incur fixed costs but it must cover at
least its variable costs.
Cost-output relationship and nature and behaviour of cost curves in
the short run
In order to study the relationship between the level of output and
corresponding cost of production, we have to prepare the cost schedule of
the firm. A cost-schedule is a statement of variations in costs resulting from
variations in the levels of output. It shows the response of costs to changes
in output. Table 6.1 represents a hypothetical cost schedule of a firm.

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Table 6.1: Hypothetical Cost Schedule

Output TFC TVC TC AFC AVC AC MC

in Units in Rs. in Rs. in Rs. in Rs. in Rs. In Rs. in Rs.
0 360 – 360 – – – –
1 360 180 540 360 180 540 180
2 360 240 600 180 120 300 60
3 360 270 630 120 90 210 30
4 360 315 675 90 78.75 168.7 45
5
5 360 420 780 72 84 156 105
6 360 630 990 60 105 165 210

On the basis of the cost schedule, we can analyse the relationship between
changes in the level of output and costs of production. If we represent the
relationship between the two in a graphical manner, we get different types of
cost curves in the short run.
In the short run, we will study the following kinds of cost concepts and cost
curves.
Total fixed cost (TFC)
TFC refers to total money expenses incurred on fixed inputs like plant,
machinery, tools and equipments in the short run. Total fixed cost
corresponds to the fixed inputs in the short run production function. TFC
remains the same at all levels of output in the short run. It is the same even
when output is nil. It indicates that whatever may be the quantity of output,
whether 1 to 6 units, TFC remains constant. Figure 6.1 depicts the total
fixed cost curve. The TFC curve is horizontal and parallel to OX-axis,
showing that it is constant regardless of output per unit of time. TFC starts
from a point on Y-axis indicating that the total fixed cost will be incurred
even if the output is zero. In our example, Rs. 360 is the TFC. It is obtained
by summing up the product or quantities of the fixed factors multiplied by
their respective unit price.

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TFC = TC - TVC.

Cost of production
TFC
360

X
0
Output
Figure 6.1: Total Fixed Cost Curve

Total Variable Cost (TVC)

TVC refers to total money expenses incurred on the variable factor inputs
like raw materials, power, fuel, water, transport and communication, etc, in
the short run. Total variable cost corresponds to variable inputs in the short
run production function. It is obtained by summing up the quantities of
variable inputs multiplied by their prices. The formula to calculate TVC is as
follows. TVC = TC - TFC. TVC = f (Q), i.e., TVC is an increasing function of
output. In other words TVC varies with output. It is nil, if there is no
production. Thus, it is a direct cost of output. Figure 6.2 depicts the total
variable cost curve. TVC rises sharply in the beginning, gradually in the
middle and sharply at the end in accordance with the law of variable
proportions. The law of variable proportions explains that in the initial
stages, to obtain a given quantity of output, the relative change (variation) in
variable factors that are needed are in lower proportion, but after a point
when the diminishing returns operate, variable factors are to be employed in
a larger proportion to increase the same level of output.
TVC curve slope upwards from left to right. TVC curve rises as output is
expanded. When output is zero, TVC also will be zero. Hence, the TVC
curve starts from the origin.

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TVC = TC - TFC

Cost of production
Y

TVC

0 X
Output

Figure 6.2: Total Variable Cost Curve

Total cost (TC)

Total cost refers to the aggregate money expenditure incurred by a firm to
produce a given quantity of output. The total cost is measured in relation to
the production function by multiplying the factor quantities with their prices.
TC = f (Q) which means that TC varies with output. Theoretically speaking,
TC includes all kinds of money costs, both explicit and implicit cost. Normal
profit is included in the total cost as it is an implicit cost. It includes fixed as
well as variable costs. Hence, TC = TFC +TVC. Figure 6.3 depicts the total
cost curve.
TC varies in the same proportion as TVC. In other words, a variation in TC
is the result of variation in TVC since TFC is always constant in the short
run.

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TC
Y TC = TFC + TVC
TVC
Cost of production

360 TFC

0 x
Output

Figure 6.3: Total Cost Curve

Total cost curve rises upwards from left to right. In our example, the TC
curve starts from Rs. 360 because even if there is no output, TFC is a
positive amount. TC and TVC have the same shape because an increase in
output increases them both by the same amount since TFC is constant. TC
curve is derived by adding up vertically the TVC and TFC curves. The
vertical distance between TVC curve and TC curve is equal to TFC and is
constant throughout because TFC is constant.
Average fixed cost (AFC)
Average fixed cost is the fixed cost per unit of output. When TFC is divided
by total units of output, AFC is obtained, Thus, AFC = TFC/Q. Figure 6.4
depicts the average fixed cost curve.
Y
Cost of Production

Figure 6.4: Average Fixed Cost Curve

AFC

0 X
Output

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AFC and output have inverse relationship. It is higher at smaller levels and
lower at higher levels of output in a given plant. The reason is simple to
understand. Since AFC = TFC/Q, it is a pure mathematical result that the
numerator remaining unchanged, the increasing denominator causes
diminishing cost. Hence, with the increase in output, TFC spreads over each
unit of output. Consequently, AFC diminishes continuously. This relationship
between output and fixed cost is universal for all types of business
concerns.
The AFC curve has a negative slope. The curve slopes downwards
throughout the length. The AFC curve goes very nearer to X axis, but never
touches the X-axis. Graphically, it will fall steeply in the beginning, gently in
middle and tend to become parallel to OX-axis. Mathematically speaking, as
output increases, AFC diminishes. But AFC will never become zero because
the TFC is a positive amount. AFC will never fall below a minimum amount
because in the short run, plant capacity is fixed and output cannot be
expanded to an unlimited extent.
Average variable cost (AVC)
The average variable cost is variable cost per unit of output. AVC can be
computed by dividing the TVC by total units of output. Thus, AVC = TVC/Q.
The AVC will come down in the beginning and then rise as more units of
output are produced with a given plant. This is because, as we add more
units of variable factors in a fixed plant, the efficiency of the inputs first
increases and then decreases. Figure 6.5 depicts the average variable cost
curve.
The AVC curve is a U-shaped cost curve. It has three phases.
AVC = TVC / Q
Y
Cost of production

AVC C
A

B

X
0 Output

Figure 6.5: Average Variable Cost Curve

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a) Decreasing phase – In the first phase from A to B, AVC declines. As the

output expands, the AVC declines because when we add more quantity of
variable factors to a given quantity of fixed factors, output increases more
efficiently and more than proportionately due to the operation of increasing
returns.
b) Constant phase – In the II phase, i.e. at B, AVC reaches its minimum
point. When the proportion of both fixed and variable factors are ideal, the
output will be optimal. After the firm operates at its normal full capacity,
output reaches its zenith and as such AVC will reach its minimum point.
c) Increasing phase – In the III phase, from B to C, AVC rises. After the
normal capacity is crossed, the AVC rises sharply. This is because
additional units of variable factors will not result in more than proportionate
output. Hence, greater output may be obtained but at much greater AVC. It
is clear that as long as increasing returns operate, AVC falls and when
diminishing returns set in, AVC tends to increase.
Average total cost (ATC) or average cost (AC)
AC refers to cost per unit of output. AC is also known as the unit cost since
it is the cost per unit of output produced. AC is the sum of AFC and AVC.
Average total cost or average cost is obtained by dividing the total cost by
total output produced. AC = TC/Q. Also, AC is the sum of AFC and AVC.
In the short run, AC curve also tends to be U-shaped. The combined
influence of AFC and AVC curves will shape the nature of AC curve. Figure
6.6 depicts the average cost curve.
ATC = AFC + AVC
Y
Cost of production

A AC

C

B
X
0 Output
Figure 6.6: Average Cost Curve

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As we observe, average fixed cost begins to fall with an increase in output

while average variable cost declines and subsequently rises. As long as the
falling effect of AFC is much more than the rising effect of AVC, the AC
tends to fall. At this stage, increasing returns and economies of scale
operate and complete utilisation of resources forces the AC to fall.
When the firm produces the optimum output, AC drops to its minimum. This
is called as least–cost output level. Again, at the point where the rise in AVC
exactly counterbalances the fall in AFC, the balancing effect causes AC to
remain constant.
In the third stage, when the rise in average variable cost is more than drop
in AFC, then the AC shows a rise, When output is expanded beyond the
optimum level of output, diminishing returns set in and diseconomies of
scale starts operating. At this stage, the indivisible factors are used in sub-
optimal proportions. Thus, AC starts rising in the third stage.
The short run AC curve is also called as “plant curve”. It indicates the
optimum utilisation of a given plant or optimum plant capacity.
Marginal cost (MC)
Marginal Cost may be defined as the net addition to the total cost as one
more unit of output is produced. In other words, it implies additional cost
incurred to produce an additional unit. For example, if it costs Rs. 100 to
produce 50 units of a commodity and Rs. 105 to produce 51 units, then MC
would be Rs. 5. It is obtained by calculating the change in total costs as a
result of a change in the total output. Also, MC is the rate at which total cost
changes with output. Hence, MC =  TC /  TQ. Where,  TC stands for
change in total cost and  TQ stands for change in total output. Also MCn =
TCn –TC n-1
It is necessary to note that MC is independent of TFC and it is directly
related to TVC as we calculate the cost of producing only one unit. In the
short run, the MC curve also tends to be U-shaped.
The shape of the MC curve is determined by the laws of returns. If MC is
falling, production will be under the conditions of increasing returns and if
MC is rising, production will be subject to diminishing returns. Figure 6.7
depicts the marginal cost curves.

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Cost of production

A MC

C
B


0 X
Output

Figure 6.7: Marginal Cost Curve

Table 6.2 indicates the relationship between AC and MC.

Table 6.2: Relationship between Average Cost and Marginal Cost

Output in Units TC in Rs. AC in Rs. Difference MC (Rs.)

1 150 150 –
2 190 95 40
3 220 73.3 30
4 236 59 16
5 270 54 34
6 324 54 54
7 415 59.3 91
8 580 72.5 165

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Relation between AC and MC

Figure 6.8 depicts the relationship between average cost and marginal cost.

AC

MC
Cost


AC=MC

X
Output

Figure 6.8: Relationship between Average cost and Marginal Cost

From the diagram, it is clear that:

1. Both MC and AC fall up to a certain range of output and rise afterwards.
2. When AC falls, MC also falls but at certain range of output, MC tends to
rise even though AC continues to fall. However, MC would be less than
AC. This is because MC is attributed to a single unit whereas in the
case of AC, the decreasing AC is distributed over all the units of output
produced.
3. As long as AC is falling, MC is less than AC. Hence, MC curve lies
below AC curve. It indicates that the fall in MC is more than the fall in
AC. MC reaches its minimum point before AC reaches its minimum.
4. When AC is rising, after the point of intersection, MC will be greater than
AC. This is because in case of MC, the increasing MC is attributed to a
single unit, whereas in case of AC, the increasing AC is distributed over
all the output produced.
5. So long as the AC is rising, MC is greater than AC. Hence, MC curve
lies to the left side of the AC curve. It indicates that rise in MC is more
than the rise in AC.

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6. MC curve intersects the AC curve at the minimum point of the AC curve.

This is because, when MC decreases, it pulls AC down and when MC
increases, it pushes AC up. When AC is at its minimum, it is neither
being pulled down nor being pushed up by the MC. Thus, when AC is
minimum, MC = AC. The point of intersection indicates the least cost
combination point or the optimum position of the firm. At output Q, the
firm is working at its “optimum capacity” with lowest AC. There is scope
for “maximum capacity” with rising cost, beyond Q.
Thus we have discussed the cost-output relationship in the short run.

6.5 Cost-Output Relationship in the Long Run

In this section, we will discuss the cost output relationship in the long run.
Long run is defined as a period of time where adjustments to changed
conditions are complete. It is actually a period during which the quantities of
all factors, variable as well as fixed factors, can be adjusted. Hence, there
are no fixed costs in the long run. In the short run, a firm has to carry on its
production within the existing plant capacity, but in the long run, it is not tied
up to a particular plant capacity. If demand for the product increases, it can
expand output by enlarging its plant capacity. It can construct new buildings
or hire them, install new machines, employ administrative and other
permanent staff. It can make use of the existing as well as new staff in the
most efficient way and, there is lot of scope for transforming indivisible
factors into divisible factors. On the other hand, if demand for the product
declines, a firm can cut down its production permanently. The size of the
plant can also be reduced and other expenditure can be minimized. Hence,
production cost comes down to a greater extent in the long run.
As all costs are variable in the long run, the total of these costs is the total
cost of production. Hence, the distinction between fixed and variables costs
in the total cost of production will disappear in the long run. In the long run,
only the average total cost is important and considered in taking long term
output decisions.
Long run average cost is the long run total cost divided by the level of
output. In brief, it is the per-unit cost of production of different levels of
output by changing the size of the plant or scale of production.

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The long run cost–output relationship is explained by drawing a long run

cost curve through short–run curves as the long period is made up of many
short–periods just as the day is made up of 24 hours and a week is made
out of 7 days. This curve explains how costs will change when the scale of
production is varied. Figure 6.9 depicts a long run average cost curve.

LAC

SAC 1
Cost of Production

SAC 2
SAC 3
SAC 4 SAC 5

0 Output Q X
Q

Figure 6.9: Changes in Cost with Variations on Scale of Production

The long run-cost curves are influenced by the law of returns to scale as
against the short run cost curves which are subject to the working of law of
variable proportions.
In the short run, the firm is tied with a given plant and as such, the scale of
operation remains constant. There will be only one AC curve to represent
one fixed scale of output in the short run. In the long run, as it is possible to
alter the scale of production, one can have as many AC curves as there are
changes in the scale of operations.
In order to derive LAC curve, one has to draw a number of SAC curves,
each curve representing a particular scale of output. The LAC curve will be
tangential to the entire family of SAC curves. It means that it will touch each
SAC curve at its minimum point.

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Production cost in short run and long run

Figure 6.10 depicts the production cost in the short run and in the long run.

SAC 2 SAC 1 SAC 3

LAC
Cost of Production

K3
K1

 
L1  L3
L2

0 X
M1 M2 M3
Output

Figure 6.10: Production Cost Curves

In the diagram, the LAC curve is drawn on the basis of three possible plant
sizes. Consequently, we have three different SAC curves – SAC1, SAC2
and SAC3. They represent three different scales of output. For output OM2,
the AC will be L2M2 in the short run as well as the long run.
When output is to be expanded to OM3, it can be obtained at a higher
average cost of production. K3M3 is the short run AC because scale of
production would remain constant in the short run. But the same output of
OM3 can be produced at a lower AC of L3M3 in the long run since the scale
of production can be modified according to the requirements. The distance
between K3L3 represent difference between the cost of production in the
short run and long run.
Similarly, when output is contracted to OM1 in the short run, K1M1 will
become the short run AC and L1M1 will be the long run AC. Hence, K1L1
indicates the difference between short run and long run cost of production.
If we join points L1, L2 and L3 we get LAC curve.

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Important features of long run AC curves

The important features of long run AC curves are as follows:
1. Tangent curve – Different SAC curves represent different operational
capacities of different plants in the short run. LAC curve is the locus of all
these points of tangency. The SAC curve can never cut a LAC curve
though they are tangential to each other. This implies that for any given level
of output, no SAC curve can ever be below the LAC curve. Hence, SAC
cannot be lower than the LAC in the long run. Thus, LAC curve is tangential
to various SAC curves.
2. Envelope curve – It is known as envelope curve because it envelops a
group of SAC curves appropriate to different levels of output.
3. Flatter U-shaped or dish-shaped curve – The LAC curve is also U
shaped or dish-shaped cost curve. But it is less pronounced and much
flatter in nature. LAC gradually falls and rises due to economies and
diseconomies of scale.
4. Planning curve – The LAC curve is described as the planning curve of
the firm because it represents the least cost of producing each possible
level of output. This helps in producing optimum level of output at the
minimum LAC. This is possible when the entrepreneur is selecting the
optimum scale plant. Optimum scale plant is that size where the minimum
point of SAC is tangent to the minimum point of LAC.
5. Minimum point of LAC curve – It should be always lower than the
minimum point of SAC curve. The LAC curve will touch the optimum plant
SAC curve at its minimum point.
A rational entrepreneur would select the plant of optimum scale. Optimum
scale plant is that size at which SAC is tangent to LAC, such that both the
curves have the minimum point of tangency. In the diagram, OM2 is
regarded as the optimum scale of output, as it has the least per unit cost. At
OM2 output LAC = SAC.
LAC curve will be tangent to SAC curves lying to the left of the optimum
scale or right side of the optimum scale. But at these points of tangency,
neither LAC nor SAC is at its minimum. SAC curves are either rising or
falling indicating a higher cost.

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Managerial use of LAC

The study of LAC is of great importance in managerial decision making
process. Few examples that quote the importance of studying LAC in the
managerial decision making process, are as follows:
1. It helps the management in the determination of the best size of the
plant to be constructed or, in getting the minimum cost output for a new
plant.
2. The LAC curve helps a firm to decide the size of the plant to be adopted
for producing the given output. For outputs less than cost lowering
combination at the optimum scale i.e., when the firm is working subject
to increasing returns to scale, it is more economical to use a slightly
large plant operating at less than its minimum cost – output than to use
a smaller unit. Conversely, at output beyond the optimum level, i.e.
when the firm experiences decreasing returns to scale, it is more
economical to use a slightly smaller plant than to use a slightly larger
one. Thus, it explains why it is more economical to use a slightly small
plant rather than to use a large plant.
3. LAC is used to show how a firm determines the optimum size of the
plant. An optimum size of plant is one that helps in best utilisation of
resources in the most economical manner.
Thus we have discussed features, importance and use of long run average
costs.

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Long run marginal cost

Figure 6.11 depicts the long run marginal cost curve.

LMC LAC

SMC 3
E

SMC 1 SAC 3
Cost of Production

SAC 1 D
SMC
A 2
SAC 2

B
C

0 X
N Q R
Output

Figure 6.11: Long Run Marginal Cost Curve

A long-run marginal cost curve can be derived from the long-run average
cost curve. Just as the SMC is related to the SAC, similarly the LMC is
related to the LAC and, therefore, we can derive the LMC directly from the
LAC. In the diagram we have taken three plant sizes and the corresponding
three SAC and SMC curves. The LAC curve is drawn by enveloping the
family of SAC curves. The points of tangency between the SAC and the
LAC curves indicate different outputs for different plant sizes.
If the firm wants to produce ON output in the long run, it will have to choose
the plant size corresponding to SAC1. The LAC curve is tangent to SAC1 at
point A. For ON output, the average cost is NA and the corresponding
marginal cost is NB. If LAC curve is tangent to SAC1 curve at point A, the
corresponding LMC curve will have to be equal to SMC1 curve at point B.
The LMC will pass through point B. In other words, where LAC is equal to
SAC curve (for a given output) the LMC will have to be equal to a given
SMC.

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If output OQ is to be produced in the long run, it will be done at point C

which is the point of tangency between SAC2 and the LAC. At point C, the
short –run average cost (SAC2) and the short-run marginal cost (SMC2) are
equal and, therefore, the LAC for output OQ is QC and the corresponding
LMC is also QC. The LMC curve will, therefore pass through point C.
Finally, for output OR, at point D the LAC is tangent to SAC3. For OR output
at point E, LMC is passing through SMC3. By connecting points B, C and E,
we can draw the long-run marginal cost curve.
Costs of production: formulae
TC = Cost per unit x Total production. Or TC = TFC + TVC
TFC = (TC – TVC) or (AFC x Q)
TVC = (TC – TFC) or (AVC x Q) or addition of MC
AFC = (AC – AVC) or (TFC/Q)
AVC = (AC – AFC) or (TVC/Q)
AC = (AFC + AVC) or (TC/Q)
MC = (TCn - TCn-1) or ( TC /  TQ)

6.6 Summary
Let us recapitulate the important concepts discussed in this unit:
 Cost analysis indicates the various amounts of costs incurred to produce
a particular quantity of output in monetary terms.
 The various kinds of cost concepts help a manager to take right
decisions. Cost function explains the relationship between the amounts
of costs to be incurred to produce a particular quantity of output.
 Short run cost function gives information about the nature and behaviour
of various cost curves. Long run cost function tells us how it is possible
to obtain more output at lower costs in the long run.
 Thus, the knowledge of both production function and cost functions help
a business executive to work out the best possible factor combinations
to maximise output with minimum costs.

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6.7 Glossary
Average cost: Cost per unit of output.
Average fixed cost: Fixed cost per unit of output.
Average variable cost: Variable cost per unit of output.
Cost function: Technical relationship between the cost and output.
Fixed costs: These are costs that do not vary with either expansion or
contraction in output.
Marginal cost: Additional cost incurred to produce an additional unit of
output. Net addition to the total cost as one more unit of output is produced.
Opportunity cost: Revenue which could have been earned by employing
that good or service in some other alternative uses.
Total cost: The aggregate money expenditure incurred by a firm to produce
a given quantity of output.
Total fixed cost: Total money expenses incurred on fixed inputs like plant,
machinery, tools and equipments in the short run.
Total variable cost: Total money expenses incurred on the variable factor
inputs like raw materials, power, fuel, water, transport and communication,
etc., in the short run.
Variable costs: Costs which directly and proportionately increase or
decrease with the level of output produced.

Self Assessment Questions

1. Opportunity cost of anything is the alternative that has been _____.
2. Marginal cost deals with changes in cost of ______ unit where as
incremental cost deals with changes in cost of ________.
3. AC minus AVC would give us _________.
4. Total cost includes ___________ profits.
5. Marginal cost is associated with _________ costs.
6. In the long run, all costs are ______________.
7. Average total cost increases if marginal cost is greater than average
total cost. (True/False)
8. Marginal cost measures how total cost changes when input prices
change. (True/False)

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9. A fixed cost is a cost the firm must pay even if output is zero.
(True/False)
10. A short-run cost function assumes that all inputs are fixed in supply
(True/False)

Activity:
Go to a local manufacturer producing goods for local consumption like tin
boxes, baskets, etc and find out how the manufacturer ascertains the
market price for his product after taking into consideration the costs of
manufacturing.

6.8 Terminal Questions

1. Give a brief description of the following:
a. Implicit and explicit cost
b. Actual and opportunity cost
2. Discuss the various determinants of costs.
3. Explain cost output relationship with reference to:
a. Total fixed cost and output
b. Total variable cost and output
4. Explain features of LAC curve with a diagram.

6.9 Answers

Self Assessment Questions

1. foregone
2. One, a group of units
3. AFC
4. Normal
5. Variable
6. Variable
7. True
8. False
9. True
10. False

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Terminal Questions
1. a. Explicit costs are those costs which are in the nature of contractual
payments and are paid by an entrepreneur to the factors of
production. Explicit cost are the earnings of owner-employed
resources Refer to section 6.2.
b. Actual cost are those costs that involve financial expenditures at
some time and hence, are recorded in the books of accounts.
Opportunity cost of anything is the cost of displaced alternatives or
costs of sacrificed alternatives. Refer to section 6.2.
2. The following factors deserve our attention in this connection:
technology, rate of output, size of Plant and scale of production, prices
of factor inputs. Refer to section 6.2.
3. a. Fixed costs in the short run remain constant because the firm does
not change the size of plant and the amount of fixed factors
employed.
b. The costs corresponding to variable factors are discussed as
variable costs. Refer to section 6.4.
4. The important features of long run AC curves are as follows: tangent
curve, envelope curve, flatter U-shaped or dish-shaped curve,
planning curve Refer to section 6.5.

6.10 Case Study

It May Get Worse for Aluminium

Kunal Bose
The market remains in the habit of springing surprises, occasionally
brutal. Otherwise, who could have thought as late as September that
aluminium, the metal next only to steel in production and use, would sink
below $2,000 a tonne in the third week of November to come close to its
lowest since July 2010? This is a shocker, as in the first nine months of
2011, aluminium realised an average price of $2,498 a tonne, about 18
per cent up year-on-year.

No doubt at prevailing prices, a large swathe of capacity has become

unprofitable to run. Estimates of loss making capacity range from 25 per
cent, according to Russia’s Rusal, to RBS banking group saying nearly

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half the world’s aluminium producers are not able to recover costs. What
is going to save the day for Hindalco, in the midst of major capacity
expansion of both alumina and aluminium and the largely government-
owned National Aluminium Company (Nalco), through with its second
phase of expansion, is that they remain in the lowest cost quartile of
global aluminium production costs. In recent periods, however, Nalco has
come under pressure because Mahanadi Coalfields, with which it has
mines linkage, has repeatedly tripped in redeeming supply commitments.
When Nalco buys coal through e-auction to bridge supply shortfall, it
pays up to three times more than what is charged by Mahanadi
Coalfields.

Cost effectiveness of a smelter depends largely on what price it gets

electricity and also whether it has ownership of bauxite mines. The
average share of electricity in aluminium production costs across the
world is 25 per cent, with the high of 40 per cent in China. Even while
Nalco’s electricity capacity of 1,200 Mw is in excess of power
requirements of its 460,000 tonne smelter, intermittent shortfall in coal
supply from the designated agency is not allowing the company to reap
full benefits of captive power.

This is happening at a time when aluminium prices are found to be well

below the world industry’s marginal cost of production. Tom Albanese,
CEO of Rio Tinto, which got its portfolio hugely expanded on its takeover
of Alcan in 2007, says “For the near term, I am concerned about general
softening of prices when we continue to see cost escalation.” Rio’s
problem got compounded by appreciating currencies in Canada and
Australia, where it has a majority of its operations.

Discussion Questions:
1. What can business firms do in such cases where they are unable to
recover their production costs due to uncontrollable factors?
2. Analyse the factors that influence costs in commodity-based
industries as compared to factors that influence costs incurred by
firms in the information technology sector.
(Source: Business Standard, New Delhi, December 6, 2011)
Hint: Use the theoretical concept and answer the questions

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Reference:
 Marshall, Alfred (1920), Principles of Economics, 8th edition, Macmillan
and Co.
 Business Standard, New Delhi, December 6, 2011

E-Reference:
 www.economictimes.com – retrieved on December 6th 2011

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