Cost & Cost Curves

8/13/2019 Cost & Cost Curves

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PRESENTATION BYMANOJ KUMAR SUNUWAR

MAHENDRA AADARSHSA VIDHYASHRAM CAMPUSSATDOBATO, LALITPUR

NEPAL

Date: 2069-08-15


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BASIC CONCEPT OF COSTIn the process of production of goods and

services it requires the use of various

factors of production such as land, labour,

capital and entrepreneur/organization.

These factors of production helps inproduction process and as a reward they

get payment for their services.

Producer has to pay prices to these factorsof production such as rent for land, wages

for labour, interest for capital and profit for

entrepreneur.


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The sum of these payment made for various

factors of production is known as cost of

production.

In conclusion, the sum of the prices paid to theinputs like rent, wages, interest and profit by the

producer to produce goods and services is known

as cost of production.The term cost of production can be analyzed under

the following sub headings:

1. Money Cost:- The payment made in terms of money to the

inputs used in production in the form of rent,

wages, salaries, allowances, profit, interest and

rice of raw materials is known as mone cost.


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3. Explicit Cost:- Producer does not possess all factors of

production required in the process of productionof goods and services.

- At that time producer borrows factors of

productions from external sources and pays theremuneration for their services.

- The payment made for those factors of

production which are borrowed from external

sources in terms of money is called explicit cost.

- All explicit costs are written in the Book of

Accounts, which is very important in keeping

profit and loss account.


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If he uses, these factors for somebody else, he

gets remuneration for their services. Therefore,

economist calculate the costs of the factors of

production of ones own possession even when

they are used in own production process.

This cost is calculated on the basis of

opportunity cost and in this cost capital

consumption allowances is also included.

This cost is not included in Book of Account but

play vital role in business decisions.

5. Opp0rtunity Cost:This cost is known as the next best alternative

cost which is sacrificed by producer.

F l l t th t f


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For example: let us suppose that a farmer can

produce 300 kg of rice in one hector land by

using certain factors. If the farmer produces

maize at that land he can produce 200 kg ofmaize only by using same factors as before.

Here, cost of producing rice and maize is same.

In this situation, if farmer produce maize, thenhis opportunity cost of producing 200 kg maize

is 300 kg rice. And similarly, if he produce rice,

then his opportunity cost of producing 300 kg of

rice is 200 kg maize.

6. Accounting Cost:The cost which are necessary for accounting

purpose is known as accounting cost.


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It includes only direct cost or payment

made in-terms of money to the factors of

production. It does not include real cost

and the opportunity cost of self owned

resources or self employed resources.

For example: rent paid for land, factory

buildings, wages paid for labourers,

interest for capital, prices for rawmaterials, fuels, transportation etc. in form

of cash are the example of accounting cost.


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7. Economic Cost:Economic cost is the aggregate cost of

explicit and implicit cost. Such cost coversboth monetary cost and other services

provide by the producer including normal

profit.i.e. Economic Cost = Accounting Costs +

Implicit Costs.

Question:

What is cost and define various types of

costs.


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CONCPET OF FIXED AND VARIABLE COST In the process of production, a producer employs

or used various factors of production such as

land, labour, capital, organization, raw materialsetc.

These factors of production can be classified into

two categories. There are some factors whichcan be used for a longer period for producing

more than one batch of goods and services.

These factors do not change their form in oneuse are called fixed factors of production. The

fixed factors capital like machinery, land and

building and permanent staff are included in this

category.


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There are some other factors which can have

only one use, these are called variable factors

of production. The raw materials are includedin this category.

Hence, the cost of production is composed of

two cost fixed cost and variable cost.1. Fixed Cost:The amount of money value paid to the fixed

factors of production used in productionprocess is known as fixed cost.

This cost is also known as supplementary

cost or overhead cost.


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Fixed cost do not change with any change in

output. Fixed cost are made in the initial

phase of production so it must be paid even ifthe firmsoutput is zero.

Salary paid to the permanent staff,

managerial cost, rental payment, interest andsome portion of depreciation charge are the

examples of fixed cost.

2. Variable Cost:Variable cost is the price or money value paid

to the variable factors of production used in

the production process.


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Variable cost are directly related to the

production. So, variable cost remains zero at

zero level of production and it increases with the

increase in level of output.

It includes the payments made for raw

materials, fuel, power, transportation, wages and

other similar variable resources.

The main difference between variable and fixed

costs is only a short run phenomenon. Nothing

remains fixed in long run. That means all factors

of production became variable in long run.

Because, change would occur in the staff and

amount of capital.


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CONCEPT OF SHORT RUN COST AND LONGRUN COST1. CONCEPT OF SHORT RUN COST:Price or money value paid to the fixed and

variable factors of production in short run is

called short run cost.

Short run is that period where all factors ofproduction can not be changed. That means

some factors of production remains fixed and

some factors of production are changed.

Fixed cost remains unchanged along with

change in production of goods and services and

the variable cost changes along with change in

roduction of oods and services.


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Short run cost can be classified into following

three headings:

A. Short-Run Total CostB. Short-Run Average Cost and

C. Short-Run Marginal Cost

A. Short Run Total Cost: There are three types of cost falls under short

run total cost, which are as follows:

i. Short-Run Total Fixed Cost (STFC)

ii. Short-Run Total Variable Cost (STVC)

iii. Short-Run Total Cost (STC)


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i. Short-Run Total Fixed Cost (STFC): The total amount of price or money value paid

to the fixed factors in the process of productionin a short period is known as total fixed cost.

Total fixed cost remains constant/unchanged,

whatever be level of output.

To derive the TFC curve let us take help

following table:Quantity of Output (Q) TFC in Rs.

0 451 45

2 45

3 45

4 45

5 45


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In the above table total cost is Rs. 45 when

output is zero and the in output increase being

1, 2, 3, 4, 5 units but total fixed cost remains

unchanged i.e. Rs.45. By using above

information we can derive short run total fixed

cost curve as follows:

Graphically, TFC

OUTPUT

STFC

1 2 3O

45


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TVC curve is inverse S-shaped from origin, which

due to operation of law of variable proportion.

It can be represent with the help of followingtable:

Short Run Variable CostQuantity of Output Total Variable Cost (TVC) in Rs.

0 0

1 35

2 45

3 50

4 53

5 55

6 65

7 80


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In the above table when output is zero total variable

cost is also zero. When output level increases variable

cost also increases. In the table, variable cost is equal

to Rs. 35 when only 1 unit of output is produced andthey rise to Rs.80 when 7 units of output are produced.

Graphically,

0

10

20

30

40

50

60

70

80

90

0 1 2 3 4 5 6 7 8

Total Variable Cost (TVC) in Rs.

Total Variable Cost (TVC) in Rs.

TVC

Output

TVC Curve


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In the above figure, along x-axis we plot level of

output and along y-axis we plot TVC. Total variable

cost is represented by TVC curve. It start from

origin and increasing upward from left to right.

TVC curve seems like inverse S.

iii. Total Cost (TC): Total Cost is the sum of total fixed cost and total

variable cost at each level of output or production.

i.e. TC= TFC + TVC

At zero level of output, TC is equal to the firms

TFC. Then for each unit of output TC varies by

same amounts as varies in the variable cost.


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Short run total cost can be represent by following table:

Short Run Total Cost

Quantity of Output TFC TVC TC

0 45 0 45

1 45 35 80

2 45 45 90

3 45 50 95

4 45 53 98

5 45 55 100

6 45 65 110

7 45 80 125

8 45 100 145


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In the above table, TC increase at the same

direction of the increase in TVC because total

cost is the sum of TFC and TVC.

From above table we can derive the short run

total cost curve, which is shown below:

0

20

40

60

80

100

120

140

160

0 1 2 3 4 5 6 7 8 9

TFC

TVC

TC

Cost

Output

TC

TVC

TFC


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In the above figure, we plot output along x-

axis and we plot cost along y-axis. Where

we clearly see that TC is same shaped as ofTVC. TC curve starts above the origin

because of TFC. Inverse S-shaped TC

signifies that TC curve is explained by thelaw of diminishing returns in production.

Question:1. Define and draw TFC, TVC and TC curves.

2. Define fixed cost and variable cost with

the example.


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SHORT RUN PER UNIT COSTS There are four types of short run per unit costs,

which are as follows:

1. Short Run Average Fixed Cost (SAFC): Average Fixed Cost (AFC) is the per unit fixed

cost of production. AFC at each level of

production can be obtained by dividing the TFC

by corresponding level of output (Q).

i.e. AFC = TFC/Q

Total fixed cost is independent of output, so AFC

declines as long as production increases but

never became zero. In graphical representation

AFC curve is rectangular hyperbolic.


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To derive AFC curve, let us take help of following table:

Average Fixed CostQuantity of Output (Q) TFC AFC

0 45 -

1 45 45

2 45 22.5

3 45 15

4 45 11.2

5 45 9

6 45 7.5

7 45 6.4


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In the above table, as increase in output TFC

remains same but AFC decreases continuously

as increase in output but never be zero.

Graphically,AFC/TFC

OUTPUT

TFC

AFC

0

5

10

15

20

25

30

35

40

45

50

0 1 2 3 4 5 6 7 8

TFC 45

AFC 0

f


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In the above figure, along x-axis we plot output

and along y-axis we plot AFC and TFC. As

increase in output AFC continuously falls

downward from left to the right but never

touches both axis.

Which means, at very low level of output AFC is

very high but it declines continuously as

production increases but remains positive.

2. Short Run Average Variable Cost (SAVC): Average variable cost (AVC) is the per unit

variable cost of production.

It is calculated by dividing total variable cost

(TVC) by the corresponding level of output.

I i i ll AVC d d i h


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Initially AVC decreases and it reaches to

minimum point and finally it increases. hence,, it

is U shaped.

AVC curve can be derived with the help of

following table:

Average Variable CostQuantity of Output (Q) TVC AVC

0 0 -

1 35 35

2 60 30

3 75 25

4 80 205 90 18

6 105 17.5

7 130 18.6

8 180 22.5

9 250 27.810 340 34


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G hi l d i ti f AVC


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Graphical derivation of AVC curve:

TVC

OUTPUT

0

50

100

150

200

250

300

350

400

0 2 4 6 8 10 12

TVC

TVC

0

5

10

15

20

25

30

35

40

0 2 4 6 8 10 12

AVC

AVC -

OUTPUT

AVC

I th b fig l g i l t t t d


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In the above figure, along x-axis we plot output and

along y-axis we plot cost. In the figure initially

average cost falls downward from left to right it

reaches to minimum point and finally it starts torise upward from left to right.

Initially average variable cost is declining due to the

operation of law of increasing returns and AC goes

on decreasing due to operation of law of decreasingreturns.

Due to this reason AVC curve is U shaped as shown

in the figure above.

3. Short Run Average Cost (AC): Average cost is the per-unit cost of production. It is

obtained by dividing total cost of production by total

output produced.


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Short Run Average CostQuantity of Output TC AC

0 45 -

1 80 80

2 90 45

3 95 31.67

4 98 24.5

5 100 20

6 120 20

7 150 21.438 180 22.5

9 210 23.3

In the above table initially average cost is


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In the above table, initially average cost is

decreasing it reaches to its minimum point,

that is at 5th unit of output AC is minimum

and at 6thunit of output AC remains constant

and finally starts to increase that is after 8th

unit of output AC goes on increasing.

Initially average cost is declining due to the

operation of law of increasing returns and AC

goes on decreasing due to operation of law ofdecreasing returns. Due to this reason AC

curve is U shaped as shown in the figure

below.

250cost


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In the above figure initially AC curve declines, itreaches to a minimum point and subsequently

rises again. Thus AC curve is U-Shaped. Which is

shown by SAC CURVE in above figure.

0

50

100

150

200

0 1 2 3 4 5 6 7 8 9 10

TC 45

AC

cost

STC CURVE

output

SAC CURVE


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300TVC

ost


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0

50

100

150

200

250

3

0 1 2 3 4 5 6 7 8 9 10

TVC

TVC

0

5

10

15

20

25

30

35

40

0 1 2 3 4 5 6 7 8 9 10

AVC -

AVC -

Output

TC

Output

Margina

lCost

MC

y urve s - ape


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We clearly observe that AFC curve's shape is

rectangular hyperbola, AVC and AC curve's shape is U.

The main reasons behind U-shaped AC curve is asfollows:

1. Due to Operation of Law of Variable Proportion:

Due to the operation of law of variable proportion AVC

and AC curves are U shaped.

According to this law when output increases at

increasing rate at that time cost will increases at

decreasing rate, when total product is maximum atthat time cost will be minimum and when total product

starts to decline at that time at that time cost will

increases at increasing rate. Thus, AC curve is U

shaped.


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3. Economies and Diseconomies of Scale:


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Due to the economies in production average cost

declines it reaches its minimum point and finally due

to the diseconomies in production average costincreases and hence, AC curve is U shaped.

Economies in production refers to the increase in

efficiency of technology, efficiency of labor, managerial

efficiency, market efficiency and etc.

Initially, efficiency of technology, efficiency of labor,

managerial efficiency, market efficiency and etc.

increases due to which cost declines as a result ACcurves slopes down it reaches to its minimum point,

beyond the minimum point efficiency starts to decline

as a result cost starts to increase and hence, AC curve

is U shaped.


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3 When AC starts to increase MC increases faster


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3. When AC starts to increase, MC increases faster

than that of AC.

4. MC cuts AC from below at its minimum point.

5. Both AC and MC shows similar characteristics

i.e. both are initially declines reaches to minimum

points and finally starts to increase. That means

both curve has similar shape, i.e. U Shape.

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Cost & Cost Curves