Cost Concepts

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Information about Cost Concepts

Published on July 15, 2009

Author: melamoon



detailed explanation of cost concepts in micro economics....

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  MC is generally declining at a increasing. decreasing rate.  MC crosses ATC and  ATC and AVC decline AVC at their minimum at first, reach a point. minimum, then  If MC is below the average increase at higher value: levels of output.  Average value will be  The difference decreasing. between ATC and AVC  If MC is above the average value: is equal to AFC.  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 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…

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