1. THEORY OF COSTS
Short Run

2. Decision making in different time
periods
 Short run for the firms and very short run for
the industry.
 Long run for the firms and short run for the
industry.
 Very long run for the firms and long run for the
industry.

3. Theory of costs
• Costs of a firm is incurred to establish the
production unit and to purchase different
factors of production.
• Cost of a firm (TC) is classified into two
broad categories - Fixed cost (TFC) and
Variable cost (TVC).
i.e. TC = TFC + TVC
• However, nothing is fixed in the long run.

4. Theory of costs
Fixed costs
Fixed costs are expenses that does not
change in proportion to the activity of a
business.
Fixed costs include overheads (rent,
insurance-premium, interests), and also
direct costs such as payroll (particularly
salaries).

5. Theory of costs
Fixed cost does not change with the
volume of production.
costs
100
TFC
O
Q

6. Theory of costs
Variable costs
Variable costs change in direct
proportion to the activity of a business
such as sales or production volume. In
retail, the cost of goods is almost entirely
variable. In manufacturing, direct material
costs, wages, fuel costs are examples of
variable costs.

7. Theory of costs
For example, a manufacturing firm pays for
raw materials. When activity is decreased,
less raw material is used, and so the
spending for raw materials falls. When
activity is increased, more raw material is
used and spending therefore rises.
Although tax usually varies with profit, which
in turn varies with sales volume, it is not
normally considered a variable cost.

8. Total costs for firm X
Output TFC
(Q)
(£)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
40
20
TFC
0
0
1
2
3
4
fig
5
6
7
8

9. Total costs for firm X
Output TFC TVC
(Q)
(£)
(£)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
0
10
16
21
28
40
60
91
40
20
TFC
0
0
1
2
3
4
fig
5
6
7
8

10. Total costs for firm X
Output TFC TVC
(Q)
(£)
(£)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
0
10
16
21
28
40
60
91
TVC
40
20
TFC
0
0
1
2
3
4
fig
5
6
7
8

11. Total costs for firm X
100
TVC
80
Diminishing marginal
returns set in here
60
40
20
TFC
0
0
1
2
3
4
fig
5
6
7
8

12. Total costs for firm X
Output TFC TVC
(Q)
(£)
(£)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
0
10
16
21
28
40
60
91
TVC
40
20
TFC
0
0
1
2
3
4
fig
5
6
7
8

13. Output TFC TVC
(Q)
(£)
(£)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
Total costs for firm X
TC
(£)
0
10
16
21
28
40
60
91
12
22
28
33
40
52
72
103
TVC
40
20
TFC
0
0
1
2
3
4
fig
5
6
7
8

14. Output TFC TVC
(Q)
(£)
(£)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
Total costs for firm X
TC
(£)
0
10
16
21
28
40
60
91
TC
12
22
28
33
40
52
72
103
TVC
40
20
TFC
0
0
1
2
3
4
fig
5
6
7
8

15. Total costs for firm X
TC
100
TVC
80
Diminishing marginal
returns set in here
60
40
20
TFC
0
0
1
2
3
4
fig
5
6
7
8

16. Average fixed cost
Average fixed cost (AFC) = TFC/Q
where TFC = fixed cost, Q = total number of
units produced.
Unit fixed costs decline along with volume,
following a rectangular hyperbola. As a
result, the total unit cost of a product will
decline as volume increases.

17. Average Fixed costs
Costs
AFC
O
Q

18. Average variable cost
Average variable cost (AVC) is the TVC of a firm
divided by the total units of output (Q).
AVC = TVC/Q
costs
AVC
Y
O
Q

19. Average cost
Average cost (AC) is the TC of a firm divided by
the total units of output (Q).
AC = TC/Q = AFC + AVC
costs
AC
Z
O
Q

20. Marginal Cost
The additional cost incurred to produce one
additional unit of output is called the
Marginal Cost (MC).
MC = dC/dQ

21. MC
The marginal cost curve is U-shaped.
Marginal cost is relatively high at small
quantities of output - then as production
increases, it declines - then reaches a
minimum value - then rises.
This shape of the marginal cost curve is
directly attributable to increasing, then
decreasing marginal returns (the law of
diminishing marginal returns).

22. Marginal costs
Costs (£)
MC
Diminishing marginal
returns set in here
x
Outputfig
(Q)

23. Numerical Example
Q
TFC
TVC
TC
AFC
0
100
0
100
1
100
20
120
100
2
100
37
137
50
3
100
52
152
33.33
4
100
80
180
25
5
100
120
220
20
6
100
165
265
16.67
AVC
AC
MC
20
120
20
18.5
68.5
17
17.33 50.67
15
20
45
28
24
44
40
27.5
44.17
45

24. Average and marginal costs
MC
AC
Costs (£)
AVC
z
y
x
AFC
Outputfig
(Q)

25. LONG RUN

26. Long run cost curves
The Long run average cost (LRAC or LAC)
curve illustrates - for a given quantity of
production - the average cost per unit
which a firm faces in the long run (i.e.
when no factors of production is fixed).

27. LRAC
LRAC curve is derived from a series of short
run average cost curves.
It is also called the ‘Envelope curve' since it
envelops all the short run average cost
curve.
The curve is created as an envelope of an
infinite number of short-run average total
cost curves.

28. LAC
The LRAC curve is U-shaped, reflecting
economies of scale when it is negativelysloped and diseconomies of scale when it
is positively sloped.
In perfect competition, the LRAC curve is
flat at the point of equilibrium – in this
stage the firm is enjoying constant returns
to scale.

29. LAC
In some industries, the LRAC is L-shaped,
and economies of scale increase
indefinitely. This means that the largest
firm tends to have a cost advantage, and
the industry tends naturally to become a
monopoly, and hence is called a natural
monopoly. Natural monopolies tend to
exist in industries with high capital costs in
relation to variable costs, such as water
supply and electricity supply.

30. Costs
Long-run average cost curves
Economies of Scale
LRAC
O
Output
fig

31. long-run average cost curves
Costs
Diseconomies of Scale
O
Output
fig
LRAC

32. Costs
long-run average cost curves
O
Constant costs
LRAC
Output
fig

33. Long-run Costs
• Long-run average costs
– assumptions behind the curve
• factor prices are give
• state of technology and factor quality are given
• firms choose least-cost combination of factors

34. A typical long-run average cost curve
Costs
LRAC
O
Output
fig

35. Costs
A typical long-run average cost curve
O
Economies
of scale
Constant
costs
Output
fig
Diseconomies
of scale
LRAC

36. Long-run Costs
• Long-run average costs
– assumptions behind the curve
• factor prices are give
• state of technology and factor quality are given
• firms choose least-cost combination of factors
– shape of the LRAC curve
– a typical LRAC curve
– long-run average and marginal cost curves

37. Costs
Long-run average and marginal costs
Economies of Scale
LRAC
LRMC
O
Output
fig

38. Long-run average and marginal costs
Costs
LRMC
O
Diseconomies of Scale
Output
fig
LRAC

39. Costs
Long-run average and marginal costs
O
Constant costs
LRAC = LRMC
Output
fig

40. Long-run average and marginal costs
Initial economies of scale,
then diseconomies of scale
LRAC
Costs
O
LRMC
Output
fig

41. Long-run Costs
• Long-run average costs
– assumptions behind the curve
• factor prices are given.
• state of technology and factor quality are
given.
• firms choose least-cost combination of
factors.

42. Envelope Curve
The envelope curve is based on the point of
each short-run ATC curve that provides
the lowest possible average cost for each
quantity of output.

43. Deriving long-run average cost curves: plants of fixed size
SRAC1 SRAC
2
SRAC3
Costs
1 factory
2 factories
O
SRAC5
SRAC4
5 factories
3 factories
Output
fig
4 factories

44. Deriving long-run average cost curves: factories of fixed size
SRAC1 SRAC
2
SRAC3
SRAC5
SRAC4
Costs
LRAC
O
Output
fig

45. Costs
Deriving a long-run average cost curve: choice of factory size
Examples of short-run
average cost curves
O
Output
fig

46. Deriving a long-run average cost curve: choice of factory size
Costs
LRAC
O
Output
fig