CONCEPT OF COST

AND
TRADITIONAL AND
MODERN THEORY OF COST
 WHAT IS COST?
• Cost, in the context of economics, refers to the value
of resources, both monetary and non-monetary, that
must be sacrificed or expended to achieve a specific
objective or produce a particular good or service.
Costs represent the expenses and investments incurred
by individuals, firms, or organizations in the process
of producing goods and services.
 CONCEPTS OF COST
• Explicit Costs:
Explicit costs, also known as accounting costs, are the actual out-of-pocket expenses incurred
by a business in its day-to-day operations. These costs are easily measurable and typically
include items like wages, rent, materials, and utilities.

• Implicit Costs:
Implicit costs are the opportunity costs associated with using resources that a business already
owns or employs in its operations. They represent the value of resources that could have been
used elsewhere but are instead used internally. Common examples include the owner's time
and the foregone interest on invested capital.
• Money Cost:
Money cost, also known as nominal cost, refers to the cost of an economic resource or good measured
in terms of the currency or money paid for it. It represents the actual financial outlay or expenditure
incurred in acquiring a resource or purchasing a product.
Money costs are denominated in a specific currency (e.g., dollars, euros) and are directly associated
with financial transactions.

• Real Cost:
Real cost refers to the total value of resources, both monetary and non-monetary, that are expended or
used in a particular decision or action.
It encompasses all tangible and intangible costs, including money spent, time invested, and the value of
resources that could have been used elsewhere.

• Opportunity Cost:
Opportunity cost is a specific type of real cost that represents the value of the next best alternative that
is foregone when a decision is made or a resource is used for a particular purpose.
• Economic Cost:
Economic cost refers to the total cost incurred by a firm or society when making a decision or
taking an action.
It includes both explicit (monetary) costs and implicit (opportunity) costs and is used to assess
the financial impact of choices.

• Social Cost:
Social cost goes beyond economic cost and includes all the costs incurred by society as a
whole, including externalities.
It encompasses not only the direct financial expenses but also the broader societal impacts,
such as environmental, health, and social consequences, resulting from a decision or action.
• Direct Cost:
Direct costs are expenses that can be traced directly and exclusively to a specific project,
department, or activity.
Example: The cost of materials used to manufacture a particular product is a direct cost because
it directly relates to that product's production.

• Indirect Cost:
Indirect costs are expenses that cannot be traced directly to a specific project or product and are
incurred to support overall business operations.
Example: Rent for a factory building is an indirect cost because it benefits the entire production
process, not just one specific product.
Incremental Cost:
• Incremental costs, also known as marginal costs, represent the additional cost
incurred by producing one more unit of a product or service.
Example: If a bakery produces 100 loaves of bread and decides to produce one
more, the cost of producing that one additional loaf is the incremental cost.

• Sunk Cost:
Sunk costs are expenditures that have already been made and cannot be recovered
or changed, regardless of future decisions.
Example: If a company spent $50,000 on research for a project that was later
cancelled, the $50,000 is a sunk cost because it cannot be recovered and should
not influence future decisions about the project.
 TRADITIONAL THEORY OF COST
• Traditional theory distinguishes between the short run and the long run. The short run is the
period during which some factors) is fixed; usually capital equipment and entrepreneurship
are considered as fixed in the short run.

• The long run is the period over which all factors become variable.
 SHORT-RUN COSTS OF THE
TRADITIONAL THEORY:
• In the traditional theory of the firm total costs are split into two groups total fixed costs and total variable costs:
• Total Cost (TC):
Total cost is the overall cost incurred by a firm in producing a specific quantity of goods or providing a service.
It includes both fixed costs and variable costs, representing the total economic expenditure.

• Total Fixed Cost (TFC):

Total fixed cost refers to the sum of all costs that do not change with variations in the level of production.
These costs remain constant in the short run, regardless of how much a firm produces.

• Total Variable Cost (TVC):

Total variable cost is the sum of all costs that change in direct proportion to changes in the level of production.
As production increases, total variable costs rise, and they decrease as production decreases.
• Average cost (AC) is the total cost incurred by a firm divided by the quantity of goods or services produced. It represents the cost
per unit of output and is calculated as:
Average Cost (AC) = Total Cost / Quantity Produced

• Average Fixed Cost (AFC):

Average Fixed Cost (AFC) is the total fixed cost incurred by a firm divided by the quantity of goods or services produced.
AFC represents the fixed cost per unit of output and typically decreases as production levels increase since fixed costs are spread over
a larger quantity.

• Average Variable Cost (AVC):

Average Variable Cost (AVC) is the total variable cost incurred by a firm divided by the quantity of goods or services produced.
AVC represents the variable cost per unit of output and typically exhibits a U-shaped relationship with production levels, initially
decreasing due to economies of scale and then increasing due to diminishing marginal returns.

• Marginal Cost (MC):

Marginal cost (MC) is the additional cost incurred by producing one more unit of a good or service.
It helps firms determine the optimal level of production and pricing by comparing the MC to the selling price, aiming to maximize
profit.
MC is calculated as the change in total cost divided by the change in quantity produced.
 WHY IS AC CURVE U SHAPED?

• (i) On the Basis of AFC and AVC In the short run, since AC = AFC + AVC. Therefore, the
behaviour of AC curve directly depends upon the behaviour Of AFC and AVC crores. AC
curve is obtained by adding AFC and AVC curves and as a result AC curve gets U - shape.
(ii) On the Basis of the Law of Variable Proportions The U -shape of average cost curve
can also be expalined through the law of variable proportions. In the beginning with increase
in output, average cost falls because of the operation of the law of increasing returns. After
reaching the minimum point, when we increase the output, average cost starts increasing
because of the operation of the law of diminishing returns. Thus due to the law of variable
proportions, the AC curve takes U -shape.
 WHY IS MC CURVE U SHAPED ?
• The marginal cost curve is U-shaped in the short-run due to the operation of the "law of
variable proportions". According to the law, MC curve initially slopes downward till it
reaches its minimum point and thereafter, it starts rising. Therefore, it leads to U-shape of
the curve when presented graphically.
 RELATIONSHIP BETWEEN AC AND
1) When AC Falls, MC is Lower than AC:
MC
When average cost falls, marginal cost is less than AC. In Table 8, AC is falling till it
becomes Rs.8, and MC remains less than Rs.8. In Fig. 9, AC is falling till point E,
and MC continues to be lower than AC. In this case, marginal cost falls more rapidly
than the average cost. That is why when marginal cost (MC) curve is falling, it is
below the average cost (AC) curve. It is shown in Fig. 9.

(2) When AC Rises, MC is Greater than AC

When average cost starts rising, marginal cost is greater than average cost. In Table 8,
when AC rises from Rs.8 to Rs.9, MC rises from Rs.8 to Rs.16. In Fig. 9, AC starts
rising from point E. And, beyond E, MC is higher than AC.

(3) When AC does not Change, MC is Equal to AC:

When average cost does not change, then MC = AC. It happens when falling AC
reaches its lowest point. In Table 8, at the 7th unit, average cost does not change. It
sticks to its minimum level of Rs.8. Here, marginal cost is also Rs.8. Thus, Fig. 9
shows that MC curve is intersecting AC curve at its minimum point E.
 RELATIONSHIP BETWEEN
DIFFERENT COST CURVES IN
SHORT PERIOD
AFC is declining with rise in output and the marginal
cost curve intersects both the average variable cost
curve and (short-run) average total cost curve at their
minimum points. When the marginal cost curve is
above an average cost curve the average curve is
rising. When the marginal costs curve is below an
average curve the average curve is falling.
 LONG RUN COST CURVES OF
TRADITIONAL THEORY
• The Long-run Average cost curve or the LAC curve is the locus of points denoting the least
cost of producing different levels of output in the long run. It shows the minimum average
costs of producing the corresponding output in the long-run.
• Given the technology, the firm is free to choose the plant size which entails the least cost.
For example, if the firm decides to produce OQ1 level of output, then it will choose the plant
size SAC2 and not SAC1.
• If the demand for the firm’s output increases to OQ3, then the average costs start increasing
along the plant SAC2, and the firm decides to set up a larger plant size SAC3, to minimize
its average costs of production in the long-run.
• The long-run average curve does not touch the short-run
average cost curves on their minimum points. Graphically it
can touch the minimum points of SACs only under constant
returns to scale. In the phase of increasing returns to scale and
decreasing cost, the LAC curve touches the SAC curves to the
left of the minimum points of the SAC curves, and in the
phase of diminishing returns, it touches the SAC curves to the
right of their lowest point.
• The LAC is, therefore, not the locus of the lowest points of
SAC curves. The downward-sloping portion of LAC
comprises of only increasing returns and diminishing cost
portions of SAC curves.
• The LAC curve is also known as the ‘Envelope curve’ as it
envelops the short-run cost curves.
 LONG TERM MARGINAL COST
CURVE OF TRADITIONAL
THEORY
• Long run marginal cost is defined at the additional
cost of producing an extra unit of the output in the
long-run i.e. when all inputs are variable. The LMC
curve is derived by the points of tangency between
LAC and SAC.
• Note an important relation between LMC and SAC
here. When LMC lies below LAC, LAC is falling,
while when LMC is above LAC, LAC is rising. At
the point where LMC = LAC, LAC is constant and
minimum.
 MODERN THEORY OF COST CURVES
• Modern economists including Stigler, Andrews and Friedman have questioned the validity
of U-shaped cost curves both theoretical as well as on empirical grounds. Also the long run
costs in modern theory are not U- shaped but L- shaped. The Modern theory suggests the
existence of „built- in- reserve capacity „which imparts flexibility and enables the plant to
produce larger output without adding to the costs. Built –in- reserve capacity are planned by
firms.
 SHORT TERM AFC OF MODERN THEORY

The plant always have some reserve

capacity and if needed a firm by
making use of this reserve capacity
can produce more at less cost.
SHORT TERM AVC CURVE OF MODERN THEORY

• In modern theory, Average variable cost is not U shaped

rather it is saucer shaped and has a flat stretch over a
range of output. This flat stretch represents the „built in
reserve capacity‟ of the firm to meet seasonal and cyclical
changes in the demand. The average variable cost curve is
as follows:
 SHORT TERM AC CURVE MODERN THEORY
• The short-run Average costs consist of the Average fixed costs and Average variable costs.
The short-run average variable cost curve at each level of output. The smooth and
continuous fall in the average cost curve is due to the fact that the AFC curve is a rectangular
hyperbola and the AVC curve first falls and then becomes horizontal within the range of
reserve capacity. This is reserved capacitz output. Beyond that it starts rising steeply. The
curve of average cost is as follows:
SHORT TERM MC CURVE OF MODERN THEORY

• .
LONG RUN AVERAGE COST CURVE
LONG RUN MARGINAL COST CURVE
THANK YOU

BY : SIMRAN PARMAR
UID 23IMH10002

KANISHKA CHAUHAN
UID 23MBS10015