L11 PGP IIMS 2026 COST (2)

COST ANALYSIS L - 11 PGP.

CASE M S . R UCHIRA WAS OPENING A NEW OXYGEN PLANT LOOKING AT THE BUSINESS OPPORTUNITY AND THE SOCIAL REQUIREMENT . S HE HAD APPROACHED A COMPANY MANUFACTURING MACHINE FOR OXYGEN AND THE PRICE QUOTED BY THE FIRM WAS INR 2 CRORES . H ER BANK APPROVED HER LOAN FOR THE SAID AMOUNT . S UDDENLY WHILE SURFING THE NET FOR BUSINESS OPPORTUNITIES TO LEARN MORE ABOUT OXYGEN PLANTS , SHE CAME ACROSS ANOTHER FIRM FROM NEW DELHI WHICH IS MANUFACTURING AND SUPPLYING OXYGEN MAKING MACHINES . S HE SPOKE TO HER OTHER BUSINESS PARTNERS AND THEY DECIDED TO CONTACT THE NEW VENDOR . S HE VISITED THEIR WEBSITE BUT WAS NOT ABLE TO GET MUCH INFORMATION FROM THERE . S HE THEN CALLED AT THE NUMBER THAT WAS GIVEN IN THE WEBSITE . S HE SPOKE TO S OVAN WHO INFORMED HER THAT IT WAS HIS FATHER WHO CARRIED OUT THE DEALING PART . O N CONTACTING THEY FOUND OUT THAT THIS FIRM WAS SUPPLYING THE SAME MACHINE FOR RUPEES 1 , 00 , 00 , 000 . I NITIALLY THE PARTNERS WERE SURPRISED ABOUT THE VALIDITY OF THIS NEW FIRM AS THERE WAS A 50 % REDUCTION IN THE COST . T HEY THEN DECIDED TO CONTACT THE FIRM IN PERSON AND WENT TO NEW DELHI TO HAVE A LOOK AT THEIR OFFICE . O N VISITING THE SITE THEY FOUND OUT THAT THIS NEW FIRM WAS ASSEMBLING THE PARTS AND ONE OF THE PARTS WAS BEING IMPORTED FROM GERMANY . H OWEVER , AS THEY WERE BUYING THINGS IN BULK QUANTITY AND THEY HAD A HIGHER SALES TURNOVER THAN THE PREVIOUS VENDOR THEY WERE ABLE TO CUT COSTS ..

ACCOUNTING COSTS THE ACCOUNTING SECTION OF AN ORGANIZATION ONLY TAKES INTO ACCOUNT THAT COST THOSE COSTS WHICH CAN BE MEASURED IN TERMS OF MONEY THEY ARE ALSO KNOWN AS NOMINAL COSTS A FEW EXAMPLES OF THESE COSTS ARE THE WAGES AND SALARIES PAID RENT PAID ADVERTISING EXPENSES SELLING EXPENSES , INTEREST ON LOANS , STATIONARY CHARGES , TELEPHONE CHARGES , ETC . ANOTHER NAMES GIVEN FOR THESE TYPE OF COURSE IS EXPLICIT COSTS WHICH MEANS THAT THESE COSTS ARE TANGIBLE AND THE ORGANIZATION IS AWARE OF THEM . T HESE COSTS ARE RECORDED IN THE BOOKS OF ACCOUNTS ..

REAL COST THE REAL COSTS ARE MUCH WIDER IN SCOPE AND COVER ALL THE ASPECTS REGARDING COSTS FOR THE PRODUCTION OF A UNIT OF THE PRODUCT IT ALSO INCLUDES THE NON MONETARY COSTS ALL THE PSYCHOLOGICAL COSTS WHICH ACCRUE TO A FIRM . FOR EXAMPLE , IF A NEW START - UP IS BEING ORGANIZED THE OWNERS SACRIFICES ON HIS TIME WITH HIS FAMILY HIS FRIENDS , USES HIS OWN RESOURCES . T HESE SACRIFICES CANNOT BE MEASURED IN TERMS OF MONEY BUT THEY ARE COST TO THE PRODUCTION . T HEY ARE KNOWN AS REAL COSTS . HOWEVER , AS PER THE ACCOUNTING PRINCIPLES IT DOES NOT QUALIFY AS COST BECAUSE THERE IS NO FLOW OF CASH IN THESE TRANSACTIONS AND THEREFORE , THEY DO NOT BECOME A PART OF THE BOOK OF ACCOUNTS . IN MODERN TIME THE REAL COSTS HAVE BECOME VERY SIGNIFICANT . T HE REAL COST OF PRODUCTION OF A COMMODITY REFERS TO THE EXERTION OF LABOUR , SACRIFICE INVOLVED IN THE ABSTINENCE FROM PRESENT CONSUMPTION BY THE SAVERS TO SUPPLY CAPITAL , AND SOCIAL EFFECTS OF POLLUTION , CONGESTION , AND ENVIRONMENTAL DISTORTIONS.

MARSHALL (1920) I N A MUCH PHILOSOPHICAL WAY MARSHALL HAD DESCRIBED “ REAL COST ” AS FOLLOWS : “T HE PRODUCTION OF A COMMODITY GENERALLY REQUIRES MANY DIFFERENT KINDS OF LABOUR AND THE USE OF CAPITAL IN MANY FORMS . T HE EXERTIONS OF ALL THE DIFFERENT KINDS OF LABOUR THAT ARE DIRECTLY OR INDIRECTLY INVOLVED IN MAKING IT TOGETHER WITH THE ABSTINENCES OR RATHER THE WAITING REQUIRED FOR SAVING THE CAPITAL USED IN MAKING IT — ALL THESE EFFORTS AND SACRIFICES TOGETHER WILL BE CALLED THE REAL COST OF PRODUCTION OF COMMODITY .” A CCORDING TO M ARSHALL , THUS , THE REAL COST OF PRODUCTION SIGNIFIES TOILS , TROUBLES , SACRIFICE ON ACCOUNT OF LOSS OF CONSUMPTION FOR SAVINGS , SOCIAL EFFECTS OF POLLUTION CAUSED BY FACTORY SMOKE , AUTOMOBILES , ETC . E VIDENTLY , THE CONCEPT OF REAL COST IS AN ABSTRACT IDEA . I TS EXACT MEASUREMENT IS NOT POSSIBLE ..

OPPORTUNITY COST • ONE OF THE MOST IMPORTANT CONCEPTS OF ECONOMICS AND A LOT OF MICRO ECONOMIC CONCEPTS ARE BASED ON OPPORTUNITY COST THIS IS THE COST OF THE NEXT BEST ALTERNATIVE AVAILABLE TO A PRODUCER OR A PERSON . • F OR EXAMPLE , IF AN INDIVIDUAL HAS ₹ 10000 IT HAS ALTERNATIVE USERS LIKE BUYING A KINDLE , SAVING THE MONEY , INVESTING IT INTO EQUITY OR STARRING THE CASH IN HAND ..

EXAMPLES • D ETERMINATION OF R ELATIVE P RICES OF G OODS . F OR INSTANCE , IF THE SAME GROUP OF FACTORS CAN PRODUCE EITHER ONE CAR OR SIX SCOOTERS , THEN THE PRICE OF ONE CAR WILL TEND TO BE AT LEAST SIX TIMES MORE THAN THAT OF ONE SCOOTER . S UPPOSE , OPPORTUNITY COST OF 1 MOTOR CAR IS 6 SCOOTERS . T HE PRICE OF SCOOTER IS R S . 30 , 000 , WHILE THE PRICE OF CAR IS R S . 2 , 00 , 000 . • I N THIS CASE , IT IS WORTHWHILE TO PRODUCE CARS RATHER THAN SCOOTERS . B ECAUSE , IF HE PRODUCES 6 SCOOTERS , HE WILL GET ONLY R S . 1 , 80 , 000 , WHEREAS A CAR FETCHES HIM R S . 2 , 00 , 000 , THAT IS , R S . 20 , 000 MORE . T HIS WOULD ALSO MEAN AN EFFICIENT RESOURCE ALLOCATION.

DECISION - MAKING AND EFFICIENT RESOURCE ALLOCATION D ETERMINATION OF N ORMAL R EMUNERATION TO A F ACTOR . T HE OPPORTUNITY COST SETS THE VALUE OF A PRODUCTIVE FACTOR FOR ITS BEST ALTERNATIVE USE . I T IMPLIES THAT IF A PRODUCTIVE FACTOR IS TO BE RETAINED IN ITS NEXT BEST ALTERNATIVE USE , IT MUST BE COMPENSATED FOR OR PAID AT LEAST WHAT IT CAN EARN FROM ITS NEXT BEST ALTERNATIVE USE . A FACTOR AGENT OR OWNER WILL DECIDE ABOUT THE USE OF THE ECONOMIC RESOURCES IN THAT OCCUPATION WHERE ITS OPPORTUNITY COST IS HIGH . IF AN E CONOMICS P ROFESSOR CAN GET A JOB IN A BANK AS AN ECONOMIST ON A MONTHLY SALARY OF R S . 2 , 00 , 000 AGAINST R S . 1 , 20 , 000 IN A COLLEGE , THEN IT IS QUITE LIKELY THAT HE WOULD RESIGN FROM THE COLLEGE AND JOIN THE BANK . I T WOULD ALSO MEAN A MORE EFFICIENT USE OF HIS KNOWLEDGE AND TALENT . I T FOLLOWS THAT A RESOURCE WILL ALWAYS TEND TO MOVE OR WILL BE USED IN AN OCCUPATION WHERE IT HAS A HIGH OPPORTUNITY COST . T HUS , THE CONCEPT OF OPPORTUNITY COST SERVES AS A USEFUL ECONOMIC TOOL IN ANALYSING OPTIMUM RESOURCE ALLOCATION AND RATIONAL DECISION - MAKING ..

EXPLICIT COSTS E XPLICIT COSTS REFER TO THE ACTUAL MONEY OUTLAY OR OUT OF POCKET EXPENDITURE OF THE FIRM TO BUY OR HIRE THE PRODUCTIVE RESOURCES IT NEEDS IN THE PROCESS OF PRODUCTION . I T IS REFERRED TO AS OUT - OF - POCKET COSTS . T HE FOLLOWING ITEMS OF A FIRM ’ S EXPENDITURE ARE EXPLICIT MONEY COSTS : C OSTS OF RAW MATERIALS ; W AGES AND SALARIES P OWER CHARGES R ENT OF BUSINESS OR FACTORY PREMISES I NTEREST PAYMENTS OF CAPITAL INVESTED I NSURANCE PREMIUMS T AXES LIKE PROPERTY TAX , DUTIES , LICENSE FEES , ETC . M ISCELLANEOUS BUSINESS EXPENSES LIKE MARKETING AND ADVERTISING EXPENSES ( SELLING COSTS ) TRANSPORT COST , ETC . T HE ABOVE LIST OF ITEMS INCLUDED IN MONEY COST IS AN EXPLICIT PAYMENT MADE BY THE FIRM . T HESE ARE RECORDED EXPENDITURES DURING THE PROCESS OF PRODUCTION . I T IS , THUS , KNOWN AS ACCOUNTING COST OR EXPLICIT MONEY COSTS , AS THESE ARE ACTUAL MONETARY EXPENDITURES INCURRED BY THE FIRM ..

IMPLICIT COSTS • I MPLICIT COSTS ARE THE OPPORTUNITY COSTS OF THE USE OF FACTORS WHICH A FIRM DOES NOT BUY OR HIRE BUT ALREADY OWNS . • I MPLICIT MONEY COSTS ARE IMPUTED PAYMENT WHICH ARE NOT DIRECTLY OR ACTUALLY PAID OUT BY THE FIRM AS NO CONTRACTUAL DISBURSEMENT IS FIXED FOR THEM . S UCH IMPLICIT MONEY COSTS ARISE WHEN THE FIRM OR ENTREPRENEUR SUPPLIES CERTAIN FACTORS OWNED BY HIMSELF . F OR INSTANCE , • W AGES OF LABOUR RENDERED BY THE ENTREPRENEUR HIMSELF . • I NTEREST ON CAPITAL SUPPLIED BY HIM . • R ENT OF LAND AND PREMISES BELONGING TO THE ENTREPRENEUR HIMSELF AND USED IN HIS PRODUCTION . • N ORMAL RETURNS ( PROFITS ) OF ENTREPRENEUR , A COMPENSATION NEEDED FOR HIS MANAGEMENT AND ORGANISATIONAL ACTIVITY . • IN THE ECONOMIC SENSE , REAL BUSINESS OR ECONOMIC PROFIT IS THE SURPLUS OF TOTAL REVENUE OVER TOTAL ECONOMIC COST . • E CONOMIC COST = A CCOUNTING COSTS ( OR EXPLICIT COST ) + I MPLICIT COST ..

PAST COSTS AND FUTURE COSTS P AST COSTS ARE ACTUAL COSTS INCURRED IN THE PAST AND THEY ARE ALWAYS CONTAINED IN THE INCOME STATEMENTS . T HEIR MEASUREMENT IS ESSENTIALLY A RECORD KEEPING ACTIVITY . T HESE COSTS CAN ONLY BE OBSERVED AND EVALUATED IN RETROSPECT . I F THEY ARE REGARDED AS EXCESSIVE , MANAGEMENT CAN INDULGE IN POST - MORTEM CHECKS JUST TO FIND OUT THE FACTORS RESPONSIBLE FOR THE EXCESSIVE COSTS , IF ANY , WITHOUT BEING ABLE TO DO ANYTHING ABOUT REDUCING THEM . F UTURE COSTS ARE THOSE COSTS THAT ARE LIKELY TO BE INCURRED IN FUTURE PERIODS . S INCE THE FUTURE IS UNCERTAIN , THESE COSTS HAVE TO BE ESTIMATED AND CANNOT BE EXPECTED TO BE ABSOLUTELY CORRECT FIGURES . P AST COSTS SERVE AS THE BASIS FOR PROJECTING FUTURE COSTS . I N PERIODS OF INFLATION AND DEFLATION , THE TWO COST CONCEPTS DIFFER SIGNIFICANT.

SUNK COSTS ARE EXPENDITURES THAT HAVE BEEN MADE IN THE PAST OR MUST BE PAID IN THE FUTURE AS PART OF CONTRACTUAL AGREEMENT OR PREVIOUS DECISION . F OR EXAMPLE , THE MONEY ALREADY PAID FOR MACHINERY , EQUIPMENT , INVENTORY AND FUTURE RENTAL PAYMENTS ON A WAREHOUSE THAT MUST BE PAID AS PART OF A LONG - TERM LEASE AGREEMENT ARE SUNK COSTS . I N GENERAL , SUNK COSTS ARE NOT RELEVANT TO ECONOMIC DECISIONS . F OR EXAMPLE , THE PURCHASE OF SPECIALIZED EQUIPMENT DESIGNED TO ORDER FOR A PLANT . W E ASSUME THAT THE EQUIPMENT CAN BE USED TO DO ONLY WHAT IT WAS ORIGINALLY DESIGNED FOR AND CANNOT BE CONVERTED FOR ALTERNATIVE USE . T HE EXPENDITURE ON THIS EQUIPMENT IS A SUNK COST . A LSO , BECAUSE THIS EQUIPMENT HAS NO ALTERNATIVE USE ITS OPPORTUNITY COST IS ZERO AND , HENCE , SUNK COSTS ARE NOT RELEVANT TO ECONOMIC DECISIONS . S OMETIMES THE SUNK COSTS ARE ALSO CALLED AS NON - AVOIDABLE OR NON - ESCAPABLE COSTS ..

SHORT RUN COST T HE SHORT RUN IS DEFINED AS A PERIOD IN WHICH THE SUPPLY OF AT LEAST ONE ELEMENT OF THE INPUTS CANNOT BE CHANGED . T O ILLUSTRATE , CERTAIN INPUTS LIKE MACHINERY , BUILDINGS , ETC . , CANNOT BE CHANGED BY THE FIRM WHENEVER IT SO DESIRES . I T TAKES TIME TO REPLACE , ADD OR DISMANTLE THEM . S HORT - RUN COSTS ARE THE COSTS THAT CAN VARY WITH THE DEGREE OF UTILISATION OF PLANT AND OTHER FIXED FACTORS . I N OTHER WORDS , THESE COSTS RELATE TO THE VARIATION IN OUTPUT , GIVEN PLANT CAPACITY . S HORT - RUN COSTS ARE , THEREFORE , OF TWO TYPES : FIXED COSTS AND VARIABLE COSTS . I N THE SHORT - RUN , FIXED COSTS REMAIN UNCHANGED WHILE VARIABLE COSTS FLUCTUATE WITH OUTPUT . T HE SHORT - RUN COST FUNCTION RELATES TO THE SHORT - RUN PRODUCTION FUNCTION . A SHORT - RUN PRODUCTION FUNCTION Q = F ( A , B , C , D ... N ), STATED IN GENERAL , IMPLIES TWO SETS OF INPUT COMPONENT : ( I ) FIXED INPUTS , AND ( II ) VARIABLE INPUTS . T HUS , FACTORS OF PRODUCTION EMPLOYED , IN THE SHORT RUN , ARE CLASSIFIED AS FIXED FACTORS AND VARIABLE FACTORS . F IXED FACTORS ARE UNALTERABLE . T HESE FACTORS ARE , FOR INSTANCE , MACHINERIES , FACTORY BUILDING , MANAGERIAL STAFF , ETC . , WHICH REMAIN UNCHANGED OVER A PERIOD OF TIME . V ARIABLE FACTORS ARE LABOUR , RAW MATERIALS , POWER , ETC . , THE INPUTS OR WHICH ARE VARIED TO VARY THE OUTPUT IN THE SHORT RUN . S INCE COSTS REFER TO THE PRICES PAID TO THE FACTORS OF PRODUCTION , PRICES PAID FOR FIXED FACTORS AND THOSE PAID FOR VARIABLE FACTORS ARE TERMED AS FIXED COSTS AND VARIABLE COSTS RESPECTIVELY ..

FIXED COSTS F IXED COSTS ARE THAT PART OF THE TOTAL COST OF THE FIRM WHICH DOES NOT CHANGE WITH OUTPUT . E XPENDITURES ON DEPRECIATION , RENT OF LAND AND BUILDINGS , PROPERTY TAXES , AND INTEREST PAYMENT ON BONDS ARE EXAMPLES OF FIXED COSTS . G IVEN A CAPACITY , FIXED COSTS REMAIN THE SAME IRRESPECTIVE OF ACTUAL OUTPUT . F IXED COSTS ARE THE AMOUNT SPENT BY THE FIRM ON FIXED INPUTS IN THE SHORT - RUN . F IXED COSTS ARE , THUS , THOSE COSTS WHICH REMAIN CONSTANT , IRRESPECTIVE OF THE LEVEL OF OUTPUT . T HESE COSTS REMAIN UNCHANGED EVEN IF THE OUTPUT OF THE FIRM IS NIL . F IXED COSTS , THEREFORE , ARE KNOWN AS “ SUPPLEMENTARY COSTS ” OR “ OVERHEAD COSTS .” P AYMENTS OF RENT FOR BUILDING . I NTEREST PAID ON CAPITAL . I NSURANCE PREMIUMS . D EPRECIATION AND MAINTENANCE ALLOWANCES . A DMINISTRATIVE EXPENSES — SALARIES OF MANAGERIAL AND OFFICE STAFF , ETC . P ROPERTY AND BUSINESS TAXES , LICENSE FEES , ETC . T HESE COSTS ARE OVERHEAD COSTS IN THE SENSE THAT THEY ARE TO BE INCURRED EVEN IF THE FIRM IS SHUT DOWN TEMPORARILY AND THE CURRENT PRODUCTION MAY BE NIL . F URTHER , THEY DO NOT CHANGE AS THE OUTPUT INCREASES . T HUS , FIXED COSTS ARE ALSO REFERRED TO AS “ UNAVOIDABLE CONTRACTUAL COSTS ” WHICH OCCUR EVEN IF THERE IS NO OUTPUT . I N BRIEF , THE COSTS INCURRED ON THE BUSINESS PLANT ARE CALLED FIXED COSTS ..

VARIABLE COSTS V ARIABLE COSTS ARE THOSE COSTS THAT ARE INCURRED BY THE FIRM AS A RESULT OF THE USE OF VARIABLE FACTOR INPUTS . T HEY ARE DEPENDENT UPON THE LEVEL OF OUTPU T . ON THE OTHER HAND , CHANGE WITH CHANGES IN OUTPUT . E XAMPLES OF VARIABLE COSTS ARE WAGES AND EXPENSES ON RAW MATERIAL . OR PRIME COSTS REPRESENT ALL THOSE COSTS WHICH CAN BE ALTERED IN THE SHORT - RUN AS THE OUTPUT ALTERS . T HESE ARE REGARDED AS “ AVOIDABLE CONTRACTUAL COSTS ” ( WHEN OUTPUT IS NIL ). T HE SHORT - RUN VARIABLE COSTS INCLUDE : P RICES OF RAW MATERIALS , W AGES OF LABOUR , F UEL AND POWER CHARGES , E XCISE DUTIES , SALES TAX , T RANSPORT EXPENDITURE , ETC . B ESIDES , USER COSTS ARE INCLUDED IN VARIABLE COSTS FOR ANALYTICAL PURPOSES . U SER COST IS THE DEPRECIATION CAUSED BY THE ACTUAL USE OF CAPITAL ASSETS LIKE MACHINERY . I T IS LINKED WITH THE RATE OF OUTPUT ..

TYPES OF PRODUCTION COSTS AND THEIR MEASUREMENT I N ECONOMIC ANALYSIS , THE FOLLOWING TYPES OF COSTS ARE CONSIDERED IN STUDYING COST DATA OF A FIRM : • T OTAL C OST (TC), • T OTAL F IXED C OST (TFC), • T OTAL V ARIABLE C OST (TVC), • A VERAGE F IXED C OST (AFC), • A VERAGE V ARIABLE C OST (AVC), • A VERAGE T OTAL C OST (ATC), AND • M ARGINAL C OST (MC)..

TOTAL COST (TC) • T OTAL COST IS THE AGGREGATE OF EXPENDITURES INCURRED BY THE FIRM IN PRODUCING A GIVEN LEVEL OF OUTPUT . T OTAL COST IS MEASURED IN RELATION TO THE PRODUCTION FUNCTION BY MULTIPLYING FACTOR PRICES WITH THEIR QUANTITIES • I N THE SHORT - RUN , TOTAL COST MAY BE BIFURCATED INTO TOTAL FIXED COST AND TOTAL VARIABLE COST . • T HUS , TOTAL COST MAY BE VIEWED AS THE SUM OF TOTAL FIXED COST AND TOTAL VARIABLE COST AT EACH • LEVEL OF OUTPUT . S YMBOLICALLY , TC = TFC + TVC ..

TOTAL FIXED COST (TFC) • T OTAL FIXED COST CORRESPONDS TO FIXED INPUTS IN THE SHORT - RUN PRODUCTION FUNCTION . I T IS OBTAINED BY SUMMING UP THE PRODUCT OF QUANTITIES OF THE FIXED FACTORS MULTIPLIED BY THEIR RESPECTIVE UNIT PRICES . TFC REMAINS THE SAME AT ALL LEVELS OF OUTPUT IN THE SHORT RUN . • S UPPOSE A SMALL FURNITURE SHOP PROPRIETOR STARTS HIS BUSINESS BY HIRING A SHOP AT A MONTHLY RENT OF R S . 1 , 000 BORROWING R S . 50 , 000 FROM A BANK AT AN INTEREST RATE OF 10 % AND RENTS CAPITAL EQUIPMENT WORTH R S . 2 , 000 PER MONTH . T HEN HIS MONTHLY TOTAL FIXED COST IS ESTIMATED TO BE : • R S . 1 , 000 + R S . 2 , 000 + R S . 500 = R S . 3 , 500 (R ENT ) (E QUIPMENT COST ) (M ONTHLY INTEREST ON THE LOAN ).

TOTAL VARIABLE COST (TVC) C ORRESPONDING TO VARIABLE INPUTS IN THE SHORT - RUN PRODUCTION , IS THE TOTAL VARIABLE COST . I T IS OBTAINED BY SUMMING UP THE PRODUCT OF QUANTITIES OF INPUT MULTIPLIED BY THEIR PRICES . A GAIN , TVC = F(Q) WHICH MEANS , TOTAL VARIABLE COST IS AN INCREASING FUNCTION OF OUTPUT . S UPPOSE , IN OUR ILLUSTRATION OF THE FURNITURE SHOP PROPRIETOR , IF HE WERE TO START WITH THE PRODUCTION OF CHAIRS HE EMPLOYS A CARPENTER ON A WAGE OF R S . 200 PER CHAIR . H E BUYS WOOD WORTH R S . 2 , 000 REXINE SHEETS WORTH R S . 1 , 500 , SPENDS R S . 400 FOR OTHER REQUIREMENTS TO PRODUCE 3 CHAIRS . T HEN HIS TOTAL VARIABLE COST FOR PRODUCING 3 CHAIRS IS MEASURED AS R S . 2 , 000 ( WOOD PRICE ) + R S . 1 , 500 ( REXINE COST ) + R S . 400 ( ALLIED COST ) + R S . 600 ( LABOUR CHARGES )= R S . 4 , 500 ..

AFC T HUS , AVERAGE FIXED COSTS IS THE FIXED COST PER UNIT OF OUTPUT . • WHERE Q STANDS FOR THE NUMBER OF UNITS OF THE PRODUCT . • THUS , WHEN TFC = R S . 3,500 AND Q = 3. AFC?.

AVERAGE VARIABLE COST (AVC) • A VERAGE VARIABLE COST IS TOTAL VARIABLE COST DIVIDED BY TOTAL UNITS OF OUTPUT . • T HUS , AVERAGE VARIABLE COST IS VARIABLE COST PER UNIT OF OUTPUT . I N THE ABOVE EXAMPLE , • TVC = R S . 4,500 FOR Q = 3.

AVERAGE TOTAL COST (ATC) A VERAGE TOTAL COST OR AVERAGE COST IS TOTAL COST DIVIDED BY TOTAL UNITS OF OUTPUT . • T HUS :.

MARGINAL COST (MC) T HE MARGINAL COST IS ALSO A PER UNIT COST OF PRODUCTION . I T IS THE ADDITION MADE TO THE TOTAL COST BY PRODUCING ONE MORE UNIT OF OUTPUT . S YMBOLICALLY , MC N = TC N – TC N – 1 THAT IS , THE MARGINAL COST OF THE N TH UNIT OF OUTPUT IS THE TOTAL COST OF PRODUCING N UNITS MINUS THE TOTAL COST OF PRODUCING N – 1 ( I . E . , ONE LESS IN THE TOTAL ) UNITS OF OUTPUT . S UPPOSE , THE TOTAL COST OF PRODUCING 4 CHAIRS ( I . E ., N = 4) IS R S . 10,000 WHILE THAT FOR 3 CHAIRS ( I . E . , N – 1 IS R S . 8,000. M ARGINAL COST OF PRODUCING THE 4 TH CHAIR , THEREFORE , WORKS OUT AS UNDER : MC4 = TC4 – TC3 = R S . 10,000 – R S . 8,000 = R S . 2,000. MARGINAL COST MAY BE DEFINED AS THE CHANGE IN TOTAL COST ASSOCIATED WITH A 1 UNIT CHANGE IN OUTPUT . I T IS ALSO AN “ EXTRA - UNIT COST ” OR INCREMENTAL COST , AS IT MEASURES THE AMOUNT BY WHICH TOTAL COST INCREASES WHEN OUTPUT IS EXPANDED BY ONE UNIT . I T CAN ALSO BE CALCULATED BY DIVIDING THE CHANGE IN TOTAL COST BY THE 1 UNIT CHANGE IN OUTPUT ..

SHORT - RUN TOTAL COSTS SCHEDULE OF A FIRM F UNCTIONALLY , THE COST BEHAVIOUR , I . E . , COST - OUTPUT RELATIONSHIP , IS OBSERVED IN THE SHORT RUN AS WELL AS LONG - RUN . W E HAVE , THUS , SHORT - RUN COST FUNCTION WHICH STATES COST - OUTPUT RELATIONSHIP OR THE BEHAVIOUR OF COSTS UNDER A GIVEN SCALE OF OUTPUT IN THE SHORT - RUN . S IMILARLY , THERE IS THE LONG - RUN COST FUNCTION WHICH STATES COST - OUTPUT RELATIONSHIP OR THE BEHAVIOUR OF COSTS WITH THE CHANGING SCALE OF OUTPUT IN THE LONG RUN . T HE SHORT - RUN AND LONG - RUN COST FUNCTIONS ARE IMPORTANT FOR A FIRM TO CONSIDER THE PRICE OR EQUILIBRIUM LEVEL OF OUTPUT DETERMINATION . C OST FUNCTION OF A FIRM CAN BE EXPRESSED STATISTICALLY AS COST SCHEDULE OR GRAPHICALLY IN THE FORM OF A COST CURVE . A COST SCHEDULE IS A STATEMENT OF VARIATIONS IN COSTS RESULTING FROM VARIATIONS IN THE LEVEL OF OUTPUT . I T SHOWS THE RESPONSE OF COSTS TO CHANGES IN OUTPUT . C OST SCHEDULES DEPEND UPON THE LENGTH OF THE TIME INTERVAL . S O , THEY VARY FROM SHORT PERIOD TO LONG PERIOD ..

COST SCHEDULE.

DIMINISHING MARGINAL RETURNS AND MARGINAL COST Diminishing marginal returns means that the marginal product of labor declines as the quantity of labor employed increases. As a result, when there are diminishing marginal returns, marginal cost will increase as output increases.

DIAGRAM Figure (a) shows fixed cost FC does not vary with output—it is shown as a horizontal line at $50. Variable cost VC is zero when output is zero and then increases continuously as output increases. The total cost curve TC is determined by vertically adding the fixed cost curve to the variable cost curve. Because fixed cost is constant, the vertical distance between the two curves is always $50. Figure (b) shows the corresponding set of marginal and average variable cost curves.4 Because total fixed cost is $50, the average fixed cost curve AFC falls continuously from $50 when output is 1, toward zero for large output. The shapes of the remaining curves are determined by the relationship between the marginal and average cost curves. Whenever marginal cost lies below average cost, the average cost curve falls. Whenever marginal cost lies above average cost, the average cost curve rises. When average cost is at a minimum, marginal cost equals average cost..

DIAGRAM.

EXPLANATION OF THE U - SHAPE OF ATC CURVE T HE REASONS WHY THE ATC CURVE IS U - SHAPED ARE NOT FAR TO SEEK . S INCE , ATC = AFC + ATC , IT FOLLOWS THAT THE BEHAVIOUR OF THE ATC CURVE IS DETERMINED BY THE AVC CURVE AND AFC CURVE . T HE AFC CURVE IS A RECTANGULAR HYPERBOLA , WHICH IMPLIES THAT THE AVERAGE FIXED COST DIMINISHES CONTINUOUSLY AS OUTPUT EXPANDS . I N THE INITIAL STAGE , THE AVC CURVE ALSO SLOPES DOWNWARD . A S SUCH , IN THE BEGINNING THE ATC CURVE TENDS TO FALL WHEN OUTPUT EXPANDS . A T A CERTAIN POINT , HOWEVER , THE AVC STARTS RISING , SO THE AVC CURVE HAS A POSITIVE SLOPE , YET THE ATC CURVE CONTINUES TO FALL . T HIS IS DUE TO THE PREDOMINANT INFLUENCE OF THE FALLING AFC CURVE . S INCE THE FALLING EFFECT OF AFC CURVE IS STRONGER THAN THE RISING EFFECT OF AVC CURVE AT THIS STAGE , THE NET EFFECT CAUSES ATC TO FALL . B UT , AS THE OUTPUT EXPANDS FURTHER TO A HIGHER LEVEL , THE AVC CURVE TENDS TO RISE SHARPLY DUE TO THE OPERATION OF THE LAW OF DIMINISHING RETURNS . N OW , THE RISING EFFECT OF AVC BEING PREDOMINANT , IT MORE THAN DISCOUNTS THE FALLING EFFECT OF AFC CURVE , SO THE NET EFFECT IS THAT THE ATC STARTS RISING . I NDEED , AT THE POINT WHERE THAT RISE OF AVC EXACTLY NULLIFIES THE FALL OF AFC , THE BALANCING EFFECT CAUSES ATC TO REMAIN CONSTANT FIRST AND THEN WHEN THE RISING EFFECT OF AVC BECOMES MORE PRONOUNCED THE ATC STARTS RISING . A S SUCH THE OVERALL ATC CURVE ASSUMES U - SHAPE . T HE FALLING PATH OF ATC IS LARGELY DUE TO THE FALLING AFC CURVE , WHILE ITS RISING PATH IS LARGELY INFLUENCED BY THE RISING AVC CURVE . I T MAY BE NOTED THAT THE DISTANCE BETWEEN ATC AND AVC CURVE BECOMES NARROW AS THE CURVES MOVE UPWARD . T HIS IS A CLEAR INDICATION OF THE INCREASING INFLUENCE OF AVC ON ATC IN THE LATER STAGE . I N THIS WAY , THE SLOPES OF THE ATC CURVE , INITIALLY NEGATIVE AND THEREAFTER POSITIVE , REFLECT THE COMBINED I NFLUENCE OF FIXED AND VARIABLE COST CURVES . T HE ECONOMIC REASON UNDERLYING THE U - SHAPE OF THE AVERAGE COST CURVE IS THAT THERE IS GREATER IMPORTANCE OF FIXED COSTS IN ANY FIRM TILL THE NORMAL CAPACITY IS EXHAUSTED AND THE NORMAL POINT OR THE POINT OF LEAST COST COMBINATION OF VARIOUS FACTORS ( FIXED AND VARIABLE ) IS REACHED . T HE AVERAGE COST , THEREFORE , DECLINES IN THE BEGINNING . B UT ONCE THE NORMAL OUTPUT OF THE PLANT IS REACHED , MORE AND MORE VARIABLE FACTORS ARE TO BE EMPLOYED DUE TO THE DIMINISHING RETURNS SO THAT THE VARIABLE COST RISES SHARPLY TO INCREASE THE OUTPUT FURTHER WHICH OUTWEIGHS THE EFFECT OF FALLING AVERAGE FIXED COST SO THAT THE ATC STARTS MOVING WITH AVC ..

RELATIONSHIP BETWEEN MARGINAL COST AND AVERAGE COSTS THE MC CUTS BOTH AVC AND ATC AT THEIR MINIMUM . WHEN BOTH THE MC AND AVC ARE FALLING , AVC WILL FALL AT A SLOWER RATE . WHEN BOTH THE MC AND AVC ARE RISING , MC WILL RISE AT A FASTER RATE . AS A RESULT , MC WILL ATTAIN ITS MINIMUM BEFORE THE AVC . IN OTHER WORDS , WHEN MC IS LESS THAN AVC , THE AVC WILL FALL , AND WHEN MC EXCEEDS AVC , AVC WILL RISE . THIS MEANS THAT AS LONG AS MC LIES BELOW AVC , THE LATTER WILL FALL AND WHERE MC IS ABOVE AVC , AVC WILL RISE . THEREFORE , AT THE POINT OF INTERSECTION WHERE MC = AVC , AVC HAS JUST CEASED TO FALL AND ATTAINED ITS MINIMUM BUT HAS NOT YET BEGUN TO RISE . SIMILARLY , THE MC CURVE CUTS THE ATC CURVE AT THE LATTER ’ S MINIMUM POINT . THIS IS BECAUSE MC CAN BE DEFINED AS THE ADDITION EITHER TO TC OR TVC RESULTING FROM ONE MORE UNIT OF OUTPUT . HOWEVER , NO SUCH RELATIONSHIP EXISTS BETWEEN MC AND AFC , BECAUSE THE TWO ARE NOT RELATED ; MC BY DEFINITION INCLUDES ONLY THOSE COSTS WHICH CHANGE WITH OUTPUT , AND FC BY DEFINITION IS INDEPENDENT OF OUTPUT ..

AC AND MC • W HEN AC IS MINIMUM , THE MC IS EQUAL TO AC . T HUS , MC CURVE MUST INTERSECT AT THE MINIMUM POINT OF ATC CURVE . • W HEN AC IS FALLING , MC IS ALSO FALLING INITIALLY , AFTER A POINT MC MAY START RISING BUT AC CONTINUES TO FALL . H OWEVER , AC IS GREATER THAN MC ( AC > MC ). H ENCE , ULTIMATELY AT A POINT BOTH COSTS WILL BE EQUAL . T HUS , WHEN MC AND AC ARE FAILING , MC CURVE LIES BELOW THE AC CURVE . • O NCE MC IS EQUAL TO AC , THEN AS THE OUTPUT INCREASES AC WILL START RISING AND MC CONTINUES TO RISE FURTHER BUT NOW MC WILL BE GREATER THAN AC . T HEREFORE , WHEN BOTH THE COSTS ARE RISING , MC CURVE WILL ALWAYS LIE ABOVE THE AC CURVE ..

MC: CRITICAL FROM MANAGERIAL POV T HE MARGINAL COST CONCEPT IS VERY CRUCIAL FROM THE MANAGER ’ S POINT OF VIEW . M ARGINAL COST IS A STRATEGIC CONCEPT BECAUSE IT DESIGNATES THOSE COSTS OVER WHICH THE FIRM HAS THE MOST DIRECT CONTROL . M ORE SPECIFICALLY , MC INDICATES THOSE COSTS WHICH ARE INCURRED IN THE PRODUCTION OF THE ADDITIONAL UNIT OF OUTPUT AND THEREFORE , ALSO THE COST WHICH CAN BE “ SAVED ” BY REDUCING TOTAL OUTPUT BY THE ADDITIONAL UNIT . A VERAGE COST FIGURES DO NOT PROVIDE THIS INFORMATION . A FIRM ’ S DECISIONS AS TO WHAT OUTPUT LEVEL TO PRODUCE IS LARGELY INFLUENCED BY ITS MARGINAL COST . W HEN COUPLED WITH MARGINAL REVENUE , WHICH INDICATES THE CHANGE IN REVENUE FROM ONE MORE OR ONE LESS UNIT OF OUTPUT , MARGINAL COST ALLOWS A FIRM TO DETERMINE WHETHER IT IS PROFITABLE TO EXPAND OR CONTRACT ITS LEVEL OF PRODUCTION ..

EXERCISE 2 • TFC REMAINS CONSTANT AT ALL LEVELS OF OUTPUT . I T IS THE SAME EVEN WHEN THE OUTPUT IS NIL . F IXED COSTS ARE THUS INDEPENDENT OF OUTPUT . • TVC VARIES WITH THE OUTPUT . I T IS NIL WHEN THERE IS NO OUTPUT . V ARIABLE COSTS ARE , THUS , DIRECT COSTS OF THE OUTPUT . • TVC DOES NOT CHANGE IN THE SAME PROPORTION . I NITIALLY , IT IS INCREASING AT A DECREASING RATE , BUT AFTER A POINT , IT INCREASES AT AN INCREASING RATE . T HIS IS DUE TO THE OPERATION OF THE LAW OF VARIABLE PROPORTIONS OR NON - PROPORTIONAL OUTPUT , WHICH SUGGESTS THAT INITIALLY TO OBTAIN A GIVEN AMOUNT OF OUTPUT RELATIVELY , VARIATIONS IN FACTORS ARE NEEDED IN LESS PROPORTION , BUT AFTER A POINT WHEN THE DIMINISHING PHASE OPERATES , VARIABLE FACTORS , ARE TO BE EMPLOYED IN A GREATER PROPORTION TO INCREASE THE SAME ‘ LEVEL ’ OF OUTPUT . • TC VARIES IN THE SAME PROPORTION AS THE TVC . T HUS , IN THE SHORT PERIOD , THE CHANGES IN TOTAL COST ARE ENTIRELY DUE TO CHANGES IN THE TOTAL VARIABLE COSTS , AS FIXED COSTS , THE OTHER COMPONENT OF TOTAL COSTS , REMAIN CONSTANT ..

ASSUMPTIONS • D ATA IN THE TABLE SHOW THE BEHAVIOUR OF TFC, TVC AND TC IN THE SHORT RUN . • T HE DATA ARE BASED ON THE FOLLOWING ASSUMPTIONS : • L ABOUR AND CAPITAL ARE THE TWO FACTOR INPUTS . • L ABOUR IS THE VARIABLE FACTOR . • C APITAL IS THE FIXED FACTOR . • P RICE OF LABOUR IS R S . 10 PER UNIT . P RICE OF CAPITAL IS R S . 25 PER UNIT . • S INCE 4 UNITS OF CAPITAL ARE USED AS FIXED FACTORS , THE TOTAL FIXED COST ( TFC ), R S . 100 REMAINS CONSTANT THROUGHOUT • T HE TOTAL VARIABLE COST ( TVC ) VARIES WITH THE VARIATION IN LABOUR UNITS . • 6 TH C OLUMN MEASURES THE TOTAL COST . I T IS TFC AND TVC AT ALL LEVELS OF OUTPUT.

ANALYSE THE COST DATA IN DETAIL.

A CURVE REPRESENTING SUCH DATA IS ALWAYS A RECTANGULAR HYPERBOLA . H ENCE , THE AFC CURVE IS A RECTANGULAR HYPERBOLA . I T , THUS , IMPLIES THAT ANY POINT ON THE CURVE GIVES THE SAME TOTAL COST AS THE PRODUCT OF MULTIPLICATION OF AVERAGE FIXED COST BY THE UNITS OF OUTPUT . T HIS PROPERTY OF THE CURVE SIGNIFIES THE FACT THAT TOTAL FIXED COST IS CONSTANT THROUGHOUT . A CURVE REPRESENTING SUCH DATA IS ALWAYS A RECTANGULAR HYPERBOLA . H ENCE , THE AFC CURVE IS A RECTANGULAR HYPERBOLA . I T , THUS , IMPLIES THAT ANY POINT ON THE CURVE GIVES THE SAME TOTAL COST AS THE PRODUCT OF MULTIPLICATION OF AVERAGE FIXED COST BY THE UNITS OF OUTPUT . T HIS PROPERTY OF THE CURVE SIGNIFIES THE FACT THAT TOTAL FIXED COST IS CONSTANT THROUGHOUT . T HE AFC CURVE IS RECTANGULAR HYPERBOLA CURVE INDICATING THAT OVERHEADS COSTS ARE SPREAD OUT WHEN OUTPUT IS INCREASED . T HE AVC IS A U - SHAPED CURVE INDICATING THAT AVC INITIALLY FALLS AND THEN RISES WITH INCREASED OUTPUT . I T REFLECTS THE LAW OF DIMINISHING RETURNS . ATC CURVE IS VIEWED AS THE SUM OF THE AFC AND AVC CURVES . T HE ATC CURVE IS U - SHAPED . MC CURVE IS ALSO U - SHAPED . I T IS DERIVED FROM THE TVC CURVE . A VERAGE V ARIABLE C OST C URVE (AVC C URVE ) . T HE AVERAGE VARIABLE COST GENERALLY DECLINES IN THE INITIAL STAGES AS THE FIRM EXPANDS AND APPROACHES THE OPTIMUM LEVEL OF OUTPUT . A FTER THE PLANT CAPACITY OUTPUT IS REACHED , THE AVERAGE VARIABLE COST BEGINS TO RISE SHARPLY . T HUS , USUALLY , THE AVERAGE VARIABLE COST CURVE DECLINES INITIALLY , REACHES THE MINIMUM AND THEN GOES ON RISING . T HE AVC CURVE IS , THUS , SLIGHTLY U - SHAPED , INDICATING THAT AS THE OUTPUT INCREASES INITIALLY , THE AVERAGE VARIABLE COST.

COST IN THE LONG RUN.

The User Cost of Capital Firms often rent or lease equipment, buildings, and other capital used in the production process. On other occasions, the capital is purchased. In our analy- sis, however, it will be useful to treat capital as though it were rented even if it was purchased. An illustration will help to explain how and why we do this. Let's suppose that Delta Airlines is thinking about purchasing a new Boeing 777 airplane for $150 million. Even though Delta would pay a large sum for the air- plane now, for economic purposes the purchase price can be allocated or amor- tized across the life of the airplane. This will allow Delta to compare its revenues and costs on an annual Pow basis. We will assume that the life of the airplane is 30 years; the amortized oost is therefore $5 million per year. The million can be viewed as the annual economic depreciation for the airplane. So far, we have ignored the fact that had the firm not purchased the airplane, it could have earned interest on its $150 million. This forgone interest is an opportunity cost that must be accounted for. lherefore, the user cost of capital— the annual cost of owning and using the airplane instead of selling it or never buying it in the first place—is given by the sum of the economic depreciation and the interest (i.e., the financial return) that could have been earned had the money Iven invested elsewhere." Formally, User Cost of Capital = Economic Depreciation + (Interest Rate) (Value of Capital) • user cost of capital Annual cost of owning and using a capital asset, equal to economic depreciaton plus forgone interest-.

The Isocost Line We begin by lcx»king at the cost of hiring factor inputs, which can be represented by a firm 's isocost lines. An isocost line shows all possible combinations of labor and capital that can be purchased for a given total cost To see what an isocost line looks like, recall that the total cost C of producing any particular output is given by the sum of the firm's labor cost WL and its capital cost rK: C=wL+rK (7.2) For each different level of total cost, equation (7.2) describes a different isoccst line. In Figure 73, for example, the isocost line Co describes all possible combi- nations of labor and capital that cost a total of CD to hire. If we rewrite the total cost equation as an equation for a straight line, we get K = ctr- Capital year per year MPL/MPK = tv/r • isocost une Graph showing possee combinations of labor and capital that can be purchased a given total cost_ c, per year.

FIRM’S EXPANSION PATH In (a), the expansion path (from the origin through points A, B, and C) illustrates the lowest cost combinations of labor and capital that can be used to produce each level of output in the long run—i.e., when both inputs to production can be varied. In (b), the corresponding long-run total cost curve (from the origin through points D, E, and F) measures the least cost of producing each level of output..

CHARACTERISTICS OF LONG - RUN COSTS THE LONG - RUN PERIOD IS LONG ENOUGH TO ENABLE A FIRM TO VARY T HE LONG - RUN PERIOD IS LONG ENOUGH TO ENABLE A FIRM TO VARY ALL ITS FACTOR INPUTS . I N THE LONG - RUN , A FIRM IS NOT TIED TO A PARTICULAR PLANT CAPACITY . I T CAN MOVE FROM ONE PLANT CAPACITY TO ANOTHER WHENEVER IT IS OBLIGED TO DO SO IN THE LIGHT OF CHANGES IN DEMAND FOR ITS PRODUCTS . T HE FIRM CAN EXPAND ITS PLANT IN ORDER TO MEET THE LONG - TERM INCREASE IN DEMAND OR REDUCE PLANT CAPACITY IF THERE IS A DROP IN DEMAND . I N THE LONG - RUN , THUS , THERE ARE ONLY THE VARIABLE COSTS OR DIRECT COSTS AS TOTAL COST . T HERE IS NO DICHOTOMY OF TOTAL COST INTO FIXED AND VARIABLE COSTS AS WE SEE IN THE SHORT - RUN ANALYSIS ..

I N THE LONG - RUN , WHEN WE EXAMINE THE UNIT COST OF A FIRM , WE COME ACROSS ONLY THE AVERAGE C OSTS AND MARGINAL COSTS . H ENCE , WE HAVE ONLY TO STUDY THE SHAPE AND RELATIONSHIPS OF THE LONG - RUN AVERAGE COST CURVE AND THE LONG - RUN MARGINAL COST CURVE . A S A MATTER OF FACT , THE LONG - RUN IS A ‘ PLANNING HORIZON . ’ A LL ECONOMIC ACTIVITY ACTUALLY OPERATES IN THE SHORT - RUN , THE LONG - RUN IS ONLY A PERSPECTIVE VIEW FOR THE FUTURE COURSE OF ACTION . T HUS , AN ECONOMIC ENTITY — ENTREPRENEUR OR CONSUMER — CAN PLAN HIS COURSE OF ACTION IN THE LONG - RUN , BUT IN THE REAL COURSE OF OPERATION CHOOSES ACTUALLY NUMEROUS ASPECTS OF THE SHORT - RUN . T HIS MEANS , THE LONG - RUN COMPRISES ALL POSSIBLE SHORT - RUN SITUATIONS FROM WHICH A CHOICE IS MADE FOR THE ACTUAL COURSE OF OPERATION ..

M ETHODOLOGICALLY , THE LONG - RUN AVERAGE COST CURVE ( LAC ) IS THE ENVELOPE OF THE VARIOUS SHORT RUN AVERAGE COST CURVES . I T IS DRAWN AS TANGENT TO THE SAC S . THE LAC IS DERIVED AS TANGENT TO SAC 1 , SAC 2 AND SAC 3 . T HE LAC IS , THUS , A FLATTER U - SHAPED CURVE . E NVELOPE C URVE . T HE LAC CURVE IS ALSO REFERRED TO AS THE ‘ ENVELOPE CURVE ’, BECAUSE IT IS THE ENVELOPE OF A GROUP OF SHORT - RUN AVERAGE COST CURVES APPROPRIATE TO DIFFERENT LEVELS OF OUTPUT . AT OQ 2 LEVEL OF OUTPUT , SAC IS TANGENT TO LAC AT BOTH THE MINIMUM POINTS . T HUS , OQ 2 IS REGARDED AS THE OPTIMUM SCALE OF OUTPUT , AS IT HAS THE MINIMUM PER UNIT COST . I T SHOULD BE NOTED THAT , THERE WILL BE ONLY ONE SUCH POINT ON THE LAC CURVE TO WHICH A SAC CURVE IS TANGENT AS WELL AS BOTH HAVE THE MINIMUM POINTS AT THE POINT OF TANGENCY . A ND AS SUCH THIS PARTICULAR SAC PHASE IS REGARDED AS THE MOST EFFICIENT ONE . A LL OTHER SAC CURVES ARE TANGENT TO THE LAC BUT AT THE POINT OF TANGENCY NEITHER LAC NOR SAC CURVE HAS THE MINIMUM POINT . I N FACT , AT ALL THESE POINTS SAC CURVES ARE EITHER RISING NOR FALLING , SHOWING A HIGHER COST ..

P LANNING C URVE . LAC CURVE IS REGARDED AS THE LONG - RUN PLANNING DEVICE , AS IT DENOTES THE LEAST UNIT COST OF PRODUCING EACH POSSIBLE LEVEL OUTPUT AND THE SIZE OF THE PLANT IN RELATION TO THE LAC CURVE . A RATIONAL ENTREPRENEUR WOULD SELECT THE OPTIMUM SCALE OF PLANT . T HE OPTIMUM SCALE OF PLANT IS THAT PLANT SIZE AT WHICH A SAC IS TANGENT TO THE LAC , SUCH THAT BOTH THE CURVES HAVE THE MINIMUM POINT OF TANGENCY ..

M INIMUM C OST C OMBINATIONS . S INCE LAC IS DERIVED AS THE TANGENT TO VARIOUS SAC CURVES UNDER CONSIDERATION , THE COST LEVELS BE PRESENTED BY THE LAC CURVE FOR DIFFERENT LEVELS OF OUTPUT REFLECT MINIMUM COST COMBINATIONS OF RESOURCE INPUTS TO BE ADOPTED BY THE FIRM AT EACH LONG - RUN LEVEL OF OUTPUT . F LATTER U - S HAPED . T HE LAC CURVE IS LESS U - SHAPED OR RATHER DISH - SHAPED . T HIS MEANS THAT IN THE BEGINNING IT GRADUALLY SLOPES DOWNWARDS AND THEN , AFTER REACHING A CERTAIN POINT , IT GRADUALLY BEGINS TO SLOPE UPWARDS . T HIS IMPLIES THAT IN THE LONG - RUN WHEN THE FIRM ADOPTS A LARGER SCALE OF OUTPUT , ITS LONG - RUN AVERAGE COST IN THE BEGINNING TENDS TO DECREASE . A T A CERTAIN POINT , IT REMAINS CONSTANT , AND THEN RISES . T HIS BEHAVIOUR OF LONG - RUN AVERAGE COSTS IS ATTRIBUTED TO THE OPERATION OF LAWS OF RETURNS TO SCALE . I NCREASING RETURNS IN THE BEGINNING CAUSE DECREASING COSTS , CONSTANT RETURNS , CONSTANT COSTS , AND THEN DECREASING RETURNS , INCREASING COSTS.

LONG - RUN MARGINAL COST CURVE (LMC) • L IKE THE SHORT - RUN MARGINAL COST CURVE , THE LONG - RUN MARGINAL COST CURVE IS ALSO DERIVED FROM THE SLOPE OF TOTAL COST CURVE AT THE VARIOUS POINTS RELATING TO THE GIVEN OUTPUT EACH TIME . T HE SHAPE OF LMC CURVE HAS ALSO A FLATTER U - SHAPE , INDICATING THAT INITIALLY AS OUTPUT EXPANDS IN THE LONG - RUN WITH THE INCREASING SCALE OF PRODUCTION TENDS TO DECLINE . A T A CERTAIN STAGE , HOWEVER , LMC TENDS TO INCREASE ..

THE LAC REFERS TO THE LONG - RUN AVERAGE COST CURVE . A ND THE LMC REFERS TO THE LONG - RUN MARGINAL COST CURVE . THE RELATIONSHIP BETWEEN LAC AND LMC MAY BE TRACED AS FOLLOWS : W HEN LAC CURVE DECREASES , LMC CURVE ALSO DECREASES AND LMC < LAC . A T A CERTAIN STAGE , LMC TENDS TO RISE , THOUGH LAC CONTINUES TO FALL . I NDEED , LMC IS STILL LESS THAN LAC . W HEN LAC IS THE MINIMUM , LMC=LAC . T HUS , THE LMC CURVE INTERSECTS , AT THE LOWEST POINT OF THE LAC CURVE . T HEREAFTER BOTH THE LAC AND LMC CURVES SLOPE UPWARDS . N OW LMC > LAC . S O , THE LMC CURVE LIES ABOVE THE LAC CURVE.

ECONOMIES OF SCALE • L ARGE SCALE PRODUCTION IS ECONOMICAL IN THE SENSE THAT THE COST OF PRODUCTION IS LOW . T HE LOW COST IS A RESULT OF WHAT IS CALLED “ ECONOMIES OF SCALE . ” • I N A BROAD SENSE , ANYTHING WHICH SERVES TO MINIMISE AVERAGE COST OF PRODUCTION IN THE LONG - RUN AS THE SCALE OF OUTPUT INCREASES IS REFERRED TO AS “ ECONOMIES OF SCALE . ” I T IS MEASURED IN MONEY TERMS . • I N A NARROW SENSE , HOWEVER , THE TERM ‘ ECONOMIES OF SCALE ’ RELATES TO THE CHARACTERISTICS OF THE PRODUCTION PROCESS BY WHICH AVERAGE PRODUCTIVITY IS ENHANCED WITH THE EXPANDING SCALE OF OUTPUT . R EAL ECONOMIES ARE MEASURED IN PHYSICAL TERMS . I NCREASING RETURNS TO SCALE ARE CAUSED BY THESE REAL ECONOMIES ..

ECONOMIES OF SCALE AND THE LAC T HE LAC CURVE IS THE MIRROR IMAGE OF THE RETURNS TO THE SCALE IN THE LONG - RUN . A S A MATTER OF FACT , INCREASING RETURNS TO SCALE CAN BE LARGELY TRACED TO THE ECONOMIES WHICH BECOME AVAILABLE TO A FIRM WHEN IT EXPANDS ITS SCALE OF OPERATIONS . A S A RESULT OF THESE ECONOMIES , THE FIRM ENJOYS A NUMBER OF COST ADVANTAGES AND RETURN IN TERMS OF TOTAL OUTPUT . T HUS , ECONOMIES OF SCALE EXPLAIN THE FALLING SEGMENT OF THE LAC CURVE . T HIS SHOWS THAT THE DECLINING AVERAGE COST OF OUTPUT IN THE LONG - RUN IS DUE TO ECONOMIES OF LARGE - SCALE ENJOYED BY THE FIRM . I NCREASING LAC IS ATTRIBUTED TO THE DISECONOMIES OF SCALE AFTER A CERTAIN POINT OF FURTHER EXPANSION ..

I NCREASING AVERAGE COSTS IN THE LONG RUN , ATTRIBUTED TO THE GROWING DISECONOMIES OF SCALE , SET A LIMIT TO THE FURTHER EXPANSION OF THE FIRM . E CONOMIES AND DISECONOMIES OF SCALE REFLECT UPON THE BEHAVIOUR OF THE LAC CURVE . A NALYTICALLY SPEAKING THE DOWNWARD SLOPE OF THE LAC CURVE MAY BE ATTRIBUTED TO THE INTERNAL ECONOMIES OF SCALE . S IMILARLY , THE UPWARD SLOPE OF THE LAC CURVE IS CAUSED BY THE INTERNAL DISECONOMIES OF SCALE . A ND , THE HORIZONTAL SLOPE OF THE LAC CURVE MAY BE EXPLAINED IN TERMS OF THE BALANCE BETWEEN INTERNAL ECONOMIES AND DISECONOMIES.