25  Theory of cost: Short-run and long-run cost curves

25.1 Cost in Economics — Wider than Cost in Accounting

In accounting, cost is the historical money expenditure on inputs. In economics, cost is the opportunity cost of using resources — the value of the next-best alternative foregone. Economic cost therefore includes both explicit costs (cash payments to outsiders for wages, rent, materials) and implicit costs (the imputed value of owner-supplied resources — own labour, own capital, own premises). This makes economic profit = Total revenue − (explicit + implicit costs), while accounting profit = Total revenue − explicit costs. A firm earning zero economic profit is earning normal profit — a competitive return on its resources.

25.2 Cost Concepts

TipImportant Cost Concepts
Concept Working content
Explicit cost Out-of-pocket payments to suppliers, workers, lenders
Implicit cost Imputed cost of owner-supplied resources
Accounting cost Explicit cost only
Economic cost Explicit + Implicit
Opportunity cost Value of next-best foregone
Sunk cost Already incurred; irrelevant to future decisions
Fixed cost Independent of output (rent, depreciation, salary of permanent staff)
Variable cost Varies directly with output (raw material, wages, power)
Marginal cost Additional cost of producing one more unit
Average cost Total cost ÷ Quantity
Replacement cost What it would cost today to replace an asset
Differential / Incremental Difference in cost between two alternatives
Out-of-pocket vs Book cost Cash outflow vs non-cash (depreciation)
Private vs Social cost Borne by firm vs borne by society
Historical vs Current cost Past acquisition vs present value

25.3 Short-Run Cost Curves

In the short run, at least one input is fixed (typically plant and equipment). Costs split into fixed and variable:

TipShort-Run Cost Functions
Function Formula Shape
TFC Total Fixed Cost Constant, independent of Q Horizontal line
TVC Total Variable Cost Rises with Q S-shaped — rises slowly then faster
TC Total Cost TFC + TVC Same shape as TVC, shifted up by TFC
AFC Average Fixed Cost TFC / Q Rectangular hyperbola — falls continuously
AVC Average Variable Cost TVC / Q U-shaped
ATC / AC Average Total Cost TC / Q = AFC + AVC U-shaped (higher and to the right of AVC)
MC Marginal Cost dTC / dQ U-shaped; cuts AVC and ATC at their minima 

flowchart LR
  MC[MC] -->|cuts at minimum| AVC[AVC]
  MC -->|cuts at minimum| ATC[ATC]
  AFC[AFC] -->|+| AVC --> ATC
  TFC[TFC] -->|+| TVC[TVC] --> TC[TC]
    classDef default fill:#003366,color:#ffffff,stroke:#ffcc00,stroke-width:3px,rx:10px,ry:10px;

25.3.1 Key Relationships

TipCost-Curve Relationships
  • MC < AC → AC falling.
  • MC = AC → AC at minimum.
  • MC > AC → AC rising.
  • The same relations hold for MC and AVC.
  • AFC falls continuously as Q rises — TFC spread over more units.
  • AVC reaches its minimum before ATC because falling AFC delays ATC’s bottom.
  • The vertical gap between ATC and AVC equals AFC — and narrows with output.

25.3.2 Why U-Shaped Short-Run Curves?

The Law of Variable Proportions explains the U-shape — initially increasing returns to the variable input pull cost down; later, diminishing returns push cost up. MC at its minimum corresponds to MP at its maximum; AVC at its minimum corresponds to AP at its maximum.

25.4 Long-Run Cost Curves

In the long run all inputs are variable. The firm can change plant size. The long-run average cost curve (LRAC) is the envelope of an infinite number of short-run AC curves, each corresponding to a different plant size.

25.4.1 Three Phases of LRAC

TipThree Phases of LRAC
Phase Behaviour Driver
Falling LRAC Economies of scale dominate Technical, managerial, marketing, financial gains
Flat LRAC At the Minimum Efficient Scale (MES) CRS region
Rising LRAC Diseconomies of scale Communication, bureaucracy, resource scarcity

The U-shape of LRAC reflects this — but the U is flatter and the trough is wider than for SRAC because the firm has more flexibility in the long run.

25.4.2 LRAC as Envelope

The LRAC is tangent to each SRAC curve at one point. At the minimum point of LRAC, it is tangent to the SRAC of the optimal-size plant at that plant’s minimum AC.

25.4.3 Long-Run Marginal Cost (LMC)

LMC is derived analogously and intersects LRAC at LRAC’s minimum.

25.5 Sraffian / Modigliani Analysis and L-Shaped LRAC

Empirical studies (Bain 1956; Modigliani; Wiles) often find that LRAC is L-shaped rather than U-shaped — costs fall sharply at first, then flatten out indefinitely. This reflects the rare occurrence of diseconomies in modern firms with professional management.

25.6 Economies of Scope and Learning Curve

TipTwo Further Concepts
  • Economies of scope — cost saving from producing two or more products together rather than separately (e.g., banking products through one branch network).
  • Learning curve / Experience curve — average cost per unit falls with cumulative output — workers and managers get more skilled. Often expressed as: each doubling of cumulative output cuts unit cost by 20–30 %.
NoteDistractor warning

PYQ trap: economies of scale relate to current output rate; economies of scope to product mix; learning curve to cumulative output over time. These three are distinct.

25.7 Short-Run vs Long-Run Cost — Summary

TipShort-Run vs Long-Run Cost
Aspect Short Run Long Run
Plant size Fixed Variable
Cost split Fixed + Variable All variable
AC curve U-shaped (Law of Variable Proportions) U or L-shaped (Returns to Scale)
MC curve U-shaped; cuts AVC and ATC at their minima Cuts LRAC at LRAC’s minimum
LRAC — Envelope of SRACs

25.8 Practice Questions

Q 01 AFC Easy

The Average Fixed Cost curve takes the shape of:

  • AA horizontal line
  • BA U-shape
  • CA rectangular hyperbola
  • DA straight line sloping up
View solution
Correct Option: C
AFC = TFC/Q is a **rectangular hyperbola** — falls continuously without reaching zero.
Q 02 MC-AC Easy

Marginal cost cuts the average cost curve at:

  • AThe origin
  • BMaximum of AC
  • CMinimum of AC
  • DWhere MC = 0
View solution
Correct Option: C
MC cuts AC and AVC from below at their **minimum** points.
Q 03 Profit Medium

Accounting profit is:

  • ATotal revenue − explicit and implicit costs
  • BTotal revenue − explicit costs only
  • CTotal revenue − implicit costs only
  • DTotal revenue + implicit costs
View solution
Correct Option: B
Accounting profit excludes implicit costs. Economic profit subtracts both.
Q 04 Concepts Medium

Match each cost concept with its description:

Concept Description
(i) Sunk cost (a) Cost of next-best foregone
(ii) Opportunity cost (b) Cost already incurred; irrelevant for decision
(iii) Implicit cost (c) Difference between two alternatives
(iv) Incremental cost (d) Imputed cost of owner-supplied resources
  • A(i)-(b), (ii)-(a), (iii)-(d), (iv)-(c)
  • B(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • C(i)-(c), (ii)-(d), (iii)-(a), (iv)-(b)
  • D(i)-(d), (ii)-(c), (iii)-(b), (iv)-(a)
View solution
Correct Option: A
Sunk — already incurred; Opportunity — next best foregone; Implicit — imputed; Incremental — difference.
Q 05 AVC Medium

The AVC curve reaches its minimum **before** the ATC curve because:

  • AAVC includes fixed cost
  • BAFC keeps falling, delaying ATC's bottom
  • CAVC excludes variable cost
  • DMC is higher
View solution
Correct Option: B
Falling AFC delays ATC's minimum past AVC's minimum.
Q 06 LRAC Medium

The long-run average cost curve (LRAC) is best described as:

  • AThe envelope of short-run AC curves
  • BA horizontal line
  • CAlways a straight line
  • DEqual to AVC
View solution
Correct Option: A
LRAC envelops all SRAC curves; sometimes called the *planning curve*.
Q 07 Sunk Medium

A sunk cost is:

  • ARelevant for future decisions
  • BIrrelevant for future decisions, as it cannot be recovered
  • CAlways equal to opportunity cost
  • DAlways zero
View solution
Correct Option: B
Sunk costs are unrecoverable and **irrelevant** to forward-looking decisions.
Q 08 Scope Medium

Economies of *scope* arise when:

  • AOutput rate increases
  • BProducing two or more products together is cheaper than separately
  • CCumulative output rises
  • DInputs become cheaper
View solution
Correct Option: B
Scope economies — joint production cheaper than separate (banking, telecom multi-product).
Q 09 Learning Hard

The learning / experience curve refers to:

  • AFalling cost per unit with cumulative output
  • BFalling cost per unit with current rate of output
  • CRising cost per unit with cumulative output
  • DNo relation between cost and output
View solution
Correct Option: A
Cost falls as **cumulative experience** rises — each doubling typically cuts unit cost by 20-30 %.
Q 10 Compute Medium

When 100 units are produced TC is ₹10,000; when 101 units, TC is ₹10,050. Marginal cost of the 101st unit is:

  • A₹100
  • B₹50
  • C₹10,050
  • D₹0
View solution
Correct Option: B
MC = ΔTC/ΔQ = 50/1 = **₹50**.
Q 11 Gap Medium

The vertical gap between ATC and AVC equals:

  • ATFC
  • BAFC
  • CMC
  • DTVC
View solution
Correct Option: B
ATC = AFC + AVC, so ATC − AVC = **AFC**; it narrows as Q rises.
Q 12 Fixed Easy

Which is an example of a fixed cost?

  • ARaw material
  • BElectricity power consumed by machines
  • CSalary of permanent watchman
  • DDaily wage of casual labour
View solution
Correct Option: C
Permanent staff salary does not vary with output → **fixed cost**.
Q 13 MC=MP Hard

MC reaches its minimum when:

  • AAP is at maximum
  • BMP is at maximum
  • CTP is at maximum
  • DMP is zero
View solution
Correct Option: B
MC = w / MP; MC is minimum when **MP is maximum**.
Q 14 L-shape Hard

L-shaped LRAC empirical findings are most associated with:

  • AMarshall
  • BBain (1956), Wiles, Modigliani
  • CCobb-Douglas
  • DSraffa
View solution
Correct Option: B
Empirical L-shaped LRAC — Bain, Wiles, Modigliani.
Q 15 Economic profit Medium

"Normal profit" corresponds to:

  • ANegative economic profit
  • BZero economic profit
  • CPositive economic profit
  • DNegative accounting profit
View solution
Correct Option: B
Normal profit = a competitive return; firm earns *zero* economic profit (covers all opportunity costs).
Q 16 Costs Medium

Which cost is **not** typically a variable cost?

  • ADirect material
  • BDirect wages
  • CPower consumed by production machinery
  • DRent of factory building
View solution
Correct Option: D
Rent is *fixed* in the short run.
Q 17 Private-Social Medium

The difference between social cost and private cost reflects:

  • AInflation
  • BExternalities
  • CSunk costs
  • DDepreciation
View solution
Correct Option: B
Externalities — costs imposed on others (pollution) make social cost > private cost.
Q 18 MES Hard

The Minimum Efficient Scale (MES) is the:

  • ASmallest output level at which LRAC reaches its minimum
  • BLargest output at which a firm survives
  • CBreak-even point
  • DShut-down point
View solution
Correct Option: A
MES — smallest output at which LRAC is minimum; explains plant size in many industries.
Q 19 U-shape Medium

The U-shape of the SRAC curve is explained by:

  • AReturns to scale
  • BLaw of Variable Proportions
  • CDiminishing marginal utility
  • DEngel's law
View solution
Correct Option: B
SR U-shape — Law of Variable Proportions; LR U-shape — returns to scale.
Q 20 Match Medium

Match each curve with its property:

Curve Property
(i) AFC (a) U-shaped; reaches minimum first
(ii) AVC (b) Continuously falling rectangular hyperbola
(iii) ATC (c) U-shaped; reaches minimum later than AVC
(iv) MC (d) Cuts AVC and ATC at their minima
  • A(i)-(b), (ii)-(a), (iii)-(c), (iv)-(d)
  • B(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • C(i)-(c), (ii)-(b), (iii)-(d), (iv)-(a)
  • D(i)-(d), (ii)-(c), (iii)-(a), (iv)-(b)
View solution
Correct Option: A
AFC — falling hyperbola; AVC — U, minimum first; ATC — U, minimum later; MC — cuts AVC, ATC at minima.

25.9 Quick Recall

ImportantQuick recall
  • Cost concepts: explicit, implicit, opportunity, sunk, fixed, variable, marginal, average, replacement, incremental, private vs social.
  • Accounting profit = TR − Explicit cost; Economic profit = TR − (Explicit + Implicit). Normal profit = zero economic profit.
  • Short-run curves: TFC horizontal; TVC rises (S-shape); TC = TFC + TVC. AFC rectangular hyperbola; AVC, ATC U-shaped; MC U-shaped and cuts AVC, ATC at minima.
  • Relationships: MC < AC ⇒ AC falling; MC = AC ⇒ AC minimum; MC > AC ⇒ AC rising. ATC − AVC = AFC (narrows with Q).
  • Cause of SR U-shape: Law of Variable Proportions. MC minimum at MP maximum; AVC minimum at AP maximum.
  • LRAC: envelope of SRACs; U-shaped due to economies → constant → diseconomies of scale; empirically often L-shaped (Bain 1956, Modigliani).
  • Minimum Efficient Scale (MES) — smallest output at minimum LRAC.
  • Economies of scope (product mix); learning / experience curve (cumulative output).