flowchart LR MC[Marginal Cost MC] -- cuts at minimum --> AVC[Average Variable Cost AVC] MC -- cuts at minimum --> AC[Average Cost AC] AFC[Average Fixed Cost AFC] -- falls continuously --> AC AVC -- + AFC --> AC style MC fill:#FFEBEE,stroke:#C62828 style AVC fill:#FFF8E1,stroke:#F9A825 style AC fill:#E8F5E9,stroke:#2E7D32 style AFC fill:#E3F2FD,stroke:#1565C0
24 Theory of Cost
24.1 Cost in Economics — Wider than Cost in Accounting
To an economist, the cost of producing a good is the value of the resources used up in producing it — measured at opportunity cost, the value of the next best alternative foregone (varian2019?; dwivedi2021?). This is wider than the accountant’s view, which records only payments actually made.
The wider view brings in the implicit cost — the value of the owner’s time and capital, which is genuine but invisible to the books — and the opportunity cost — what the resource could have earned elsewhere.
24.2 Cost Concepts
A long list of cost concepts recurs in exam questions; the candidate must be fluent in each pair.
TipTwelve Pairs of Cost Concepts
| Concept | Definition | Distinguishing pair |
|---|---|---|
| Money cost | Cost in terms of money paid | vs Real cost |
| Real cost | Sacrifice of effort and inconvenience to factor owners | vs Money cost |
| Explicit cost | Cash payments made for inputs purchased from outside | vs Implicit cost |
| Implicit cost | Notional cost of self-owned and self-employed inputs | vs Explicit cost |
| Accounting cost | Explicit costs only (as recorded in books) | vs Economic cost |
| Economic cost | Explicit + Implicit cost | vs Accounting cost |
| Opportunity cost | Value of the next best alternative foregone | vs Outlay cost |
| Private cost | Cost borne by the firm | vs Social cost |
| Social cost | Private + External cost (pollution, congestion) | vs Private cost |
| Sunk cost | Already incurred and irrecoverable; irrelevant for future decisions | vs Incremental cost |
| Incremental cost | Additional cost from a specific decision | vs Sunk cost |
| Fixed cost | Independent of output in the short run | vs Variable cost |
| Variable cost | Varies with output | vs Fixed cost |
| Direct cost | Traceable to a product, process or department | vs Indirect cost |
| Indirect cost | Common to several products; allocated | vs Direct cost |
| Out-of-pocket | Involves current cash payment | vs Book cost |
| Book cost | Non-cash; e.g., depreciation | vs Out-of-pocket cost |
| Replacement cost | Cost of replacing an asset at current prices | vs Historical cost |
| Historical cost | Cost at the time of acquisition | vs Replacement cost |
A note on three exam-favourite ideas:
- Economic profit = Total Revenue − Economic Cost (which includes implicit cost). Economic profit is normally less than accounting profit by the size of implicit cost.
- Sunk costs are irrelevant to a forward-looking decision; only incremental cost matters.
- Opportunity cost is the master concept underlying every “what’s the cost of this choice?” question.
24.3 Short-Run Cost Analysis
In the short run, some inputs are fixed. The firm therefore has fixed and variable costs.
TipSeven Short-Run Cost Concepts
| Concept | Symbol | Formula |
|---|---|---|
| Total Fixed Cost | TFC | Independent of \(Q\) |
| Total Variable Cost | TVC | Function of \(Q\) |
| Total Cost | TC | \(TC = TFC + TVC\) |
| Average Fixed Cost | AFC | \(TFC / Q\) |
| Average Variable Cost | AVC | \(TVC / Q\) |
| Average Cost (Average Total Cost) | AC = ATC | \(TC / Q = AFC + AVC\) |
| Marginal Cost | MC | \(\Delta TC / \Delta Q = \Delta TVC / \Delta Q\) |
24.3.1 Behaviour of the cost curves
TipShape of the Short-Run Cost Curves
| Curve | Shape | Reason |
|---|---|---|
| TFC | Horizontal straight line | Fixed cost is constant |
| TVC | S-shaped, rises with output | Reflects the law of variable proportions |
| TC | TFC + TVC, parallel to TVC | Vertical sum |
| AFC | Continuously falling (rectangular hyperbola) | \(TFC\) is spread over more output |
| AVC | U-shaped | Initial gains from increasing returns; later diminishing returns |
| AC (ATC) | U-shaped, above AVC by AFC | Sum of AFC and AVC |
| MC | U-shaped; cuts AVC and AC at their minima from below | Marginal arithmetic |
24.3.2 Relations between the short-run curves
These are mechanical relations of arithmetic, not behavioural laws — and they are the most-tested points.
- \(TC = TFC + TVC\)
- \(AC = AFC + AVC\)
- \(MC = \Delta TC / \Delta Q = \Delta TVC / \Delta Q\) (TFC does not change)
- When \(MC < AVC\) → AVC is falling. When \(MC = AVC\) → AVC is at minimum. When \(MC > AVC\) → AVC is rising.
- The same logic applies to AC: MC cuts AC at AC’s minimum.
- AFC continuously falls; the gap between AC and AVC continuously narrows but never closes.
24.3.3 Worked schedule
TipA Short-Run Cost Schedule
| Q | TFC | TVC | TC | AFC | AVC | AC | MC |
|---|---|---|---|---|---|---|---|
| 0 | 60 | 0 | 60 | — | — | — | — |
| 1 | 60 | 30 | 90 | 60.0 | 30.0 | 90.0 | 30 |
| 2 | 60 | 50 | 110 | 30.0 | 25.0 | 55.0 | 20 |
| 3 | 60 | 65 | 125 | 20.0 | 21.7 | 41.7 | 15 |
| 4 | 60 | 75 | 135 | 15.0 | 18.8 | 33.8 | 10 |
| 5 | 60 | 95 | 155 | 12.0 | 19.0 | 31.0 | 20 |
| 6 | 60 | 130 | 190 | 10.0 | 21.7 | 31.7 | 35 |
Reading the schedule: AVC reaches its minimum around Q = 4 (₹18.8); MC = 20 at Q = 5 starts to rise. AC reaches its minimum a little later than AVC because AFC keeps falling.
24.4 Long-Run Cost Analysis
In the long run, all inputs are variable. The firm can choose any plant size. There is no fixed cost in the strict sense; all costs are variable.
24.4.1 The Long-Run Average Cost (LAC) curve as an envelope
For each possible plant size, there is a short-run average cost curve (SAC). The Long-Run Average Cost (LAC) curve is the envelope of all SAC curves — it touches each SAC from below at the output level for which that plant size is the cheapest. Hence the LAC is also called the planning curve.
The LAC is traditionally U-shaped, for reasons that mirror — but are different from — the short-run U-shape.
TipWhy LAC is U-Shaped (Traditional View)
| Region of LAC | Cause |
|---|---|
| Falling portion | Economies of scale — internal (specialisation, technical, financial, marketing, risk-bearing) and external (industry concentration, skilled-labour pool, infrastructure) |
| Minimum point | Minimum Efficient Scale (MES) — smallest output at which LAC is at its minimum |
| Rising portion | Diseconomies of scale — managerial diseconomies, communication breakdowns, bureaucracy, conflict of interest |
24.4.2 Modern (L-shaped) view of the LAC
Empirical work — notably by John Johnston (1960) and George Stigler — found that for many industries the LAC is L-shaped, not U-shaped: it falls and then flattens out over a wide range, with diseconomies of scale appearing only at very large output. The interpretation: management’s adaptive capacity has improved (better information systems, decentralisation, better corporate governance), so true diseconomies are deferred (dwivedi2021?).
24.4.3 Long-run marginal cost (LMC)
The Long-Run Marginal Cost (LMC) curve cuts the LAC at its minimum point — the same arithmetic relation as in the short run. At this point, $LAC = LMC = $ short-run AC = short-run MC = price (in long-run competitive equilibrium).
24.5 Economies of Scale and Scope
TipEconomies of Scale vs Economies of Scope
| Concept | Definition | Source |
|---|---|---|
| Economies of Scale | Fall in unit cost as the output of one product rises | Specialisation; spreading of fixed cost; technical economies |
| Economies of Scope | Fall in total cost when two or more products are produced jointly rather than separately | Shared inputs; common technology; joint marketing |
A bank that produces deposit-taking and lending services together at lower joint cost than two separate firms could is enjoying economies of scope. Cement companies that gain from large kilns are enjoying economies of scale.
24.6 The Learning Curve
The learning curve (Wright 1936; later popularised by Boston Consulting Group as the experience curve) captures a different cost-reduction mechanism: as cumulative output rises, the unit cost falls by a constant percentage every time cumulative output doubles. A 20-per-cent learning curve, for example, means unit cost falls to 80 per cent of its previous level with every doubling of cumulative production (wright1936?).
The learning curve is not the same as economies of scale. Economies of scale relate to the rate of output (units per period); learning relates to cumulative experience. The two often work together in practice.
24.7 Cost-Output Relationship — Short Run vs Long Run
TipShort-Run vs Long-Run Cost Behaviour
| Dimension | Short Run | Long Run |
|---|---|---|
| Inputs | Some fixed | All variable |
| Cost split | TFC + TVC | All variable |
| Average curve | SAC (one per plant size) | LAC = envelope of SACs |
| Driver of U-shape | Law of variable proportions | Economies vs diseconomies of scale |
| MC behaviour | Cuts AVC and AC at their minima | LMC cuts LAC at its minimum |
| Modern empirical shape | U-shaped | Often L-shaped |
24.8 Exam-Pattern MCQs
Q 01
Which of the following is not the same as economic cost?
View solution
Correct Option: C
Economic cost = explicit + implicit. Accounting cost recognises only the explicit; it is narrower than economic cost.
Q 02
Match the cost concept with its definition:
| Concept | Definition | ||
| (i) | Sunk cost | (a) | Cost borne by society in addition to the firm's private cost |
| (ii) | Opportunity cost | (b) | Value of the next best alternative foregone |
| (iii) | Social cost | (c) | Already incurred and irrecoverable; irrelevant for future decisions |
| (iv) | Implicit cost | (d) | Notional cost of self-owned and self-employed inputs |
View solution
Correct Option: A
Q 03
When MC is greater than AC:
View solution
Correct Option: B
MC > AC pulls the average up.
Q 04
AFC, as output rises, behaves like:
View solution
Correct Option: C
AFC = TFC / Q falls continuously and traces a rectangular hyperbola.
Q 05
From the schedule TFC = ₹100, TVC at Q = 10 is ₹150, the AC at Q = 10 is:
View solution
Correct Option: B
TC = 100 + 150 = ₹250. AC = 250 / 10 = ₹25.
Q 06
The LAC curve is described as the envelope of:
View solution
Correct Option: B
The LAC envelope wraps around the family of short-run average cost curves, touching each at the output for which that plant size is cheapest.
Q 07
Arrange the following events as cumulative production rises along a 20 % learning curve: (i) Unit cost is at the original level (ii) Cumulative output doubles for the first time (iii) Unit cost falls to 80 % of the original (iv) Cumulative output doubles a second time
View solution
Correct Option: A
Start at original cost; first doubling brings unit cost to 80 %; second doubling brings unit cost to 64 %, and so on.
Q 08
Match each long-run concept with its primary content:
| Concept | Content | ||
| (i) | Economies of scale | (a) | Cumulative-output cost reduction |
| (ii) | Economies of scope | (b) | Output per period — single product |
| (iii) | Learning curve | (c) | Joint production of two or more products at lower total cost |
| (iv) | Minimum Efficient Scale | (d) | Smallest output at which LAC is minimised |
View solution
Correct Option: A
ImportantQuick recall
- Economic cost = Explicit + Implicit; Accounting cost = explicit only.
- Opportunity cost is the master concept; Sunk cost is irrelevant for future decisions.
- Short-run identities: TC = TFC + TVC; AC = AFC + AVC; MC = ΔTVC / ΔQ.
- AFC continuously falls; AVC, AC are U-shaped; MC cuts AVC and AC at their minima.
- Long-run LAC = envelope of SACs. LMC cuts LAC at its minimum.
- Traditional LAC: U-shaped (economies → MES → diseconomies). Modern empirical LAC: often L-shaped.
- Internal economies: technical, managerial, marketing, financial, risk-bearing. External economies: industry concentration, skilled labour, infrastructure.
- Economies of Scale = lower unit cost from larger scale of one product. Economies of Scope = lower joint cost from two or more products.
- Learning curve = unit cost falls a fixed percentage with each doubling of cumulative output (Wright 1936; BCG experience curve).
- MES = smallest output at which LAC is at its minimum.