3. Opportunity cost and actual cost
• Opportunity cost
Refers to the loss of earnings due to opportunities foregone
because of the scarcity of resources.
If resources are unlimited – there would be no opportunity
The opportunity cost may be defined as the expected
returns from the second best use of the resources foregone
due to the scarcity of resources.
Economic rent or economic profit – excess of the earning
from current business over the income from other alternative
Implication – investing in the current business is preferable
so long as its economic rent is greater than zero.
4. Opportunity cost and actual cost
• Actual cost
Those costs which are actually incurred by the firm in
payment for labour, material, plant, building, machinery,
equipment, travelling and transport, advertisement, etc.
The total money expenses, recorded in the books of
accounts are, for all practical purposes, the actual costs.
Actual cost comes under the accounting concept.
5. Business Costs and Full Costs:
• Business cost
Business costs include all the expenses which are incurred
to carry out business.
The concept of business costs is similar to the actual or real
Business costs “include all the payments and contractual
obligations made by the firm together with the book cost of
depreciation on plant and equipment”.
These cost concepts are used for calculating business
profits and losses and for filling returns for income-tax and
also for other legal purposes.
6. Business Costs and Full Costs:
• Full costs
Full costs, on the contrary, include business costs,
opportunity cost and normal profit.
The opportunity cost includes the expected earnings from
the second best use of the resources, or the market rate of
interest on the total money capital, and also the value of
entrepreneur’s own services which are not charged for in the
Normal profit is a necessary minimum earning in addition to
the opportunity cost, which a firm must get to remain in its
7. Explicit and Implicit or Imputed Costs:
• Explicit costs
Explicit costs refer to those which fall under actual
or business costs entered in the books of accounts.
The payments for wages and salaries, materials,
license fee, insurance premium, depreciation
charges are the examples of explicit costs.
These costs involve cash payments and are
recorded in normal accounting practices.
8. Explicit and Implicit or Imputed Costs:
• Implicit costs
costs which do not take the form of cash outlays,
nor do they appear in the accounting system.
Implicit costs may be defined as the earning
expected from the second best alternative use of
Implicit costs are not taken into account while
calculating the loss or gains of the business, but
they form an important consideration in whether or
not a factor would remain in its present occupation.
The explicit and implicit costs together make the
9. Out-of-Pocket and Book Costs:
Out-of-pocket costs means costs that
involve current cash payments to
outsiders while book costs such as
depreciation do not require current cash
Book costs can be converted into out-
of-pocket costs by selling the assets
and having them on hire. Rent would
then replace depreciation and interest.
10. Short-Run and Long-Run Costs:
• Short-run costs are the costs which vary with the
variation in output, the size of the firm remaining the
same. In other words, short-run costs are the same as
• Long-run costs, on the other hand, are the costs which
are incurred on the fixed assets like plant, building,
machinery, etc. Such costs have long-run implication in
the sense that these are not used up in the single batch
• ‘the short-run costs are those associated with variables
in the utilization of fixed plant or other facilities whereas
long-run costs are associated with the changes in the
size and kind of plant.’
11. Incremental Costs and Sunk Costs
• Incremental Costs
Incremental costs are closely related to the concept of
marginal cost but with a relatively wider connotation. While
marginal cost refers to the cost of the marginal unit of
output, incremental cost refers to the total additional cost
associated with the marginal batch of output.
The concept of incremental cost is based on the fact that in
the real world, it is not practicable for lack of perfect
divisibility of inputs to employ factors for each unit of output
Besides, in the long run, firms expand their production; hire
more men, materials, machinery and equipment.
The expenditures of this nature are incremental costs and
not the marginal cost
12. Incremental Costs and Sunk Costs
• Sunk Costs
The Sunk costs are those which cannot be altered,
increased or decreased, by varying the rate of
For example, once it is decided to make
incremental investment expenditure and the funds
are allocated and spent, all the preceding costs are
considered to be the sunk costs since they accord
to the prior commitment and cannot be revised or
reversed or recovered when there is change in
market conditions or change in business decisions.
13. Historical and Replacement Costs:
• Historical costs are those costs of an asset acquired
in the past whereas replacement cost refers to the
outlay which has to be made for replacing an old
• Stable prices over time, other things given, keep
historical and replacement costs on par with each
other. Instability in asset prices makes the two costs
differ from each other.
• Historical cost of assets is used for accounting
purposes, in the assessment of net worth of the firm.
The replacement cost figures in the business
decision regarding the renovation of the firm.
14. Private and Social Costs:
• Private costs are those which are actually incurred or
provided for by an individual or a firm on the
purchase of goods and services from the market.
• For a firm, all the actual costs both explicit and
implicit are private costs. Private costs are
internalized costs that are incorporated in the firm’s
total cost of production.
• Social costs on the other hand, refer to the total cost
to the society on account of production of a
15. Urgent and Postponable Cost:
• Urgent costs are those costs which must be incurred
in order to continue operations of the firm. For
example, the costs of materials and labour which
must be incurred if production is to take place.
• Postponable costs refer to those costs which can be
postponed at least for some time e.g., maintenance
relating to building and machinery.
17. Traditional Theory of Cost
Short run is the period during which some
factor(s) 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
19. • 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.
20. Fixed costs
Fixed costs are expenses that does not
change in proportion to the activity of a
Fixed costs include overheads (rent,
insurance-premium, interests), and also
direct costs such as payroll (particularly
22. 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
23. 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.
32. Average fixed cost
Average fixed cost (AFC) = TFC/Q
where TFC = fixed cost, Q = total number of
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.
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).
42. Production Rules for the Short-Run
1. If expected selling price < minimum AVC
(which implies TR<TVC)
A loss cannot be avoided
Minimize loss by not producing
The loss will be equal to TFC
2. If expected selling price < minimum ATC but
> minimum AVC (TR > TVC but < TC)
A loss can not be avoided
Minimize loss by producing where MR = MC
The loss will be between 0 and TFC
43. Production Rules for the Short-Run
3. If expected selling price > minimum ATC
(which implies TR>TC)
A profit can be made
Maximize profit by producing where MR=MC
45. 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).
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
The LAC is derived from short-run cost curves.
Each point of on the LAC corresponds to a
point on a short-run cost curve, which is
tangent to the LAC at that point.
The LRAC curve is U-shaped, reflecting
economies of scale when it is negatively-
sloped 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
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.
59. 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
It is a planning curve because on the basis of
this curve the firm decides what plant to set up
in order to produce optimally the expected
level of output.
The LAC envelops the SAC curves because of
the assumption that each plant size is
designed to produce optimally a single level of
64. Envelope Curve
Each point on the LAC represents the least unit
cost for producing the corresponding level of
output. Any point above the LAC is inefficient
in that it shows a higher cost for producing the
corresponding level of output.
Any point below the LAC is economically
desirable because it implies a lower unit cost,
but it is not attainable in the current state of
technology and with the prevailing market
prices of factors of production.
The LMC is derived is derived from the SMC
curves but does not envelope them.
The LMC is formed from points of intersection of
the SRMC curves with vertical lines drawn
from the points of tangency of the
corresponding SAC curves and the LRA cost
The LMC must be equal to the SMC for the
output at which the corresponding SAC is
tangent to the LAC.
69. • The short-run average variable cost has a flat
stretch over a range of output which reflects the
fact that firms build plants with some flexibility in
their productive capacity
• The businessman will want to be able to seasonal
and cyclical fluctuations in his demand
• It gives the businessman greater flexibility for
repairs of broken down machinery without disrupting
the smooth flow of the production process
• The entrepreneur will want to have more freedom to
increase his output if demand increases because
he/she does not like to let all new demand go to his
70. • It also gives him/her some flexibility for minor alterations of
his product, in view of changing tastes of customers.
• Technology usually makes it necessary to build into the plant
some reserve capacity
• It is always allowed in case of land and building because
operations may be seriously limited if new land or new
buildings have to be acquired
• There will be some reserve capacity on the organizational
and administrative level.
The businessman will not necessarily choose the plant which
will give him today the lowest cost, but rather that equipment
which will allow him the greatest possible flexibility, for minor
alterations of his product or his technique.
72. • The salaries and other expenses of administrative
• The salaries of staff involved directly in the
production, but paid on a fixed-term basis
• The wear and tear of machinery
• The expenses for maintenance of buildings
• The expenses for the maintenance of land on which
the plant is installed and operates.
Short Run Average Fixed Costs
Largest capacity units of
machinery as absolute limit in
the short run
Small unit machinery – sets
a limit to expansion
74. • Direct labor which varies with output
• Raw materials
• Running expenses of machinery
Short Run Average Variable Costs
Better utilization of the fixed
factor and the consequent
increase in skills and
productivity of variable factor,
reduced wastage of raw
SAVC = MC
• Reduction in labor
productivity due to
longer hours of work;
• increase cost of labor
due to overtime
• wastage of materials;
• frequent breakdown of
76. • Due to the reserve capacity, which is further
planned in order to give maximum flexibility in the
operation of the firm
• Reserve capacity is completely different from
Why SAVC flat shaped over a range
77. Excess capacity vs reserve capacity
0 XX1 X2
80. • Production costs falls steeply to begin with and then
gradually as the scale of production increases
• The L-shape of production cost curve is due to the technical
economies of large scale production
• Initially these economies are substantial
• But after a certain level of output is reached all or most of
these economies are attained and the firm is said to have
reached the minimum optimal scale, given the technology of
• If new techniques are invented for larger scales of output,
they must be cheaper to operate.
81. • Each management technique is applicable to
a range of output.
• Organizational techniques may be small
scale as well as large scale
• The cost of different techniques of
management first fall up to a certain plant
• At very large scales of output managerial
costs may rise, but very slowly
82. • Production costs fall smoothly at very large
scales, while managerial costs may rise only
slowly at very large scales.
• The fall in production costs more than offsets
the probable rise of managerial costs, so that
the LRAC curve falls smoothly or remains
constant at very large scales of output.
83. Derivation of LRAC Curve
• Load factor: Ratio of average actual rate of use to the capacity
• In business practice it is customary to consider that a plant is used
‘normally’ when it operates at a level between two-thirds and three-
quarters of capacity.
• Here the typical load factor of each plant is taken as 2/3
• LAC does not turn up at very
large scales of output
• It is not the envelope of the
SATC curves, but rather