Cost Benefit Analysis in Economics -

Last Updated on: 19th September 2024, 11:57 am

Cost Benefit Analysis

Cost analysis

In this Part, we discuss about Cost Analysis, study of behaviour of cost in relation to production criteria

Cost Classification
Cost Function
Short & Long Run Cost
Total Cost
Fixed & Variable Cost
Average Cost
Marginal Cost

Cost Classification

Cost Classification refers to segregation of all expenses incurred by a producer, to get the production factors for producing the final output. Such cost also includes normal profit, needed by a firm to survive in the market.

Accounting Cost : Accounting cost (also called as Explicit Cost /Money Cost) includes expenditures, incurred in purchasing or hiring the factors of production (e.g. Workers Wages, cost of fuel and power, rent on building, cost of raw material, interest on borrowings etc.), excluding implicit cost.
Implicit Cost: Implicit cost represents the cost of factors owned by the promoter himself and employed in his own business (i.e., interest on the entrepreneur’s capital, his own salary etc.).
Economic Cost: Economic Cost is the sum of Explicit and Implicit cost. Economic costs includes those cost which are actually incurred by a firm for purchase or hire of services of labour inputs and the cost of self supplied factors of production (which are normally not recorded into the books of accounts).
Outlay Cost: Outlay cost implies the actual outlay or expenditure incurred by a firm on production of a commodity. It includes expenditure on wages and salaries, expenditure on machinery and equipment, materials, power, fuel, transportation, rents, insurance taxes etc.
Opportunity Cost: Opportunity Cost represents the alternative earning that might have been earned, if the productive capacity or services had been put to some other alternative. It indicates the advantage lost due to not using the facility in the manner originally planned.

For example, if an owned building is proposed to be used for a project, the likely rent of the building is the opportunity cost which should be taken into considerations, at the time of appraisal of the profitability of the project.

In considering opportunity cost, the best alternative (where several alternatives exist) should be considered.

Direct Cost: Direct Costsare costs directly identifiable with particular product (e.g. raw materials used in manufacturing a product).
Indirect Costs : Indirect Costs are normally some common costs which cannot be identified with a particular product (e.g. repairing of building, manager’s salaries, depreciation etc.)
Shutdown Cost: Shutdown costsare those which are incurred in the event of temporary cessation of business activities, and which could be saved if operation were allowed to be discontinued. Besides fixed costs, shutdown costs cover the additional expenditure, such as salary of security guard in looking after the property.
Abandonment Costs: It refers to the cost of retiring a fixed asset from use (e.g.old office equipment may be useless due to the development of new technology). Thus, abandonment cost involves permanent cessation of activity and may lead to sale of the assets.
Fixed Cost: Fixed costs include those costs, which do not alter with changes in the quantity of production or size of output during the period. They remain constant during the specified period, at any level of production. These costs are related to fixed factors of production, e.g. rent, interest payable (these are also sometimes referred as supplementary cost).
Variable Cost: Variable costs are those, which change with the change in the quantity of output or production. These cost rise with the increase in output and decrease with a decrease in output.
Marginal Cost: Marginal Cost refers to the additional cost for production of an additional unit of a commodity.Marginal Cost may be classified as Short-run Marginal Cost and Long-run Marginal Cost.
Semi-variable Cost: Semi-variable costs include expenses which remain constant upto a certain level of output and then start rising proportionately. These costs arise where there is no proper segregation of the cost i.e. whether it is a fixed cost or a variable cost.
Average Cost : It isthe ratio between the total cost of production and the quantity of a given output

Cost Function

Cost Function depicts the relationship between the cost of a product and its various cost determinants

The Cost function may be mathematically expressed as : C =f (O, T, U, P), where C= Cost of output, O= Size of output, T =Time under consideration, U= Utilization of capacity, P= Price of production factors

Cost Determinants

Price of Inputs: The cost of a product is determined by the prices of production factors, which depends upon the input contribution made in the total cost of a product.
Size of plant: The size of plant (or scale of operation) is inversely related to the cost. If the scale of operation rises, the cost decline and vice versa.
Level of output: Total output and total cost are directly related to each other. If the level of output rises, the total cost also rises and if the level of output declines, the total cost also declines.
Technology: The adoption of new technologies may help to decrease the cost of production to a great extent. However, in case of rapid developments of technologies, it may become obsolete over a period of time.
Stability of output: The Cost of a product is also influenced by the stability of output. Interruption and variations may increase the cost of production.
Managerial efficiency: The efficiency and productivity of input factor may be improved by efficient supervision and control of cost. This leads to reduction in cost of production.

Short-Run

Short Run is a period in which some factors are fixed and some factors are variable. Fixed factor have fixed cost and variable factor have variable cost. So, law of variable proportion applies in Short Run. In short-run, output can be increased or decreased by changing variable factors only, but fixed factors cannot be varied.

In the short run if due to any reason firm cannot cover its total variable cost, it shut down the operation temporarily because firm always try to meet marginal cost of production. If it cannot do it, firm will stop production for finding the fault.

Long-Run

Long-Run is a period in which all factors can be varied. In Long Run, there is only variable cost, it does not have fixed cost. So law of returns to scale applied in long run. In long-run, output can be increased or decreased by changing all the factors.

Short Run period and long run period cannot be quantified.

Total Cost

Total cost of production is the sum of all expenditure incurred in producing a given volume of output. Mathematically, Total Cost may be represented as :TC = TFC + TVC, where TC = Total Cost, TFC = Total Fixed Cost, TVC = Total Variable Cost.

Total Fixed Cost (TFC)

Fixed Cost does not change with changes in the level of output. TFC is parallel to X-axis. Even at zero output, fixed cost remain the same in the short run (e.g. rent and insurance).

Total fixed cost curve is a straight line parallel to horizontal axis because with change in output there is no change in total fixed cost.

Total Variable Cost (TVC)

Variable Costs are those costs that change with changes in level of output.

Output (Q)	TFC	TVC	TC
0	20	0	20
1	20	16	36
2	20	32	52
3	20	48	68
4	20	64	84

Total Variable Cost Curve-dvidya.com

Average Total Cost (ATC)

Average Total Cost (ATC) is the sum of Total Fixed Cost (TFC) and Total Variable Cost (TVC) divided by the output.

So, ATC = TC/Q or ATC = AFC + AVC. The ATC curve first falls, reaches it’s minimum and then rises. The ATC curve is ‘U’ shaped due to law of variable proportions.

Average Total Cost Curve-dividya.com

Average Fixed Cost : Average Fixed Cost (AFC) is the total fixed cost divided by the output. AFC = TFC/Q. The general shape of the AFC curve is downward sloping. It does not touch the X-axis as AFC cannot be zero. It is not ‘U’ shape (the shape is Rectangular Hyperbola)

Average Fixed Cost Curve-dividya.com

Average Variable Cost : Average variable cost (AVC) is the total variable cost divided by the output. AVC =TVC/Q. The average cost curve will first fall, then reach a minimum and then rise again. It has ‘U’ shape.

Average Variable Cost Curve-dividya.com

Average Cost Curve Components-dividya.com

Marginal Cost

Marginal Cost is an additional cost incurred for producing one more unit of output.

Marginal cost (MC) is the change in Total Cost due to change in the output.

MC = ∆Total Cost / ∆Qty. produced, or MC = ∆Total Variable Cost / ∆Qty. produced.

The MC curve is also ‘U’ shape.

For example 15 units produced at Rs.200 and 20 units produced at Rs.250, then

MC = ∆TC / ∆ unit produced = (Rs.250 – Rs.200) / (20 units – 15 units) = 50/5 = Rs.10 unit.

Total Average cost = Average Fixed Cost + Average Marginal cost

Marginal cost have a relationship with average cost. When average cost is falling, marginal cost (MC) is less than the average cost. When average cost is rising, marginal cost is greater than the average cost.

Firm attains equilibrium point under long run when AR = MR = MC

Out put (Unit)	Total fixed cost TFC	Total variable TVC	Total cost TC	Av. fixed cost AFC	Av. Variable AVC	Av.Total AC	Marginal cost MC
0	20	–	20	–	–	–	–
1	20	20	40	20	20	40	20
2	20	36	56	10	18	28	16
3	20	48	68	6.66	16	22.66	12
4	20	56	76	5	14	19	8
5	20	64	84	4	12.8	16.8	8
6	20	76	96	3.33	12.66	15.29	12
7	20	92	112	2.86	13.14	16	16
8	20	112	132	2.50	14	16.50	20
9	20	135	155	2.22	15	17.22	23

Characteristics of Marginal Cost Curve

Marginal Cost Curve-dvidya.com

At initial level, when a firm enhances its output, the total cost and variable cost start rising at a decreasing rate, because at initial level of production, the laws of increasing returns apply. At initial level, the firm enjoys many economies that cause MC to fall down.
As the output continues, marginal cost becomes minimum and then ultimately start increasing due to operation of Law of Diminishing Returns.

Thus initially MC declines and after reaching the minimum point, starts increasing. This is the reason MC curve becomes U shaped.

When average cost curve is upward moving, marginal cost must also be rising.

Long Run Average Cost

A long run Average cost curve depicts the functional relationship between output and long run cost of production. Cost that are fixed in short run can be changed in long run. In the long run, the firm has a choice in the employment of plant which yields minimum possible unit cost for producing a given output.

The average cost in long run is the total cost in long run divided by the level of output.

Long Run Average Cost (LAC) = {Long Run Total Cost (LTC)} / {Output (Q)}

In long run, the firms can utilise different sizes of plants. The given level of output can be achieved from the appropriate. Size to obtain at the lowest average cost. The long run average cost curve can be obtained from the short run average cost curves. It is tangent to various short run average cost curves.

Long Run Average Cost Curve-dvidya.com

The graph shows that for producing OQ₀ level of output the corresponding point on LAC curve is ‘A’ at which the LAC curve is tangent to Short run Average Cost Curve SAC₀.

Thus, if a firm is willing to produce OQ₀ level of output, it has to build a plant corresponding to SAC₀ and will operate the plant at point ‘A’ on this curve.

Long Run Marginal Cost

Long run marginal cost (LMC) is the extra cost on production of one more unit of commodity

LMC = ∆LTC / ∆Q, Where, LMC= Long run marginal cost, ∆LTC= Change in long run total cost, ∆Q= Change in output level

Break Even Point : Break Even Point (BEP) is the NO profit NO loss position. At break even point, revenue is equal to costs. Until firm’s production level crosses the Break Even, firm does not earn profit. Firm starts earning operating profits when it crosses Break Even point.

MCQ related to Micro Economics

MCQ related to Cost Analysis

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Cost Benefit Analysis in Economics