Cost Theory
Cost Theory explains how a firm’s costs vary with its level of output. It is a fundamental topic in microeconomics and frequently tested in UPPSC PCS exams.
Key Concepts
Short-Run Cost Curves
| Cost Type | Definition | Shape |
|---|---|---|
| Total Fixed Cost (TFC) | Cost that does not change with output | Horizontal line |
| Total Variable Cost (TVC) | Cost that changes with output | Initially increasing at decreasing rate, then at increasing rate |
| Total Cost (TC) | TFC + TVC | Same shape as TVC, shifted up by TFC |
Average and Marginal Costs
- Average Fixed Cost (AFC) = TFC / Q — declines as output rises (never rises)
- Average Variable Cost (AVC) = TVC / Q — U-shaped; falls then rises due to diminishing returns
- Average Total Cost (ATC) = TC / Q — U-shaped; sum of AFC and AVC
- Marginal Cost (MC) — change in total cost from producing one extra unit; cuts ATC and AVC from below at their minimum points
Relationship Between MC and Other Costs
- When MC < AVC, AVC falls
- When MC > AVC, AVC rises
- MC curve intersects AVC and ATC at their minimum points
Laws of Production in Short Run
Law of Variable Proportions
Three phases:
- Increasing Returns — MP of variable factor rises (MC falls)
- Diminishing Returns — MP of variable factor falls (MC rises)
- Negative Returns — TP falls, MP becomes negative
Cost Function
The cost function is derived from the production function:
- TC = f(Q) where costs increase with output
- In short run: TC = TFC + bQ + cQ² (quadratic form)
Long-Run Cost Analysis
In the long run, all inputs are variable. The Long-Run Average Cost (LAC) curve is the planning curve — it envelopes the short-run ATC curves.
- Economies of Scale: LAC falls as output increases (bulk buying, specialization, division of labour)
- Diseconomies of Scale: LAC rises at very high output levels (management difficulties)
- Minimum Efficient Scale (MES): Output level where LAC is lowest
Shape of LAC
Typically U-shaped, but can be L-shaped (natural monopoly) or saucer-shaped depending on industry structure.
Fixed vs Variable Costs
| Aspect | Fixed Costs | Variable Costs |
|---|---|---|
| Change with output | No | Yes |
| Examples | Rent, salaries, insurance | Raw materials, direct labour |
| Decision horizon | Sunk in short run | Relevant for production decisions |
| Behaviour | Constant | Initially decreasing, then increasing |
Tricks & Tips for Exam
- MC is derived from TC: MC = ΔTC / ΔQ
- In the short run, when MP is maximum, MC is minimum
- TFC is always falling (as a curve), never rises
- The gap between ATC and AVC = AFC, which narrows as output increases
- MC always cuts AVC and ATC at their lowest points (from below)
Previous year UPPSC PCS questions from Cost Theory have focused on MC curve properties, relationship between cost curves, and the Law of Variable Proportions.