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The cost and output are interrelated.

The cost of product depends upon several factors such


as volume of production, relationship between the cost and output, prices and productivity of
inputs such as land, capital, labour, time scale.
The cost-output relationship mainly differs in short-run and the long-run. In short-run, the cost
can be classified into fixed cost and variable cost. The cost-output relationship in short-run is
governed by certain restrictions in terms of fixed costs. Whereas in the long run, the cost output
relationship is governed by the effect of varying size of plant upon its cost.
Cost-output relationship facilitates many managerial relationships such as:
(a) Formulating the standards of operations.
(b) Formulating the rational policy on plant size.
(c) Formulating a policy of profit prediction.
(d) Formulating a policy of pricing fixation.
(e) Formulating a policy of promotion methods.
(f) Formulating a policy of expenses control.
Cost in Short-run
Cost in the short-run can be classified into fixed cost and variable cost. The fixed cost may
ascertain in terms of total fixed cost and average fixed cost per unit. The variable cost can be
determined in terms of average variable cost, total variable cost.
The following Table gives information about the behaviour of costs in the short-run.

From the above table, it is clear that:


I. Total fixed cost remained fixed irrespective of increase or decrease in production of activity.
2. The total variable cost increases proportionately with production. Here the rate of increase is
not constant.
3. The total cost increases with volume of production. The average fixed cost per unit decreases
as the volume of production increases; whenever production increases, the fixed costs are shared
to a greater number of units, thus, fixed cost of unit variable declines.
4. The average total cost decreases up to a certain level of production. After this level it rises
slowly. If this is represented graphically, it results in a flat U-shaped curve. The lowest point of
the average total cost curve denotes the ideal level of production.
5. Marginal cost is the change in total cost resulting from unit change in output.
6. The marginal cost also decreases up to a certain level of production, later it rises slowly.
From the above table, we find as the output goes on increasing, average fixed cost curve (1\ FC)
will continue to decrease. 1\ FC curve indicates downwards slope and it appears

10 meet the X-axis but will never meet the X-axis for several reasons. The average variable cost
(AVC) is a U-shaped curve denoting that the AVC tends to fall in the beginning when the output
is increasing but for a particular level output, it rises because of the application Law of Returns
or Law of Variables Proportions or Law of Diminishing Returns. Average total cost (ATC) is the
sum of the AVC and AFC. It is to be noted that it will be nearer to the AFC curve in the initial
stages because the higher AFC at the initial level of output has greater influence on ATC. As
output increases and AFC decreases, the influence of AFC on ATC also will decline. It indicates
with the increasing output, the ATC curve will be distancing itself from the AFC curve. In the
final stages the ATC curve will be nearer the AVC curve because the influence of AVC on ATC is
greater at higher levels of output. It is to be noted the ATC curve never touches the AVC curve or
AFC curve for several reasons-

The marginal cost curve is also a U-shaped curve. It falls in the beginning and rises sharply. The
rising marginal cost curve will pass through the minimum point of the AVC and the minimum
point on ATC at P and Q respectively.
Marginal Cost:
Marginal cost is less than the average cost when the average cost is falling. The Fig. 3.4 shows
marginal cost where MC < AC.

Average cost:
When the average cost is rising, the marginal cost is more than the average cost. The Fig. 3.5
shows average cost where MC > AC.
If average cost is constant, the marginal cost is also constant, the Fig. 3.6 presents when AC
constant, MC coincides with the AC.

Cost in Long-run
Long-run refers to the period of time over which all factors are variable. The firm has more time
at its disposal to make any change in the production depending on its requirements. The firm can
expand its production, upgrade its production facilities, enter into new markets, initiate necessary
changes in the labour force, import technology, or undertake research and development. The firm
can plan and organize every strategy to reduce its cost of production or maximize the volume of
production. It has no constraints in terms of resources. It has no fixed costs. All costs are
variable. So, the long-run costs refer to the costs of producing different levels of output by
changing the scale of production.
A long-run is also expressed as a series of short- runs. It is already expressed that every short-run
average cost curve is associated with a short-run. This further explains that the long-run is
associated with series of short-run of average cost curves. The long-run average cost curve
(LAC) is flat U-shaped curve enveloping a series of short- run average cost curves, (SACs). It is
tangential to all the SACs. The points of tangency represent minimum average cost in the long
run, and not in the short run.
The long-run and short-run average cost are equal to each other only at particular points of
tangency. Each of the SAC curves is an operating curve, which decides the current production
level. The LAC curve is planning curve as the long-run demand of the product is to be taken into
consideration before deciding upon the right size of the plant.
The U-shape implies that the cost of production continues to be low till the firm reaches the
optimum scale (Marginal cost = Average cost). Beyond this level the cost of production
increases. In the beginning stages, when the firm unleashes all its potential, that is, releases all its
inputs proportionately and simultaneously, it enjoys increasing returns to scale, for some time.
The cost of production for unit decreases. It is, at the stage, that the firm enjoys the economies of
scale. This benefit continues for some time and after reaching a particular level of output, the
long-run average cost reaches minimum beyond which the output increases less than
proportionately. This indicates that diseconomies of scale creep in.
Fig. 3.7 shows how LAC curve envelopes several short-run average cost (SAC) curves.
Suppose the firm is producing an output of OX units on a plant of SAC. If it wants to produce
OX2 units of output, either it can operate on SAC by over utilizing SAC plant or by acquiring a

bigger size plant SAC2 and operating on it. It will be less costly to operate on SAC2. If it wants
to produce OX3 units of output, it can operate on the bigger size plant SAC] at least cost. X3A3
is the least cost at the output OX) and the firm attains optimum output in the long- run at OX3
level of output. If it operates on SAC2 to produce OX3 units of output, the cost will be
prohibitively high being X3A33 as shown in Fig. 3.7.

It is to be noted that there is only one short-run average cost curve SAC3 which is tangential to
the long-run average cost curve at its minimum point. All other SAC curves are tangential to the
LAC curves at higher than their minimum average cost points.
Long-run average cost curve is of great utility for the entrepreneur to make decisions relating to
expansion of the size of the firm. It helps to minimize the costs to the advantage of the firm.
However, it is to be noted that the U- shaped LAC curve assumes away the technological
progress. One deficiency of economic theories is that technology is assumed to be constant but
whereas it is not really so and we find rapid technological changes taking place very frequently
making economic theories less relevant.
Optimum Size of the Firm
The term 'optimum' literally means the conditions that produce the best result wherein the firm
the maximum profits per unit at minimum average cost. Optimum size is defined by several
experts. For instance, Robinson defines an optimum firm as follows:
"We must mean that firm which in existing conditions of technique and organizing ability has the
lowest average cost of production per unit when all those costs which must be covered in the
long-run are included".
It is clear that a firm is said to be in optimum size when it is in a position to utilize its resources,
including technology, most efficiently. As a result of this, the cost of production is the minimal
and the productivity is very high. Many a time, we find a business unit of a particular size
operating efficiently than a unit of slightly bigger than a smaller size, this size is called the
"optimum size". The size of the firms depends on the nature of industry. An understanding of
optimum size of the firm will enable the entrepreneur or promoter to choose the right size of the
firm in the setting up of project. Generally, in every industry, there is an 'economic size' of the
firm. If a business is started with a larger than the economic size, there is every possibility of
suffering losses and hence it is necessary to understand the concept of optimum size of firm
venturing into business.

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