1. Theory of Costs
• Cost : is the monetary value of inputs used in the
production of an item.
Two types of cost of a product
• Social cost: is the cost of producing an item to the
society
• Private cost: is the cost of producing an item to the
individual producer.
1
2. Private cost of production can be measured
in two ways
Economic cost & accounting cost
A. Economic cost: the cost of all inputs used
to produce the item.
• Economic cost = Explicit costs + Implicit
cost
– Explicit costs – costs paid in cash
– Implicit cost – imputed cost of self-owned or self
employed resources based on their opportunity costs.
2
3. Implicit Vs Explicit Costs
– Opportunity cost principle - the economic cost of
an input used in a production process is the value of
output sacrificed elsewhere
The opportunity cost of an input is the value of
forgone income in best alternative employment
B. Accounting cost: refers to the cost of purchased
inputs only
It is the explicit cost of production only
3
4. Cost Concepts (Short-run cost of production)
1. Total Fixed Cost (TFC)
2. Total Variable Cost (TVC)
3. Total Cost (TC = TVC+TFC)
4. Average Fixed Cost (AFC = TFC/Q)
5. Average Variable Cost (AVC = TVC/Q)
6. Average Total Cost (AC = AFC+AVC)
7. Marginal Cost (MC= ∆TVC/∆Q
4
5. Cost concept …
• Total fixed cost (TFC) or fixed cost (FC) refers
to those costs that do not vary as the firm changes
its output level
– Examples: the payment or rent for land, buildings and
machinery, Depreciation, Interest, Taxes (property),
Insurance
– The fixed cost is independent of the level of output
produced.
– Graphically, it is depicted as a horizontal line
5
6. • Total variable cost (TVC) or Variable cost
(VC) refers to the cost that changes as the
amount of output produced is changed
– Examples - purchases of raw materials, payments
to workers, electricity bills, fuel and power costs
– Total variable cost increases as the amount of
output increases
• If no output is produced, then total variable cost is
zero; the larger the output, the greater the total
variable cost
6
7. • Total cost (TC) is the sum of total fixed cost and total
variable cost, i.e., TC = TFC + TVC
• As the level of output increases, total cost of the firm
also increases.
• Marginal cost (MC) is the additional cost incurred
from producing an additional unit of output:
MC = TC/Q
or MC = TVC/Q
7
8. Selected attributes
• MC is generally increasing.
• MC crosses ATC and AVC at their
minimum point.
• If MC is below the average cost, Average
cost will be decreasing.
• If MC is above the average cost, Average
cost will be increasing.
8
9. Total Costs of Production
Units of
output
Total Fixed
Cost
Total
Variable Cost
Total
Cost
Marginal
Cost
Average
Cost
Q TFC TVC TC MC AC
0 100 0 100 - -
1 100 30 130 30 130
2 100 50 150 20 75
3 100 60 160 10 53.3
4 100 65 165 5 41.25
5 100 75 175 10 35
6 100 95 195 20 32.5
7 100 125 225 30 32.14
8 100 165 265 40 33.12
9 100 215 315 50 35
10 100 275 375 60 37.5
9
12. Q
0
TV
C
AVC
TVC
(Total Variable Cost)
q1
The Average Variable
Cost at a point on the
TVC curve is measured by
the slope of the line from
the origin to that point.
AVC=TVC/Q
Minimum
AVC
12
15. 15
In summary, AVC, ATC and MC curves are all U-shaped due to the law of variable
proportions. The simplest total cost function which would incorporate the law of variable
proportions is the cubic polynomial of the following form.
3
2
3
2
1 Q
b
Q
b
Q
b
bo
TC
Where Q- is the level of output and b0, b1, b2 &b3 – are none zero constants.
From this type of total cost function,
bo- represents the TFC, and AFC =
Q
b0
3
3
2
2
1 Q
b
Q
b
Q
b
- represents TVC and
2
3
2
1
3
3
2
2
1
Q
b
Q
b
b
Q
Q
b
Q
b
Q
b
AVC
ATC = AFC + AVC
2
3
2
1
0
Q
b
Q
b
b
Q
b
16. Q
0
MC
AVC
AVC
(Average Variable Cost)
q1
The Marginal Cost curve passes
through the minimum point of
the AVC curve.
It is also U-shaped. First it
decreases, reaches a minimum
and then increases.
Minimum
AVC
MC (Marginal Cost)
16
18. 18
Finally, the MC curve passes through the minimum point of both ATC and AVC curves.
This can be shown by using calculus.
Suppose the TC = f (Q)
Slope of
But f (Q) is MC and Q1 (or dQ/dQ) =1
)
(
))
(
(
Q
f
dQ
Q
f
d
MC
Q
Q
f
Q
TC
AC
)
(
2
)
(
.
))
(
(
(Q))
(f
d
Q
Q
f
Q
Q
Q
f
dQ
d
AC
Q
Q
Q
f
Q
MC
Q
AC
)
(
2
f(Q)
-
MC.Q
19. 19
Thus, slope of
Slope AC = AC
Q
Q
f
where
AC
MC
Q
)
(
,
1
Now,
i) when MC<AC, the slope of AC is negative, i.e. AC curve is decreasing (initial
stage of production)
ii) When MC >AC, the slope of AC is positive, i.e. the AC curve is increasing
(after optimal combination of fixed and variable inputs.
iii) When MC = AC, the slope of AC is zero, i.e. the AC curve is at its minimum
point.
The relationship between AVC and MC can be shown in a similar fashion.
21. Total Product
(Q)
Total Variable Cost
(TVC)
Average Variable Cost
(AVC)
0 0 -
1 30 30.0
2 50 25.0
3 60 20.0
4 65 16.3
5 75 15.0
6 95 15.8
7 125 17.9
8 165 20.6
9 215 23.9
10 275 27.5
Table 5.5 Average Variable Costs of Production
21
22. The Link between Production and Cost
Maximum MP
Maximum AP
Minimum AVC
Minimum MC
Unit product
Unit cost
AP
MP
MC
AVC
Labor
Quantity 22
23. 23
Thus, TVC = WL
AVC =
Q
TVC
=
Q
WL
= W.
L
Q
1
But,
L
Q
represents APL
Therefore, AVC = W.
APL
1
Hence, AVC and APL are inversely related.Similarly, MCand MPL,
MC =
dQ
dTC
=
dQ
dTVC
(Remember that MC =
dQ
dTC
MC =
dQ
L
W
d )
.
(
MC = W.
dQ
dL
………………………… (because w is constant)
MC = W.
dQ
dL
MC = W.
dL
dQ
1
MC = W.
MPL
1
……………………………………………… (Because
dL
dQ
= MPL)
Hence, MC and MPL have also an inverse relation.
24. Summary of production and cost
There is an inverse relationship between AP and AVC
There is an inverse relationship between MP and MC
Whenever MP is above AP ,the MC is below AVC
Whenever MP is below AP ,the MC is above AVC
Whenever MP is equal to AP ,the MC is equal to AVC
i.e MP = AP when AP is maximum, MC = AVC, when
AVC is minimum
24
25. Cost Curves in the Long Run
• In the long run, the amount of all factors of production
can be varied so that there are no fixed costs.
• The time period corresponding to the long run will be
such a condition that the producers can make all the
necessary changes in the size of the plant.
• Fixed cost will be variable in the long run decision of
production
• When we say that fixed costs vary with the size of the
plant, we mean that all costs behave in the same way as
all other components of the variable costs.
25
26. The Long run average cost curves
• The long- run average cost curve is an ‘envelope’ of
all the short run ATC curves corresponding to all the
different levels of factors of production that are fixed
in the short- run.
• The LRAC curve is given by the point of tangency to
all the short-run curves representing all the alternative
plant sizes that a firm could be able to build in the
long-run.
• To know it more look at the following graph.
26
28. 28
Why is the LAC U-shaped?
The LAC curve is U-shaped due to the laws of returns to
scale(i.e increasing & decreasing returns to scale) that is, as
output expands from a very low levels increasing returns to
scale prevails (i.e., output rises proportionally more than
inputs), & so the cost per-unit of output falls
As output continues expand, the forces of decreasing returns
to scale eventually begin to overtake the forces of increasing
returns to scale & the LAC begins to rise
In general, the reason for the U-shaped ness of the LAC curve
are the existence of increasing returns to scale at initial stage
of expansion decreasing returns to scale at a later stage of
expansion.
29. 29
QO
C
(Increasing returns to scale
Decreasing returns to scale
C0 constant returns to scale
Fig the LAC curve is U-shaped due to the combined effects of increasing, constant and
decreasing returns.
Q
30. 30
LMC LAC
SMC2
SAC2
SMC3
Q3
Q2
Q1
C
Fig Long run marginal cost curve; it is derived from the short run marginal cost curves
by connecting the points of intersection of the vertical lines drawn from the point of
tangency of SAC curves with the LAC curves with and the corresponding SMC curves
SMC1
SAC1
SAC3
Q
31. 31
Dynamic changes in costs: the learning curve
Reason why a large firm may have a lower long-run average cost than a
small firm: increasing returns to scale in production it is tempting to
conclude that firms which enjoy lower average cost over time are
growing firms with increasing returns to scale but this need not be true
In long-run, average cost may decline over time because workers and
managers absorb new technological information as they become more
experienced at their job
That is, as workers get experience their efficiency increases which then
reduces the average and marginal costs of producing a unit of product
A firm’s learns’ over time as cumulative output increases. Managers
can use this learning process to help plan production and forecast future
costs.
32. 32
A
Number of labor required to produce one unit
Fig Learning Curve: shows that at the firm’s cumulative out put increases(as the firm gets
experienced),the amount of inputs(such as labor)required to produce one unit of out put decreases.
Learning
curve
Cumulative
out put
33. 33
Learning vs Economies of scale
A firm’s average cost of production can decline overtime because of growth of sales (output)
when increasing returns to scale prevails in the firm (a move from A to B on curve AC,), or it
can decline because there is a learning curve ( a move from A on AC, to C on AC2)
Thus, increasing returns to scale reduces average cost of production with increase in output,
where as learning shifts the average cost curve down ward.
Cost per unit of out put
Economies of scale
Learning AC1
AC2
Out put
A
C
B
