Cost theory

Why Study Costs?

Whatever

may be the type of firm, it is

important to ascertain that it is not incurring
losses
Decisions relating to expansion (or otherwise),
new product development, forecasting and
policy making, etc can be taken only after
considering costs
Concept of cost is closely related to production
theory
Cost function is the relationship between a
firms costs and the firms output

Cost Concepts
Money

costs (Actual Costs) are the total money

incurred by a firm in producing a commodity or
service

wages and salaries, cost of raw materials, expenses

on machines/buildings/capital goods, power
charges, transportation, advertisement, interest
expenses, taxes, depreciation etc

Implicit costs are the imputed value of the

entrepreneurs own resources and services
Variable costs are costs that vary with the volume
of output
Fixed costs do not vary with output in the short-run

Cost Concepts
Opportunity

cost is the cost of missed

opportunity or alternative forgone in having one
thing rather than the other (since resources are
limited they cannot be used to produce all
things simultaneously)
Marginal Cost is the addition to the total cost by
producing an additional unit of out put
MC = change in TC/change in TO

Costs
Short

run Diminishing marginal returns

results from adding successive quantities of
variable factors to a fixed factor
Long run Increases in capacity can lead to
increasing, decreasing or constant returns to
scale

Costs

In buying factor inputs, the firm

will incur costs
Costs are classified as:

Fixed costs costs that are not related directly to

production rent, rates, insurance costs, admin costs.
They can change but not in relation to output
Variable Costs costs directly related
to variations in output. Raw materials, labour, fuel, etc

Costs
Total

Cost - the sum of all costs incurred in

production
TC = FC + VC
Average Cost the cost per unit
of output
AC = TC/Output
Marginal Cost the cost of one more or one
fewer units of production
MC = TCn TCn-1 units

Cost Concepts(SHORT RUN)

TC=TFC+TVC
AFC=TFC/Total

Output
AVC=TVC/Total Output
AC=TC/Q = (TVC+TFC)/Q = AVC+AFC
MC = change in TC/change in TO

A Firms Short Run Costs

AverageCosts
AverageTotalcostfirmstotalcostdividedbyitslevelofoutput
(averagecostperunitofoutput)

ATC=AC=TC/Q
AverageFixedcostfixedcostdividedbylevelofoutput(fixedcost
perunitofoutput)

AFC=FC/Q
Averagevariablecostvariablecostdividedbythelevelofoutput.

AVC=VC/Q

MarginalCostchange(increase)incostresultingfrom
theproductionofoneextraunitofoutput

Denotechange.ForexampleTCchangeintotalcost

MC=TC/Q
Example:when4unitsofoutputareproduced,thecostis80,
when5unitsareproduced,thecostis90.MC=(9080)/1=10

Cost Curves for a Firm

TC

Cost 400
($ per
year)

Total cost
is the vertical
sum of FC
and VC.

300

VC
Variable cost
increases with
production and
the rate varies with
increasing &
decreasing returns.

200

Fixed cost does not

vary with output

100
50
0

10

11

12

13

FC
Output

Average and marginal costs

Average fixed costs

Marginal costs

Average total Cost (ATC) and

Average variable costs(AVC)

The Relationship Between MP, AP,

MC, and AVC

Average and marginal costs

MC

AC

Costs ()

AVC

z
y
x
AFC

fig

Output (Q)

Shift of the curves

TC

TC

Cost 400
($ per
year)

VC
300

200
FC

150
100

FC

50
0

10

11

12

13

Output

Short-Run Cost
The MC curve is very
special.
Where AVC is falling, MC
is below AVC.
Where AVC is rising, MC is
above AVC.
At the minimum AVC, MC
equals AVC.
Similarly, where ATC is
falling, MC is below ATC.
Where ATC is rising, MC is
above ATC.

Short run average cost curve, initally it is worth producing more, as you
are making use of the fixed resource(eg, computer). however, as the law
of diminishing return sets in, it is more costly to produce the extra unit of
output.
In the short term, there is at least one fixed unit of input that cannot be
changed, and because of that, the law of diminishing return applies,
saying that as you add successive units of labour into a fixed input, the
marginal return diminishes over time.

Costs ()

Why Average costs U shaped? AC

Output (Q)
Reason: In the short term, there is at least one fixed unit of input that cannot
be changed, and because of that, the law of diminishing return applies, saying
that as you add successive units of labour into a fixed input, the marginal return
diminishes over time.

Summary
Intheshortrun,thetotalcostofanylevelofoutputisthesumoffixed
andvariablecosts:TC=FC+VC
Averagefixed(AFC),averagevariable(AVC),andaveragetotalcosts
(ATC)arefixed,variable,andtotalcostsperunitofoutput;marginal
costistheextracostofproducing1moreunitofoutput.
AFCisdecreasing
AVCandATCareUshaped,reflectingincreasingandthendiminishing
returns.
Marginalcostcurve(MC)fallsandthenrises,intersectingbothAVC
andATCattheirminimumpoints.

The Long-Run Cost Function

LRAC

is made up for
SRACs

SRAC curves represent

various plant sizes
Once a plant size is
chosen, per-unit
production costs are
found by moving along
that particular SRAC
curve

The Long-Run Cost Function

The

LRAC is the lower envelope of all of the

SRAC curves.
Minimum

efficient scale is the lowest output

level for which LRAC is minimized
Is LRAC a function of market size?
What are implications?

The Envelope Relationship

The
At

envelope relationship explains that:

the planned output level, short-run average

total cost equals long-run average total cost.
At all other levels of output, short-run average
total cost is higher than long-run average total
cost.

Deriving long-run average cost curves:

factories of fixed size

Costs

SRAC1 SRAC
2

SRAC3

5 factories

1 factory
4 factories

2 factories
3 factories

SRAC5
SRAC4

fig
Output

Deriving long-run average cost curves:

factories of fixed size
SRAC1 SRAC
2

SRAC3

SRAC5
SRAC4

Costs

LRAC

fig
Output

Envelope of Short-Run
Average Total Cost Curves

Costs per unit

LRATC

SRMC1

SRATC4

SRATC1
SRMC2

SRMC4
SRATC2 SRATC3
SRMC3

Q2

Q3

Quantity

Costs per unit

Envelope of Short-Run Average Total

Cost Curves

LRATC
SRMC1

SRATC4

SRATC1
SRMC2

SRMC4
SRATC2 SRATC3
SRMC3

Q2

Q3

Quantity

The Learning Curve

Measures the percentage

decrease in additional labor
cost each time output
doubles.
An 80 percent learning
curve implies that the labor
costs associated with the
incremental output will
decrease to 80% of their
previous level.

The LR Relationship Between

Production and Cost
In

the long run, all inputs are variable.

What makes up LRAC?

Production in the Long run

Economies

of scale

specialisation

& division of labour

indivisibilities
container

principle
greater efficiency of large machines
by-products
multi-stage production
organisational & administrative economies
financial economies

Production in the Long run

Diseconomies

of scale

managerial

diseconomies
effects of workers and industrial relations
risks of interdependencies
External

economies of scale

Location
balancing

the distance from suppliers and consumers

importance of transport costs
Ancillary industries-by products

 Internal

economies and diseconomies

affect the shape of the LAC
External Economies affect the position of the
LAC
External Diseconomies may cause increase
in prices of the factors of production

Economies of Scope
There

are economies of scope when the

costs of producing goods are interdependent
so that it is less costly for a firm to produce
one good when it is already producing
another.
S = TC(QA)+TC(QB )- TC(QA QB)
TC(Q A,QB )

Economies of Scope
Firms

look for both economies of scope and

economies of scale.

Economies

of scope play an important role in

firms decisions of what combination of goods
to produce.

Summary

An economically efficient production process

must be technically efficient, but a technically
efficient process may not be economically
efficient.
The long-run average total cost curve is Ushaped because economies of scale cause
average total cost to decrease; diseconomies of
scale eventually cause average total cost to
increase.

Summary

Marginal cost and short-run average cost curves

slope upward because of diminishing marginal
productivity.
The long-run average cost curve slopes upward
because of diseconomies of scale.
The envelope relationship between short-run and
long-run average cost curves shows that the
short-run average cost curves are always above
the long-run average cost curve.

Summary

Marginal cost and short-run average cost curves

slope upward because of diminishing marginal
productivity.
The long-run average cost curve slopes upward
because of diseconomies of scale.
The envelope relationship between short-run and
long-run average cost curves shows that the
short-run average cost curves are always above
the long-run average cost curve.

Summary

Marginal cost and short-run average cost curves

slope upward because of diminishing marginal
productivity.
The long-run average cost curve slopes upward
because of diseconomies of scale.
The envelope relationship between short-run and
long-run average cost curves shows that the
short-run average cost curves are always above
the long-run average cost curve.

Revenue

Total revenue the total amount received from

selling a given output
TR = P x Q
Average Revenue the average amount received
from selling each unit
AR = TR / Q
Marginal revenue the amount received from
selling one extra unit
of output
MR = TRn TR n-1 units