THE THEORY OF COSTS

Introduction
The costs of production are very necessary factors to be considered in
almost all business decisions especially those relating to the following;
locating the weak points in production management, minimizing
production costs, finding the optimum level of output andestimating or
projecting the costs of business operation. This chapter therefore, covers
the various costs incurred in the production process both in the short run
and the long run and indicates how they affect decision making by firms.

The Theory of Costs

Costs are the expenses that are incurred by the firm during the process of
production. Economic theory distinguishes between Short Run (SR) and
Long Run Costs (LR).

Short run costs are costs over a period of production when some Factors
of Production (FOP)are fixed e.g. capital, and others variable e.g. labor.
Hence short-run cost = fixed costs + variable costs
while;

Long run costs are the costs over a production period when all factors of
production (FOP) are variable.

Costs are categorized into;

Explicit an implicit costs
Explicit costs
Explicit costs are those which involve cash payments and fall under actual
or business costs which are entered in the books of accounts. For
example, the payments for wages and salaries, materials, license fee,
insurance premium and depreciation charges etc.

Implicit costs/imputed costs

Implicit costs may be defined as the earnings expected from resources
owned by a firm or business owner in their second best alternative use.
These costsneither take the form of cash outlays, nor do they appear in
the accounting system. For example, suppose an entrepreneur utilizes his

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services in his own business instead of working as a manager in some other
firm on a salary basis, he foregoes this salary as a manager. This loss of
salary is the opportunity cost of income from his business. This is an implicit
cost of his business. The cost is implicit, because the entrepreneur suffers
the loss, but does not charge it as the explicit cost of his own business.
Although these costs are not recorded in the firm’s books of account, they
form an important consideration in whether or not a factor would remain
in its present occupation. The explicit and implicit costs together make the
economic cost. Implicit costs can also be thought of as intangible costs
that are not easily accounted for. For example, the time and effort that
an owner puts into the maintenance of the company, rather than working
on expansion, can be viewed as an implicit cost of running the business.

Economic costs = implicit + explicit costs

Accounting costs = explicit costs

VARIATION OF COSTS IN THE SHORT -RUN

In the short run some inputs are fixed while others variable, changes in
output result from change in only the variable inputs. Because of this, the
relationship between output and costs of production in the short run is
mainly explained by the law of diminishing marginal returns.

Fixed and Variable Costs

Fixed costs/supplementary costs/Indirect costs

Fixed costs are those that do not vary with variations inoutput. Fixed costs
include cost of managerial and administrative staff, depreciation of
machinery, building and other fixed assets and maintenance of land, etc.
In other words, they are expenditures on the fixed factors of production.

Illustration: Total fixed cost (TFC)

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Variable costs/ Prime costs/Direct costs
Variable costs are those, which vary with the variation in output. Variable
costs include cost of raw materials, running cost on fixed capital, such as
fuel, repairs, routine maintenance expenditure, direct labor charges
associated with the level of output and the costs of all other inputs that
vary with changes in output.
Illustration: Total variable cost (TVC)

Total cost (TC)

Total costs refer to the total amount spent on factors of production used in
the production process. They are a sum of total fixed and total variable
costs. When output is zero, TC = TFC since TVC will be zero. The shape of
the TC curve is determined by that of the TVC curve at every level of
output, just because TFC is constant. TC will continue to rise as production
increases because there must be some increase in the variable costs as
output expands. TC first increases at a decreasing rate, reaches a point
where its slope is zero (the point of inflection) and from this point, it starts
to rise at an increasing rate. Because of this, the slope of the TC curve,
which is the marginal cost (MC) curve, is U-Shaped.

Illustration: TC, TVC and TFC

Total cost, Averagefixed cost, Average variable cost and Marginal costs
Total cost refers to the total expenditureon the resources used to produce
a given level of output. In the short- run it includes both fixed and variable
costs. The total cost for a given outputcan be given by the cost function;
= +

Average Fixed Costs (AFC)

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The AFC refers to total fixed cost per unit of output produced. It is equal to
TFC/Q. The curve for AFC is downward sloping and asymptotic to both
axes because at zero output, AFC is undefined. The curve does not cross
the output axis because FC cannot be equal to zero. The curve diminishes
downwards because fixed costs are not changing yet output is changing.

Illustration: Average Fixed Costs (AFC) curve

Average Variable costs (AVC)

AVC = TVC / Q
This is total variable cost per unit of output produced. The curve is U-
shaped due to the law of diminishing marginal returns, i.e. initially, when
more output is produced, per- unit variable cost diminishes output is
increasing at an increasing rate (the fixed factors are underutilized by the
given variable factor). As more output is produced, per- unit cost will start
increasing when the fixed factor is over utilized.

Illustration: Average Variable costs (AVC) curve

Average Cost (AC)

The Average Cost (AC) of a firm is total cost per unit of output produced.
It is obtained by dividing total cost (TC) by total output (Q),
=

AC will initially be high because fixed costs will be spread over a small
number of units of output. However, as output increases, AC will start
falling as each unit is carrying a small element of fixed cost.

Illustration: Average Cost (AC) curve

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 Marginal cost (MC)
Marginal cost is the addition to the total cost resulting from producing an
additional unit of the product. Or marginal cost is the cost of a marginal
unit produced. Given the cost function, it may bedefined as;
∆
=
∆

Illustration: Marginal cost (MC) curve

Relationship between the short run cost curves

Schedule

Q TFC TVC TC AFC AVC AC MC

0 48 0 48
1 48 25 73 48.00 25.00 73.00 25
2 48 46 94 24.00 23.00 47.00 21
3 48 66 114 16.00 22.00 38.00 20
4 48 82 130 12.00 20.50 32.50 16
5 48 100 148 9.60 20.00 29.60 18
6 48 120 168 8.00 20.00 28.00 20
7 48 141 189 6.86 20.14 27.00 21
8 48 168 216 6.00 21.00 27.00 27
9 48 198 246 5.33 22.00 27.33 30
10 48 230 278 4.80 23.00 27.80 32
11 48 272 320 4.36 24.73 29.09 42
12 48 321 369 4.00 26.75 30.75 49

Graphical relationship between short run cost curves (illustration)

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The AC, AVC and MC curves are u-shaped because of the law of
diminishing returns.
 The AC lies above the AVC and AFC curves because it is a
summation of both the AVC and AFC.
 The AVC gets close to the AC curve but does not touch it due to
the existence of fixed costs. The gap between the two curves
represents the AFC.
 The MC cuts the AVC before it cuts the AC- i.e., the AC is higher
than the AVC
 The MC cuts the AVC and AC curves at their lowest points. WHY?
 AVC reaches its minimum point at a lower level of output than the
AC curve. This is because when AVC starts to increase, AC
continues to decline because of the substantial decline in the AFC
that cannot be outweighed by the increase in AVC until the
minimum point of AC.
 When the AVC and AC are declining, the MC is below them and
when they are rising, the MC is above them.
 The AFC diminishes continuously with the increase in output and it
approaches the output axis asymptotically.
 As long as AFC and AVC fall, AC also falls because AC = AFC +
AVC

Relationship between the AC and the MC curves

As concluded from the diagram above, the MC cuts the AC curve at its
lowest point. This is because; when MC decreases, it pulls AC down, and
when MC increases, it pushes AC up and when AC is at its minimum, it is
neither being pulled down nor being pushed up by the MC. At the
minimum point of AC, the slope of the AC curve is equal to zero since it is
a turning point. The output level at this point is known as the optimal level
of output.

An optimum level of output is one which can be produced at a minimum

average cost, given the technology. The minimum level of AC is

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determined by the point of intersection between AC and MC curves. At
this level of output, AC = MC. Therefore, production below or above this
level will not be optimal because if production is below, it will leave some
scope of reducing AC by producing more because MC<AC. Similarly, if
production is greater, AC can be reduced by reducing output.

Review question

The linear cost function takes the form of TC = a + bQ

Where TC= total costs; a =TFC and bQ = TVC;
If TC = 120 + 80Q

Find FC, VC, AFC, AVC, AC and MC

The quadratic cost function takes the form of TC = a + bQ2 + Q3;

If TC = 900 + 90Q2 + Q3; find FC, VC, AFC, AVC, AC and MC

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