Cost Theory

Short run costs: total costs, average costs and marginal costs
The key determinant of a time period being short run is that at least one factor of production is
fixed

Total cost (TC)

Total cost is the cost of all the resources needed to produce a given level of output. Total cost
comprises total fixed cost (TFC) and total variable cost (TVC).

Fixed costs
Fixed costs are costs which do not change when levels of production change, for example, the rent
of premises.

Variable costs
Variable costs are costs which change according to the level of output, for example, raw material
costs.

Average cost (AC)

Average cost for a given level of output is the total cost divided by the total quantity produced.
Average cost is made up of an average fixed cost per unit plus an average variable cost per unit.

Average fixed cost per unit (AFC)

Average fixed cost per unit total fixed costs divided by the number of units. It will get smaller as
the number of units produced (N) increases. This is because TFC is the same amount regardless of the
volume of output, so as number of unit gets bigger, AFC must get smaller.

Average variable costs per unit (AVC)

Average variable costs per unit total variable costs divided by the number of units. It will also
change as output volume increases, but may rise as well as fall.

Marginal cost (MC)

Marginal cost the extra cost (incremental cost) of producing one more unit of output.
E.g.-Fill the table and plot the cost curves AC, AVC, AFC and MC in a graph
Quantity TVC AVC TFC AFC TC AC MC

0 0 100 100

1 49 100 149 49

2 80 100 180 31

3 99 100 199 19

4 112 100 212 13

5 125 100 225 13

6 144 100 244 19

7 175 100 275 31

8 224 100 324 49

9 298 100 398 74

10 400 100 500 102

11 639 100 639 139

12 720 100 820 181

Long Run Costs
In long run there is no fixed cost. The average cost curve takes a “U” shape which denotes the
return to scale theory.

Economies of scale
Economies of scale means factors which cause unit cost to decline in the long run as output
increases.
As production scale increases towards QMES (the quantity at which minimum efficient scale is
achieved) the average cost falls progressively. This is the effect of economies of scale or increasing returns
to scale.
If the firm increases production above QMES towards QMAX (the quantity at which maximum
efficient scale is achieved) it will enjoy no further reduction in average costs, because the potential for
further economies of scale have been exhausted. This is the range of constant returns to scale.
If the firm increases output beyond QMAX it begins to suffer inefficiencies and rising average costs.
These are diseconomies of scale or decreasing returns to scale.
Sources of economies of scale
Internal economies: economies arising within the firm from the organization of production
 External economies: economies attainable by the firm because of the growth of the industry as a
whole
Internal economies of scale
1. Technical economies
 larger and more specialized machinery
 Dimensional economies of scale arise from the relationship between the volume of output and
the size of equipment

2. Commercial or marketing economies

 Buying economies may be available, reducing the cost of material purchases through bulk
purchase discounts
 Inventory holding becomes more efficient
 Bulk selling will enable a large firm to make relative savings in distribution costs, and
advertising costs.
 Economies of scope refer to the cost savings available by offering a wider range of products.
3. Organizational economies
 More efficient use of management
 Specialist staff
4. Financial economies
 A large cost of many firms is the interest they must pay on borrowing capital from banks. Large
firms will generally enjoy the following financial economies of scale.
External economies of scale
External economies of scale occur as an industry grows in size.

 A large skilled labour force is created and (external) educational services can be geared towards
training new entrants.
 Specialized ancillary industries will develop to provide components, transport finished goods,
trade in by-products, provide special services and so on
 Government assistance may be granted to industries that promise large amounts of jobs or
export earnings.
Diseconomies of scale
Economic theory predicts that there will be diseconomies of scale in the long run costs of a firm,
once the firm gets beyond an ideal size.
The main reasons for possible diseconomies of scale are managerial, human and behavioral
problems of a large firm. In a large firm employing many people, with many levels in the hierarchy of
management, there may be a number of undesirable effects.
Minimum efficient scale
Minimum efficient scale is the lowest level of output at which the firm can achieve minimum
average cost
The level of the minimum efficient scale (MES) will vary from industry to industry