Introduction to Economics Chapter Four Theory of Cost

CHAPTER FOUR
4. THEORY OF COSTS
Why do firms care about costs? Clearly they must pay careful attention to costs because every
Birr of cost reduces the firm’s profits. But costs are important in economics for a deeper reason;
firms will decide how much of a good to produce and sell depending on the price and cost of the
good. More precisely, supply depends upon incremental or marginal cost, which is a key concept
for understanding a firm's behavior.

The production function relates inputs to outputs. These inputs have prices and represent costs to
the firm. These prices are determined in factor markets and may or may not be affected by the
firm itself. Given the prices of inputs and the production function, we can derive cost data for the
firm. The general name for the relation between costs and output is "cost function". Hence, cost
functions are derived functions (derived from production function).The production function of a
firm and the prices it pays for its inputs determine the firm's cost function. Since a production
function can take different forms, with either one or some or all of the inputs variable, cost
functions can also take different forms.
4.1 Short-Run Costs
4.1.1. Total Cost (TC), Total Fixed Cost (TFC) and Total Variable Cost (TVC)
Short-run costs are costs over a period during which some factors of production usually capital
equipment and management) are fixed. Short-run total costs are split into two groups: total fixed
costs (TFC) and total variable costs (TVC): TC = TFC+TVC. TVC is a cost that varies as output
varies whereas TFC is a cost that does not vary with the level of output. The fixed costs include:
 Salaries of administrative staff
 Expenses for building depreciation and repairs
 Expenses for land maintenances
 Depreciation of machinery.
The variable costs include:-
 The raw materials cost
 The cost of direct labor
 The running expenses of fixed capital, such as fuel, ordinary repairs and routine
maintenance.

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Introduction to Economics Chapter Four Theory of Cost

As the TFC does not depend on the level of output, it is represented by a horizontal line.
TC
Cost
TVC

TFC
O Output (Q)
Figure 4.1: The short run TC, TFC and TVC curves
The TVC has usually an inverse-S shape which reflects the law of variable proportions.
According to this law, at the initial stage of production with a given plant, as more of the variable
factors is employed, its productivity increases and thus, TVC increases at a decreasing rate =
AVC declines. When the productivity of the variable input falls, larger and larger units of the
variable input will be needed to increase output by the same unit and thus TVC and TC increase
at increasing rates. By adding the TFC and TVC we obtain the TC of the firm.

4.1.2. Average Variable Cost, Average Fixed Cost, Average Cost and Marginal Cost Curves
A) Average Fixed Cost(AFC)
From the TFC curves we obtain average fixed cost (AFC) curves. AFC is the total fixed cost
TFC
divided by the amount of output, i.e., AFC= . Since TFC is constant, increase in Q reduces
Q
the ratio and thus the AFC approaches the quantity (output) axis as output rises.
B) Average Variable Cost (AVC)
TVC
Average variable cost is the TVC per unit of output. Symbolically, it is given by: AVC=
Q
Graphically, the AVC at each level of output is derived from the slope of a line drawn from the
origin to the point on the TVC curve corresponding to the particular level of output.
C) Average Cost(AC)
Average cost is the TC per unit of output or it is the sum of AFC and AVC. Symbolically,
TC TFC +TVC TFC TVC
AC = AC= = = + = AFC + AVC .
Q Q Q Q

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Introduction to Economics Chapter Four Theory of Cost

Graphically, the ATC curve is derived in the same way as the AVC. The ATC at any one point is
the slope of a line from the origin to the point on the TC curve.
D) Marginal Cost(MC)
The key to understand how much firm will want to produce and sell is its marginal cost of
producing goods and services. MC is the extra or additional cost of producing one extra unit of
output. Graphically, the marginal cost is the slope of the TC curve (which of course is the same
at any point as the slope of the TVC). The slope of the TC curve at any one point is the slope of a
tangent line at that point.
∆ TC ∆(TFC +TVC ) ∆ TFC ∆TVC ∆ TVC
MC= = = + = .
∆Q ∆Q ∆Q ∆Q ∆Q
Example: Given TFC and TVC, for each units of output, compute TC, AFC, AVC, AC and MC
Table: 3.2: Short Run Total, Average and Marginal Cost Schedule
Q TFC TVC TC AFC AVC AC MC
0 60 0 60 - 0 0 -
1 60 30 90 60 30 90 30
2 60 40 100 30 20 50 10
3 60 45 105 20 15 35 5
4 60 55 115 15 13.75 28.75 10
5 60 75 135 12 15 27 20
6 60 120 180 10 20 30 45
In summary the traditional theory of cost postulates that in the short run the cost curves (AVC,
ATC and MC) are U-shaped, reflecting the law of variable proportions. In the short run with a
fixed plant there is a phase of increasing productivity (falling unit costs) and a phase of
decreasing productivity (increasing unit costs) of variable factor. Between these two phases of
plant operation there is a single point at which unit costs are at a minimum. In general, the short
run cost curves can be shown as follows.
Costs MC ATC
AVC

AFC
O output (Q)
Figure 4.2: The short run AC, AFC, AVC and MC curves

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Introduction to Economics Chapter Four Theory of Cost

The relationship between ATC and AVC

The AVC is a part of the ATC, given ATC = AFC + AVC. Both AVC and ATC are U-shaped,
reflecting the law of variable proportions. However, the minimum point of the ATC occurs to the
right of the minimum point of the AVC. This is due to the fact that ATC includes AFC which
falls continuously with increase in output. Initially the fall in the AFC offsets the rise in the AVC
and thus the ATC declines. But later on the rise in the AVC more than offsets the fall in the AFC
and thus the ATC will start rising continuously. The AVC approaches the ATC asymptotically as
X increases since the AFC declines continuously. As far as the MC is below the ATC, it pulls
the ATC downwards and if the MC is above the ATC, it pulls the latter upwards. From this it
follows that the MC curve intersects the ATC at the minimum point of the ATC. This can also be
proofed by using a simple calculus.
TC
AC=
Q
=> TC =( AC )Q

dTC
MC= (By definition)
dX
d ( AC .Q) AC . dQ Q . d ( AC )
MC= = +
dQ dQ dQ
=> MC = AC + (Q) (slope of AC)
Given that X and ATC are Positive,
 MC<ATC if slope of ATC is negative.
 MC=ATC if slope of ATC=0, (at the minimum of the ATC).
 MC>ATC if slope of ATC>0.

The relationship between MC and AVC

TVC
AVC= => TVC =( AVC )Q
Q
d TC d ( TFC + TVC ) dTFC dTVC
MC= = = +
dQ dQ dQ dQ
∆ TVC
MC= (since there is no change in the TFC)
∆X
d ( AVC .Q) AVC . dQ Q . d ( AVC )
MC= = +
dQ dQ dQ
=> MC = AVC + (Q) (slope of AVC)

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Introduction to Economics Chapter Four Theory of Cost

Given that AVC and Q are Positive,

 MC<AVC if slope of AVC<0
 MC =AVC if slope of AVC=0 (at the minimum point of the AVC).
 MC >AVC if slope of AVC>0.
Relationship between Product Curves and Cost Curves
Unit products and unit cost curves are mirror images of each other, i.e.
 when AP(MP) is ring AC(MC) is falling;
 when AP(MP) is falling AC(MC) is rising; and
 when AP(MP) is maximum AC(MC) is minimum

See below for illustration of these relations.

Let TVC =wL, where w= given wage rate &L =labor input
W
TVC wL L Q w
Thus, AVC= = = w ( ) = Q , but = AP L. So, AVC=
Q Q Q L AP L
L
TVC
Similarly, MC= , since TVC =wL
Q
W
wL w L Q w
MC= = = Q , but = MP L. Thus, MC=
Q Q L MP L
L
Graphically:
AP/MP

APL
AC/MC MPL
MC
AVC

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Introduction to Economics Chapter Four Theory of Cost

O Q

4.2. Long run Cost Curves (Reading Assignment)

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