Department of Banking and Finance

BNF: 1113- Microeconomics

Unit: The Theory of Cost

Introduction

Under production theory, we were concerned with the laws of production, i.e., the relationship
between input and output. It may be recalled that the laws of production are expressed in terms
of physical quantities, e.g. labor as number of workers or labor man days, capital as unit of
plant or machinery, and output in terms of some other measures of output. However, as most
business decisions regarding price and production are taken on the basis of money value of
inputs and money value of output rather than on the basis of their physical quantities.

Now we are moving from the theory of production to the theory of cost. We shall examine here
how the cost production of a firm changes with the change in its output. In other words, cost
output relations from the subject matter of cost analysis of a business firm.

The relationship between cost and output is called ‘cost function’. The cost function of the firm
depends upon the production conditions and the prices of the factors used for production. How
much costs a firm will incur on production depends on the level of output. Moreover, the
quantity of a product that will be offered by the firm for supply in the market depends to a great
degree upon the cost of production incurred on the various possible levels of output. Cost of
production is the most important force governing the supply of a product.

It should be pointed out here that is assumed that a firm choose a combination of factors which
minimizes its cost of production for a given level of output. It is thus assumed that whatever
the level of output a firm produces, it is produced at the minimum cost possible.

In microeconomic theory, economists are generally interested in two types of cost function: the
short-run cost function and long-run cost function. Accordingly, they derive the short-run and
long run cost curves.

The concepts of Cost

Accounting costs and Economic costs

When an entrepreneur undertakes production of a commodity he has to pay prices for the
factors which he employs for production. He thus pays wages to the labors employed, prices
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for the raw materials, fuel and power used, rent for the building he hires for the production
work, and the rate interest on the money borrowed for doing business. All these are included
in his cost of production. An accountant will take into account only the payments and charges
made by the entrepreneur to the suppliers of various productive factors. In other words, the
total money expenses recorded in the books of accounts are, for all practical purposes, the
actual costs. Actual cost concept comes under the accounting cost concept.

But an economist’s view of cost is somewhat different from this. The economist takes into
account all of these accounting costs, but in addition he also into account the amount of money
the entrepreneur could have entered if he had invested his money and sold his own services
and other factors in next best alternative uses.

The accounting costs are contractual cash payments which the firm makes to other factor
owners for purchasing or hiring the various factors are also known as explicit costs. The
economists take into consideration both the explicit and implicit costs. Therefore,

Economic Costs = Accounting costs + Implicit costs

It may be pointed out that the firm will earn economic profits only if it is making revenue in
excess of the total of accounting and implicit costs.

Therefore,

Economic profits = Total revenue – Economic costs

Opportunity Cost

Opportunity cost is the loss of income due to opportunity foregone. Opportunity cost is also
called alternative or economic cost. It arises because of scarcity and alternative uses of
resources. Therefore, profit maximizing firms have to choose the best from the alternative
available to them.

The concept of opportunity cost occupies a very important place in modern economic analysis.
On the other hand, the opportunity cost of any good is the next best alternative good that is
sacrificed. The concept of opportunity cost is associated with the concept of economic rent or
economic profit.

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Business and Full costs

Business costs include all the expenses which are incurred in carrying out the business. The
concept of business cost is similar to the actual or real cost. Business costs include all the
payments and contractual obligations made by the firm together with the book cost of
depreciation on plant and equipment.

The concept of full costs includes opportunity cost and normal profit. Opportunity cost as
defined above, includes the expected earnings from the second-best use of the resources.
Normal profit is a necessary minimum earning, in addition to alternative cost which a firm
must get to remain in its present occupation.

Explicit and Implicit costs

Explicit costs are those which are actually incurred by the business firms and are entered in the
books of accounts. These costs involve cash payments and are clearly reflected by the usual
accounting practices. In contrast to these costs, there are certain other costs which do not take
the form of cash outlays. Such costs are known as implicit costs. Implicit costs are similar to
opportunity cost.

Policy related cost concepts: Private and Social costs

We have so far discussed the cost concepts that are related to the functioning of a firm as a
production unit, and those that are used in the cost- benefit analysis of the business decisions.

Private Cost: Private costs are those which are actually incurred or provided for by an
individual or a firm on the purchase of goods and services from the market. For a firm all actual
costs, both explicit and implicit are private cost.

Social Cost: Social cost, on the other hand, implies the cost which a society bears on account
of production of a commodity. Social cost includes both private cost and the external cost.
External cost includes the cost of resources for which the firm is not obliged to pay a price.

Analytical cost concepts

Short-run costs: Total fixed and Variable costs

Having explained the difference between the fixed factors and the variable factors and also
between the short -run and the long -run, we are in a position to distinguish between the fixed
costs and the variable costs which when added together make up the total cost of business.

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Fixed costs are those which are independent of output, they do not change with changes in
output. These costs are a fixed amount which much be incurred by a firm in the short-run,
whether output is small or large. Fixed costs are also known as overhead costs and include
charges such as contractual rent, insurance fee, maintenance costs, property taxes, interest on
the capital invested etc.

Variable costs, on the other hand, are those costs which are incurred on the employment of
variable factors of production whose amount can be changed in the short run. Thus, the total
variable costs change with changes in output in the short -run. These costs include payments
such as wages of labor employed, price of the raw materials.

Total costs of a business is the sum of its total variable costs and fixed costs.

TC = TFC+ TVC

Because one component, the total variable cost (TVC) varies with the changes in output, the
total cost of production (TC) will also change with the changes in the level of output. The total
cost increases as the level of output rises.

The concept of total cost, total variable cost and total fixed cost in the short run can be easily
understood with the help of the following table.

Total Cost, Total Fixed Cost, and Total Variable Cost

No. of Units of Total Fixed Cost Total Variable Cost Total Cost (TC)
Output (Q) (TFC) (TVC)
0 50 0 50
1 50 20 70
2 50 35 85
3 50 60 110
4 50 100 150
5 50 145 195
6 50 190 240
7 50 237 287
8 50 284 334

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The total fixed costs are equal to 50 and remain constant when the output is increased from 1
to 8 units of output. Even if no output is produced, the firm has to bear the fixed costs of
production. As regards the variable costs, it will be seen from the table, that variable cost are
equal to 20 when only one unit of output is produced and they rise to 284 when eight units are
produced.

As the total cost is the sum of fixed cost and the variable cost. The total cost also varies directly
with output because the variable cost increases as output is increased.

Short -Run Total Cost, Total Fixed Cost and Total Variable Cost Curves

Average Fixed Cost (TFC)

Average fixed cost is the total fixed cost divided by the number of units of output produced.
Therefore,

𝑇𝐹𝐶
AFC =
𝑄

Average Variable Cost (AVC)

Average variable cost is the total variable cost divided by the number of units of output
produced. Therefore,

𝑇𝑉𝐶
AVC =
𝑄

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Thus, average variable cost is variable cost per unit of output. The average variable cost will
generally fall as output increases from zero to the normal capacity output due to the occurrence
of increasing returns. But beyond the normal capacity output average variable cost will rise
steeply because of the operation of diminishing returns.

Average total cost (ATC) is the sum of the average variable cost and average fixed cost.
Therefore, as output increases and average fixed cost becomes smaller and smaller, the vertical
distance between the average total cost curve (ATC) and average variable cost (AVC) goes on
declining. When average fixed cost curve (AFC) approaches the X-axis, the average variable
cost curve approaches the average total cost curve (ATC).

Average Total Cost (ATC)

The average total cost is the total cost divided by the number of units produced.

𝑇𝐶
Average total cost (ATC) =
𝑄

Since the total cost is the sum of total variable cost and total fixed cost, the average total cost
is also the sum of average variable cost and average fixed cost. This can be proved as follows,

𝑇𝐶
(ATC) =
𝑄

Since TC= TVC+TFC

𝑇𝑉𝐶+𝑇𝐹𝐶
Therefore, ATC =
𝑄

The behavior of the average total cost curve will depend upon the behavior of the average
variable cost curve and average fixed cost curve. In the beginning both AVC and AFC curves
fall, the ATC curve therefore falls sharply in the beginning. When AVC curve begins rising,
but AFC curve is falling steeply, the ATC curve continues to fall. This is because during this
stage the fall in AFC curve weighs more than the rise in the AVC curve. Thus, the average total
cost curve (ATC) like the AVC curve first falls, reaches its minimum value and then rises. The
average total cost curve (ATC) is therefore almost of a ‘U’ shape.

Marginal Cost (MC)

The concept of marginal cost occupies an important place in economic theory. Marginal cost
is addition to the total cost caused by producing one more unit of output. In other words,
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marginal cost is the addition to the total cost of producing n units instead of n-1 units where n
is any given number.

MCn =TCn -TCn-1

∆𝑇𝐶 𝜕𝑇𝐶
MC= 𝑜𝑟
∆𝑄 𝜕𝑄

Where ∆ TC represents a change in total cost and ∆𝑄 represents a unit change in output.

Short run cost – output relations

The theory of short run cost behavior can be stated as the cost of production increases with the
increase in production and vice versa. Here, the question arises: what determines the rate of
change in output? The answer to this question lies in the short-run theory of production, the
laws of returns to variable input or the law of diminishing returns.

The law of diminishing returns and cost behavior

The short run theory of cost can be summarized as follows,

 Total cost (TC) increases with increase in total production (TP)

 As long as TP increases at increasing rate, Tc increases at decreasing rate.
 When TP increases at constant rate, TC also increases at constant rate.
 When TP increases at decreasing rate, TC increasing at increasing rate.

0
0

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Long-run Cost-Output Relationship

The fundamental difference between the short run and long run is that in the short run some
costs especially the cost of capital are fixed where as in the long run all cost become variable.
It implies that in the long run, firm can hire more of both labor and capital more of raw materials
and other inputs while technology remains constant.

By definition, in the long run, all the inputs become variable. Therefore, in long run the firms
expand the scale of their production by hiring a larger quantity of all the inputs. The long-run
cost-output relations, therefore imply the relationship between the changing scale of the firm
and the total output. But, in the short run this relationship is essentially on between the total
output and the variable cost (labour).

To understand the long run cost output relations and to derive long run cost curve it will be
helpful to imagine that a long run is composed or collected of a series of short run production
decisions.

Derivation of Long-run Total Cost Curve (LTC)

In order to draw the long run total cost curve, let us begin with a short run situation. Suppose
that a firm having only one plant has its short run total cost curve as given by 𝑆𝑇𝐶1. Let us also
suppose that the firm decides to add more plants to its size over time, one after the other. As a
result, two more short run total cost curves are added to 𝑆𝑇𝐶1 shown by 𝑆𝑇𝐶2 and 𝑆𝑇𝐶3 in the
following diagram.

The LTC can be drawn through the minimum points of 𝑆𝑇𝐶1 , 𝑆𝑇𝐶2 , 𝑆𝑇𝐶3 as shown by the LTC
curve corresponding to each STC.

By Dr. W.A.I. Lakmal, Department of Banking and Finance 8

Long run Average Cost Curve (LAC)

The long run average cost curve (LAC) is derived by combining the short run average cost
curves (SACs).The LAC can be drawn through the bottom of 𝑆𝐴𝐶1 , 𝑆𝐴𝐶2 , 𝑆𝐴𝐶3 as shown in
the diagram. The LAC curve is also known as Envelope Curve or Planning Curve.

Long run Marginal Cost Curve

The long run marginal cost curve can be derived from the long run total cost curve, since the
long run marginal cost at a level of output is given by the slope of the total cost curve at the
point corresponding to that level of output. Besides, the long run marginal cost curve can be
derived from the long run average cost curve, because the long run marginal cost curve is
related to the long run average cost curve in the same way as the short-run marginal cost curve
is related to short run average cost curve. In the following figure, it is depicted that how the
long run marginal cost curve LMC is derived from a long run average cost curve LAC
enveloping a family of short run average and marginal cost curves.

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0

Explanation of the U- shape of Long run Average Cost curve

We have drawn the long-run average cost curve as having an approximately U-shape. It is
generally believed by economists that long run average cost is normally U-shape that is the
long run average cost curve first declines as output is increased and then beyond a certain point
it rises. As we explained above, U shape of short run average cost curve is explained by the
law of variable proportions. But the long run average cost curve depends upon the returns to
scale.

In the Long run all inputs including the capital equipment can be varied, therefore, the relevant
principal governing the shape of the long run average cost curve is that of returns to scale. As
we explained, that returns to scale increase at the initial increases in output and after remaining
constant for a while, the returns to scale decrease. It is because of the increasing returns to scale
in the beginning that the long run average cost of production falls as output is increased and
likewise, it is because of the decreasing returns to scale that the long run average cost of
production rises beyond a certain level of output.

In other words, what are the reasons for the firm to enjoy internal economies of scale up to
certain point and then beyond why it encounters internal diseconomies of scale.

First, as the firm increases its scale of operations, it become possible to use more specialized
and technically more efficient form of all factors, specially capital equipment and machinery.
For producing higher levels of output, a technically more efficient machinery is generally
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available which when employed to produce a larger output that occur a lower cost per unit of
output.

Secondly, the scale of operations is increased and the amount of labor and other factors
becomes larger, introduction of a greater degree of division of labor or specialization becomes
larger result the long run cost per unit declines. As noted above, beyond a certain point the long
run average cost curve rises which means that the long run average cost increases as output
exceeds beyond a certain point a firm experiences net diseconomies of scale.

When the firm has become a size large enough to allow the utilization of almost all the
possibilities of division of labor and the employment of more efficient machinery, further
increase in the size of the plant will be entitle high long run unit cost because of the difficulties
of management. When the scale of operations exceeds a certain limit, the management may not
be efficient as when the scale of operations is relatively small.

Questions

1. Consider the following total cost function of a firm

TC=100 +8Q -0.12Q 2 +0.004 Q 3
a) Derive the ATC, AVC, MC, and AFC functions.
b) At what level of output AVC is minimized?
c) At what level of output MC is equal to AVC?
d) Prove that AVC reaches to its minimum before ATC becomes its minimum.

2. Given the following total cost function of a firm,

TC = Q 3 – 33Q 2 + 352Q +120
a) At what level of output, marginal cost is equal to average variable cost?
b) Determine the minimum level of average variable cost.
c) What is the output level on which marginal cost is minimized?

3. A firm has the following variable cost function,

TVC = 300Q -10Q 2 + 0.25 Q 3

If the firm’s fixed cost is equal to 200.

Find out,

a) Total Cost function

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 b) Marginal cost function
c) Average variable cost function
d) Average total cost function

4. Given the following total cost function,

TC = 1500 + 15 Q -6Q 2 + Q 3
a) Determine the total fixed cost for producing 1000 units and 500units of output.
b) When is AFC at 1000 units and 500 units?
c) Calculate TVC, AVC, MC, and AC at 50 units of output.

5. Suppose that a firm’s total cost equation is given by the following relations,
TC = 125,000 +1000 Q +0.5 Q 2
a) Determine the output level that minimizes average total cost
b) Calculate average cost and marginal cost at the level of output at which average
total cost is minimized.
c) Demonstrate that MC= ATC when ATC is minimized.

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