Theories of Cost of Production

Cost in the Short and Long Run

Cost in the short run: Total Cost of production is made up of fixed cost and variable
cost.
In the short run the firm has a fixed factor of production and always has at least one variable
factor of production . The payment made to the fixed factor of production will always be
constant.
The payment made to the variable factor increases as more and more units of outputs are
produced.

Output) Fixed Cost$ Variable Cost$ Total Cost$

(FC+VC)

0 40000 0 40,000

1 40000 60000 10000

2 40000 120,000 160000

3 40000 180000 220000

4 40000 240000 280,000

5 40000 300000 340000

Afc- tfc/i
In the short run the firm has a fixed factor of production and always has at least one variable
factor of production . The payment made to the fixed factor of production will always be contant

Different Types of Cost :

1.Total Cost( TC) This is the cost of all the productive resources used by the firm . As shown in
the table above. It can be divided into two separate categories, fixed cost and variable cost in
the short run. Therefore TC= Total fixed Cost (TFC) + Total Variable Cost (TVC)

2.Total Fixed Cost- TFC are fixed, they do not vary with output. In economics ,we usually
call these costs ``sticky” . They are called sticky because they take a long time to respond and
increase due to long term contractual agreements. Eg.of fixed costs Rent, Lease agreements
and interest payment agreements

The TFC curve is horizontal

3.Total Variable Cost - This cost varies with the level of production.
TVC of production is zero when output is zero and increases as output increases . This is
because as the firm hires more labour in order to increase production .It will have to pay more
wages.

Total Cost

As mentioned before Total Cost( TC) This is the cost of all the productive resources used by
the firm . As shown in the table above. It can be divided into two separate categories, fixed cost
and variable cost in the short run.
Therefore TC= Total fixed Cost (TFC) + Total Variable Cost (TVC)
The total cost curve is upward sloping because as output increases (total cost of production
rises) .It is important to note that the total cost curve will never start from zero. This is because
of a fixed cost which must be incurred even if output is zero
Diagrams Showing TC, TVC and TFC
2.Average Fixed Cost (AFC)
The average fixed cost can be found by dividing TFC by the number of units of output
produced . This gives us the fixed cost per unit of output

Example:
A firm incurs 4000$ fixed cost to produce 10 units of output.
Therefore Average fixed cost can be found by :

AFC= TFC/ Qty

= 4000/10
=400 per unit

N.b If output were to increase, the average fixed cost would decrease.
IF the firm increases production to 20 units , AFC falls to $200 per unit (4000/20)=200$

This is why the average fixed cost curve is downward sloping

HW. Find out what the average variable cost . and how that diagram looks. (and the
reason for the shape of this cost)

Average Variable Cost (AVC)

AVC can be found by dividing the TVC by output produced . It is given by the formula
AVC= VC/Q
It is a U shaped curve , this is because initially as output increases ,AVC would fall . As output
increases further ,AVC will reach a minimum point and then it will increase. The reason for this
is the Law of diminishing returns. This is because as we add more units of variable input to a
fixed factor they become less productive but increase cost .

Average total Cost(Average cost)

The firm average cost (AC) is the total cost divided by the # of output produced.
Formula - ATC= TC/Q
N.b this is the same as AC= TC/Q
AC tells us the cost of a single unit of the firm's output.

Eg. IF the fixed cost of a firm is $1000 and the VC is $2500 and 10 units of output is
produced. Calculate the TC and then the AC.

TC= FC+VC
$1000+$2500=3500

AC= tc/q
= 3500/10
= $350
Interpretation: On average The cost of producing one item is $350
The AC curve is also U shaped. Cost initially goes down first, reaches a minimum and
then increases. This is because of the laws of diminishing return. Resources become
less productive as we add more and more to a fixed factor of production . At the same
time we have to pay/incur expenses for these factors we are adding(inputs) to increase
output -this will add to total cost .

Merging the AC, AVC and AFC curves

Marginal Cost (MC)
Marginal cost can be defined as the increase in total cost as a result of producing one more unit
of output.
Marginal cost an be calculate by
MC= ΔTC/ Δ Q or Change in total cost/ change in
quantity(output)

TC=TFC+TVC

3600 = 2000+TVC (AC=TC/Q)

3600- 18=TC/200
3600=TC

Ex. Complete table

Output(Q) Total Cost MC-Change in
TC/CHange in Q
0 1000 n/a
1 3500 2500/1=2500
2 4500 1000/1=1000
3 6000 1500
4 8000 2000
5 11000 3000
Calculate AC-TC/Q
-
3500
2250
2000
2000
2200

Relationship between Marginal Cost(MC) and Average Cost (AC)

Initially marginal cost will fall as output increases. After reaching its minimum ,marginal cost will
increase due to diminishing return.

Marginal cost is lower than average cost and as a result average cost is downward
sloping(falling)
Eventually they intersect.
The point where MC cuts the AC curve is at its minimum. This point is known as the
productive optimum or the point of maximum efficiency in the short run.
After this intersection the MC is now higher than AC and as a result Ac is now increasing
and they are both upward sloping.

N.B. both of these curves are influenced by the law of diminishing return, and this is
shown clearly as they both first experience decreasing cost followed by increasing cost.

Comparison of MC and AC and effects on average cost:

When MC is less than AC (MC<AC)- The AC curve and AC declines

When MC=AC , Average cost is now at its minimum4t
When MC> AC -average cost is increasing

Excercise
Qty(Output) Total Cost Average Cost Marginal
Cost)Change IN
TC/Change in
QTY

0 1000 0 -

10 3500 350 2500/10 =250

20 4500 225 1000/10=100

30 6000 200 1500/10=150

40 8000 200 2000/10=200

50 11000 220 3000/10=300

60 12000 200 1000/10=100

 Qty/Output Total Cost Average Marginal COst=
Cost=TC/Q CHange in
TC/CHange in
QTy

0 20 0 -

1 70 70 50/1=50

2 120 60 50/1=50

3 170 56.6 50/1=50

4 170 42.5 0/1=0

5 200 40 30/1=30

6 160 26.6 -40/1=-40

Cost in the Long Run

In the long run all factors of production are variable. The amount of time it takes a firm to
vary all factors of production it employs is known as the long run period. In this period
the firm does not have a constraint of fixed factors.

Economies and Diseconomies of scales

In the long run firms can experience economies or diseconomies of scale.

-Economies of scale are the low cost (cost advantages) that a firm benefits from when
they expand their scale of production.
These cost savings enable the firm to produce its output at a lower cost per unit. In other words,
average cost falls per unit (AC=TC/Q)

-Diseconomies of scale on the other hand is the increasing cost that a business incurs
as its scale of production increases. This occurs when the business becomes so large or
inefficient. This means that average cost per unit also rises.

Economies of Scale (Can be Internal or External)

Internal Economies of scale are benefits that originate from the expansion of the
business itself. This may happen for several reasons, such as:

*Purchasing economies of scale- A large firm can purchase inputs at a lower price than a
smaller firm. This is because they (larger firms) are able to buy in bulk to secure discounts.
Additionally as a main customer of the supplier, large firms are able to communicate directly
with suppliers and thus set standards and prices.

*Managerial Economies of Scale- As firms get larger, more specialist and expert management
employed. They are also able to attract and pay for the better manager who increase the
efficiency of the business which eventually decreases its average cost. Smaller businesses are
not able to do this.

Financial economies of scale

Larger firms are considered less risky and therefore are able to secure loans at lower rates of
interest than small firms who have to borrow at high rates.
Additionally larger firms have more sources of finance. Egg a Public limited company can sell
shares on the stock exchange and acquire more funds.
These factors and others allow large firms to borrow expansion capital in larger quantities and
better terms compared to smaller firms.

Technological economies of Scale

This refers to the ability of the large-scale businesses to make use of technology in production
methods, which are not available to small scale businesses.
Eg. Larger firms are able to use computers and technology to replace workers on a production
line. This Mass production lowers the cost per unit (AC)

Welfare Economies
Large firms can use funds to increase working conditions and overall welfare of their
employees.eg. recreational rooms, canteens with subsidized meals . These workers feel more
motivated and work harder and more efficiently compared to workers who are not adequately
paid and treated.

Marketing economies of scales

Firms that have a larger market share are able to advertise at a lower cost per unit compared to
firms that are new to the market and have smaller market shares.

External economies of scale

These are the cost benefits that the firm realizes that originate from the growth or expansion of
the whole industry.
(The whole industry refers to neighbouring firms and others in the market and all factors outside
the reach of the firm in the same industry)

Improve Infrastructure
Large firms may induce local governments to improve roads, bridges and general
infrastructure . All firms in the area will benefit. This will contribute to reduction in transportation
and other costs for the businesses, resulting in lower cost of production

Agglomeration
Large firms may encourage related firms to set up nearby. As a result, there is a cluster of
similar firms that benefit from each other and are able to work together.
The clustering of firms encourages the development of a skilled pool of labour and workers
trained by one firm can be shifted to another without the need for this new firm having to train
said workers.
E.g. Silicon valley in the united states where all tech firms have some presence

Use of waste material

Some firms might use their neigbouring firm waste or even bi products in their production
process. These firms benefits as a result of locating close to one another ,since there is reduced
transportation and disposal costs by said firms
Diseconomies of Scale

Diseconomies of scale are cost disadvantages that result from the growth of the
organisation

Types of diseconomies of scale

1.Poor communication and industrial relations problems-

As the number of workers in firms increases, it is hard to get the messages to people at the right
time. As a result workers become isolated from management and are not aware of what is
happening. This can lead to poor quality of output ,work stoppages and strikes as workers do
not have as much value to the firms as they once felt they had. This is worker alienation

2.Coordination and Control problems- As the business grows , control of activities get harder
and there may be more steps and bureaucracy involved in decision making. This will lead to
delays and coordination as it is difficult to monitor and evaluate all the new levels of the
business hierarchical structure. As a result communication and production is not as efficient as it
should be
3.Over Specialisation- As workers become more and more specialised ,this may result to
boredom and reduce quality of work

Long Run Average Cost Curve

This is a graph that plots the average cost of a firm in the long run when all inputs are variable
(can be changed).
The LRAC is also U shaped.
Initially as output increases the LRAC will fall because of economies of scale . Further as output
increases, the LRAC will then reach a minimum point known as the minimum efficiency scale
(MES) . Finally with further increases in output as the business expands the LRAC will still rise
because of diseconomies of scale.
Long run average cost -LRAC Curve
Qm is at a minimum in the diagram above

Relationship between SRAC and LRAC

The LRAC is also U shaped, but it is much flatter than the short run average cost curve (SRAC).
The LRAC is made up of several SRAC points. The lowest point / optimal point of each SRAC is
plotted to make the LRAC.