Theory of Costs

The Costs of Production

 This theory determines the cost of inputs for
the production of a certain output.
 Each firm wants to minimize its costs to earn
Maximum profit
 There are two ways to maximize the profit
 Production Maximization
 Cost Minimization
Definition of Costs
 Total Costs (TC) -- the expenses a business
has in supplying goods and services.
 Total Fixed Costs (TFC) -- payments to
resources whose quantities can not be changed
during a fixed period of time – the short run.
 Total Variable Costs (TVC) -- payments for
additional resources used as output increases.
 Average Fixed Cost -- the total fixed cost
divided by total output.
 Average total Cost (SRATC): -- the total cost of
production divided by the total quantity of output
produced when at least one resource is fixed
 Average Variable Cost (AVC) -- total variable
cost divided by total output
 Marginal Cost--- is a change in total cost due to
per unit change in output
Fixed Costs, Variable Costs,
and Total Costs
 Fixed costs are those which are spent and
cannot be changed in the period of time
under consideration.
TFC = TC - TVC
Fixed Costs, Variable Costs,
and Total Costs
 Variable cost –
It means that cost which is changing with the
change in output.

TVC = TC -TFC
Fixed Costs, Variable Costs,
and Total Costs
 The sum of the variable and fixed costs are
total costs.

TC = FC + VC
Average Costs
 Average fixed cost equals fixed cost divided
by quantity produced which continuously
decreasing.

AFC = TFC/Q
Average Costs
 Average variable cost equals variable cost
divided by quantity produced.

AVC = TVC/Q
Average Costs
 Average total cost can also be thought of as
the sum of average fixed cost and average
variable cost.

ATC = AFC + AVC

Average Total Costs
 Average total cost (ATC):
the per unit cost derived by
dividing total cost by the
quantity of output.

 Plotting the cost on the

vertical axis and quantity of
total cost
output on the horizontal axis ATC 
generates the ATC curve. total output
Marginal Cost

 Marginal cost is the increase (decrease) in

total cost of increasing (or decreasing) the
level of output by one unit.
 In deciding how many units to produce, the
most important variable is marginal cost.
Marginal Costs
 Marginal cost (MC): the change in
cost caused by a change in output,
derived by dividing the change in
total cost by the change in the
quantity of output.

change in total cost

MC 
change in quantity of output
 Short Run Total Cost Curves
• Note that total fixed costs are flat and Total TC
remain the same for 0 units or 11 units. costs
• Note that total variable costs increase as TVC
more variable inputs are utilized.
200
• As total costs are the combination of
TVC and TFC, they are everywhere
positive and increase sharply with output
150
Output
per day TFC + TVC = TC
100
0 50 0 50
2 50 25 75
4 50 42 92 TFC
6 50 64 114 50
8 50 98 148
10 50 152 202 Output
2 4 6 8 10
Total Cost Curves
TC
$400 VC
350
300
TC = (VC + FC)
Total cost

250
200 L
150
100 O
M
50 FC
0
2 4 6 8 10 20 30
Quantity of earrings
 Total Cost Curves
TC
$400 VC
350
300
Total cost

TC = VC + FC
250
200 L
150
100 O
M
50 FC
0
2 4 6 8 10 20 30
Quantity of earrings
 Short Run Cost Curves
• To understand the relationship between
the average and marginal curves, we
calculate each of the average curves
from the total curves and then introduce Cost
the marginal curve. per unit
• The average fixed cost curve (AFC) is
the total fixed cost (TFC) divided by the 60

output level. It is high for a few units,

and becomes small as output increases.
Output
TFC / per day = AFC 40

50 0 ----
50 1 $ 50.00
50 2 $ 20
50 4 $25.00
12.50
50 6 $ 8.33
50 8 $ 6.25 AFC
50 10 $ 5.00 Output
2 4 6 8 10
Downward-Sloping Shape of
the Average Fixed Cost Curve
 The average fixed cost curve start with a
steep decline, then it becomes flatter and
flatter.
 It tells us that as output increases, the same
fixed cost can be spread out over a wider
range of output.
 Average fixed cost will decrease with each
additional unit of output
 Short Run Cost Curves
• The average variable cost curve (AVC)
is the total variable cost (TVC) divided
by the output level. It is higher either
for a few or lot of units and has some Cost
per unit
minimal point between the two where,
when graphed later, marginal costs (MC)
will cross it. 60

Output
TVC / per day = AVC
0 0 ---- 40
15 1 $ 15.00
25 2 $
42 4 $12.50
10.50
64 6 $ 10.67 20 AVC
98 8 $ 12.25
152 10 $ 15.20
AFC
Output
2 4 6 8 10
 Short Run Cost Curves
• To calculate the marginal costs curve
(MC) we take the change in TC (TC)
and divide that by the change in output.
Note: our increments for increasing Cost
output here are to increase by 1 ( 1). per unit
• Note that MC starts low and increases
as output increases. It also crosses AVC 60
at its minimum point.
MC
TC /
TC  Output MC
=
40 Note: MC always crosses
50 AVC at its minimum point.
65 15 1 $ 15.00
75 10 1 $
84 10.00 AVC
92 8 1 $ 8.00 20
102
114 12 1 $ 12.00
AFC
129
148 19 1 $ 19.00 Output
172 2 4 6 8 10
202 30 1 $ 30.00
Average and Marginal Cost
Curves
 The marginal cost curve goes through the
minimum point of the average total cost curve
and average variable cost curve.
 Each of these curves is U-shaped.
The U Shape of the Average
and Marginal Cost Curves
 When output is increased in the short-run, it
can only be done by increasing the variable
input.
 When a variable input increases then output
follows three different trends which are called
Laws of Returns.
 The cost curves are exactly opposite of laws
of returns like if law of increasing returns is
prevailing it means law of decreasing cost is
there.
The U Shape of the Average
and Marginal Cost Curves
 The law of diminishing marginal productivity
sets in as more and more of a variable input
is added to a fixed input.

 Marginal and average productivities fall and marginal costs rise.

 when average productivity of the variable input falls, average
variable cost rise.
The U Shape of the Average
and Marginal Cost Curves
 The average total cost curve (AC) is the
vertical summation of the average fixed cost
curve and the average variable cost curve.
 If the firm increased output enormously, the
average variable cost curve and the average
total cost curve would almost meet.
 The firm’s eye is focused on average total
cost—it wants to keep it low.
 Short Run Cost Curves
• The average total cost curve (ATC)
is simply TC divided by the output.
• When output is low, ATC is high
because AFC is high. Also, ATC is Cost
per unit
high when output is large as MC
grows large when output is high.
• These two relationships explain the 60
distinct U–shape of the ATC curve. MC
Note: MC always crosses
Output ATC at its minimum point.
TC / per day = ATC 40
50 0 ----
65 1 $ 65.00 ATC
75 2 $
92 4 $37.50
23.00 20
114 6 $ 19.00 AVC
148 8 $ 18.50 AFC
202 10 $ 20.20
Output
2 4 6 8 10
Per Unit Output Cost Curves
$30
28
26
24
22
20
18
16
14 MC
Cost

12 ATC
10 AVC
8
6
4
2 AFC
0 2 4 6 8 10 12 14 16 18 20 22 2426 28 30 32
Quantity of earrings
Per Unit Output Cost Curves
$30
28
26
24
22
20
18
16
14 MC
Cost

12 ATC
10 AVC
8
6
4
2 AFC
0 2 4 6 8 10 12 14 16 18 20 22 2426 28 30 32
Quantity of earrings
Long Run ATC OR Planning
Curve
 The long-run ATC shows the minimum
average cost of producing each output level
when a firm is able to choose plant size.
 Long Run Cost Curve
 The ATC curve for the firm will depend upon
the size of the plant that is operating.
 If the cost per unit varies according to the size
of the facility, then a Long Run Average
Total Cost curve (LRATC) can be mapped
out as the surface of all the minimum points
possible at all the possible degrees of scale.

Cost Representative short-run

per unit Average Cost curves

LRATC

Output level
 Relationship Between Marginal
and Average Costs
 The marginal cost and average cost curves
are related.
 When marginal cost exceeds average cost,
average cost must be rising.
 When marginal cost is less than average cost,
average cost must be falling.
Relationship Between Marginal
and Average Costs
 Marginal cost curves always intersect
average cost curves at the minimum of the
average cost curve.
 The position of the marginal cost relative to
average total cost tells us whether average
total cost is rising or falling.
Relationship Between Marginal
and Average Costs
 To summarize:

If MC > ATC, then ATC is rising.

If MC = ATC, then ATC is at its low point.
If MC < ATC, then ATC is falling.
Relationship Between Average
Cost and Average variable Costs
 AVC is one part of AC
 With an increase in output, as AVC decreases
initially, AC also follow decreasing trend
 As output increases, the difference between AVC
and AC squeezes due to continuous decrease in
AFC
 As AVC is increasing due to law of diminishing
return, AC also increases
 The minimum point of AVC comes earlier than
minimum point of AC because of AFC
Relationship Between Marginal
and Average Variable Costs
 Marginal and average total cost reflect a
general relationship that also holds for
marginal cost and average variable cost.

If MC > AVC, then AVC is rising.

If MC = AVC, then AVC is at its low point.
If MC < AVC, then AVC is falling.
 Relationship Between Marginal
and Average Costs

$90
ATC MC
80
70 Area A Area C
60 AVC Area B
Costs per unit

50 ATC
40 AVC
30 B
20
A
10 MC Q0 Q1
0
1 2 3 4 5 6 7 8 9 Quantity
Practice Questions
AC  3Q  12Q  350
2

P  60

TC  300Q  10Q  120

2

P  40
 Assignment -2
 Make a hypothetical data table and try to
make interrelationships between AC, MC
and AVC for ten observations. Keep in mind
the trend of certain variables. Support Your
answer with the help of correct graphs and
their respective interpretations like
S.NO TFC TVC TC AC AVC AFC MC
1

2
3
4 And So
on