Microeconomics

Chapter Four
Theory Of Cost
4.1. Basic concepts
Cost is the monetary value of inputs used in
production of an item.
Types of cost of production
A. Social cost: is the cost of producing an item to
the society.
B. Private cost: is the cost of producing an item
to the individual producer.
Private cost of production can be measured in
two ways:
 Economic cost - Explicit cost plus Implicit cost
 Accounting Cost - Explicit cost of production
4.2. The SR Cost Function
Cost function shows the algebraic relation
between the cost of production and various
factors which determine it.
Among others, the cost of production
depends on:
◦ the level of output produced,
◦ technology of production,
◦ prices of factors, etc.
C = f (x, t, pi)
Short run costs of the traditional theory

In the traditional theory of the firm, total

costs are split into two groups: total fixed
costs and total variable costs:
TC = TFC + TVC
Total fixed cost (TFC) - a cost which
doesn’t vary with the level of output.
Total variable cost (TVC) - include all
costs which directly vary with the level of
output.
Graphical presentation
TC

Cost
TVC

TFC

Output
Average costs
Average costs are important as we may
make comparisons with product price,
which is always stated on per unit basis.
TFC
Average fixed costs (AFC) – AFC 
Q

Average variable cost (AVC)

TVC
AVC 
Q
Average total cost (ATC)
ATC 
TC  TC TVC TFC
 
Q Q Q Q
Graphical presentation
ATC
Average cost AVC

AFC

Unit of output
The relationship between AVC,
ATC and MC
MC is the extra cost of producing one
more unit of output.
The marginal cost curve intersects both
the AVC and ATC curves at their
minimum points.
Graphical presentation
AC

AVC

AFC

MC
AC
MC

AVC

AFC

Q
Q1 Q2
The above graphical presentation can also
be shown by using calculus.
◦ Suppose the TC = f (Q), then
1
◦ Slope AC = Q MC  AC 
◦ How?
Based on this the following relationships
can be drawn:
◦ when MC<AC, the slope of AC is negative
◦ When MC >AC, the slope of AC is positive
◦ When MC = AC, the slope of AC is zero
Numerical illustrations
Suppose the short – run cost function of a
firm is given by: C=2Q3 –2Q2 + Q + 10 ,
Find:
◦ The expressions for TFC & TVC
◦ The expressions for AFC, AVC & AC and MC
◦ The minimum values of MC and AVC.
Relationship between cost and production
MC and AVC curves are mirror images of
the MP and AP curves respectively.
Unit
maximu AVC= w (L/Q)
product m MP maximum
w
AP  MC 
A MPL
P
Labo
M r
How?
Unit
cost P
M
CAV
C

minimum minimum
AVC Quan
MC
tity
4.3. The LR Cost Function
 The long – run refers to the fact that economic
agents – consumers and managers – can plan
ahead and choose many aspects of the “short –
run” in which they will operate in the future.
 The long – run consists of all possible short –
run situations among which an economic agent
may choose.
 Suppose technology is such that plants in a
certain industry can have only three different
sizes.
 The long- run average cost curve is an
‘envelope’ of all the short run ATC curves.
 Long-run Average Cost Curve
COST

LAC

SAC1

SAC2
SAC3 SAC6
SAC4
SAC5

0 Q

14
Shape of the LRAC.
Reasons for Economies of Scale
◦ Increasing returns to scale
◦ Specialization in the use of labor and capital
◦ Indivisible nature of many types of capital
equipment
◦ Productive capacity of capital equipment rises
faster than purchase price
◦ Discounts from bulk purchases
◦ Lower cost of raising capital funds
◦ Spreading promotional and R&D costs
◦ Management efficiencies
Reasons for diseconomies of Scale
◦ Decreasing returns to scale
◦ Disproportionate rise in transportation costs
◦ Input market imperfections
◦ Management coordination and control
problems
◦ Disproportionate rise in staff and indirect
labor
4.4. Dynamic changes in costs: the learning
curve
In some firms, long-run average cost may
decline over time because workers and
managers absorb new technological
information as they become more
experienced at their job.
As workers get experience their efficiency
increases which then reduces the average
and marginal costs of producing a unit of
product.
In general, a firm ’learns’ over time as
cumulative output increases.
Number of labor required to produce one
unit.
A downward slope in the learning
curve indicates the presence of the
learning curve effect.

Learning curve

A
Cumulative out
put
Learning Vs Economies of scale

Economies of scale
A

Learning

Output
----- End of Chapter Four -----