Lecture : 15 and 16

Theory of Cost : Different

costs, Definition of
Relationship Between
Different Costs and Cost
Curves, Producer’s
Equilibrium.
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 Definition of cost : The cost of production of an
individual firm operating in a market has an important
influence on the market supply of a commodity. It is very
necessary to have a clear idea about the concept of cost
of production and then proceed to study the cost curves.
The firm’s cost are the expenses producing the goods or
services sold during the period.

Fixed costs : Fixed costs are those costs that do not

vary with output. The fixed costs are rent for factory or
office space, contractual payments for equipment, interest
payments on debts, and so forth. These must be paid
even if the firm produce no output, and they will not
change if output changes.

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 Variable Cost : Variable costs are those costs that
do vary output. The variable costs are raw materials
used in the making of the commodity as well as the
costs of causal or daily labour employed. They
are incurred only when the factory is at work. In
the long-run, all costs are variable. Thus in the
long-run, fixed costs are zero.

Opportunity Cost : The opportunity cost of

production of a given commodity is the next best
alternative sacrificed in order to obtain that
commodity. So, opportunity cost is a sacrifice cost.

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 Economic Cost : By economic costs is meant those payments
which must be received by resource owners in order to ensure that
they will continue to supply them in the process of production. This
definition is based on the fact that resources are scarce and they
have alternative uses.

Implicit Costs : Implicit costs are costs of self-owned and self-

employed resources, such as; salary of the proprietor or return on
the entrepreneur’s own investment. These costs are frequently
ignored in calculating the expenses of production.

Explicit Costs : An explicit cost or an accounting cost is incurred

when an actual payment is made. Explicit costs are the paid-out
costs, i.e., payments made for productive resources purchased or
hired by the firm. They consist of the salaries and wages paid to the
employees, prices of raw and semi-finished material, overhead costs
and payments into depreciation and sinking fund accounts.
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 Total Costs : Total costs equal to fixed costs
plus variable costs. Total cost represents the
lowest total dollar expense needed to produce
each level of output.

Average Costs : Average costs equal to total

costs divided by number of quantity.

Marginal Costs/ Additional Costs: Marginal

cost is the extra cost associated with
producing one more unit of output.
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 Economic Profits : Economic profits are the excess of
revenue over total opportunity costs.

Accounting Profits : Accounting profits equal company

revenues minus accounting costs or explicit cost.

Normal Profit : A normal profit is the return that the

time and capital of the entrepreneur would earn in the
best alternative employment and is earned when total
revenues equal total opportunity cost. Economic profit is
earned when total revenues exceed total opportunity
cots.

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Now we can illustrate the concept of all
costs in the following table :
Quantity Total Total Total Average Average Marginal Average Average
(Q) Fixed Variable Cost Total Cost Cost Fixed Variable
Cost Cost (TC) Cost (AC) (MC) Cost Cost
(TFC) (TVC) (ATC) (AFC) (AVC)
1 30 10 40 40 40 --- 30 10

2 30 18 48 24 24 8 15 9

3 30 24 54 18 18 6 10 8

4 30 32 62 15.50 15.50 8 7.50 8

5 30 50 80 16 16 18 6 10

6 30 72 102 17 17 22 5 12

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 This is the family of cost schedule for a hypothetical
business enterprise operating in the short-run with total
fixed cost of 30 units in column – 2. Fixed cost does not
vary with the level of output. Total variable cost rises with
the level of output which is shown in the column – 3.
Total cost is the sum of total fixed cost and total variable
cost which is shown in the column – 4. Average cost or
average total cost is the total cost divided by the number
of quantity or it is the sum of average fixed cost and
average variable cost which is shown in the column – 5
and 6. Marginal cost is the increase in the total cost due
to increase in the output by one unit which is shown in
the column – 7.

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 Average variable cost is the total variable cost
divided by the number units produced which is
shown in the column – 9. Average fixed cost is
the total fixed cost divided by number of units
produced which is shown in the column – 8. The
following equations show the relationship among
the various measures :
TC = TFC + TVC MC =
∆TC
∆Q
TC TFC TVC
= + TC
Q Q Q AC =
Q
ATC = AFC + AVC

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 Relationship between different cost curves in the
short – run

Cost curves shows the relationship between the

level of output and the cost of producing that
output. Output is on the horizontal axis and cost
is on the vertical axis. Cost curves show what
happens to costs of production as the level of
output changes. In the above table, eight
different cost measures are provided. Together,
they make up the family of costs :

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 Total Variable Cost (TVC) : Total variable cost the cost that varies
with the level of output.
Total fixed Cost (TFC) : Total fixed cost the cost that does not vary
with the level of output.
Total Cost (TC) : Total cost is the total of the variable and fixed
costs of producing each level of output.
Average Cost (AC) : Average Cost is the total cost divided by the
quantity or output.
Marginal Cost (MC) : Marginal Cost is the addition to total cost of
producing one more unit of output.
Average Variable Cost (AVC) : Average Variable Cost is the total
variable cost divided by the quantity or output.
Average fixed Cost (AFC) : Average fixed Cost is the total fixed
cost divided by the quantity or output.
Average Total Cost (ATC) : Average Total Cost is the sum of
average variable and average fixed cost.

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 These curves are plotted in the following diagram. In panel
(a), variable cost changes with output, fixed cost does not
vary with output. Total cost is the sum of variable cost and
fixed cost. In panel (b), marginal cost is the change in total
cost that results from producing one more unit of output.
Average variable cost is the total variable cost divided by the
number units produced. Average fixed cost is the total fixed
cost divided by the number of units produced and declines
throughout. Average total cost is the sum of average variable
cost and average fixed cost. The marginal cost curve will
intersect the average variable cost curve and the average
total cost curve at their respective minimum values. When
marginal cost equals average variable cost will be at its lowest
value. When marginal cost equals average total cost ,
average total cost will be at its lowest value.

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Cost Cost

TC
MC
ATC
AVC
TVC

TFC

0 0 AFC
Output Output

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 Why the LRAC curve is U – shaped ?
Recall that in the long – run all costs are
variable; therefore, there is no distinction
between long – run variable and total costs –
there is only long – run average cost. The long –
run average cost curve shows the minimum
average cost for each level of output when all
factor inputs are variable and when factor prices
are fixed. The long – run average cost curve is
U-shaped because, first, economies of scale,
then constant returns to scale, and finally
diseconomies of scale as output expands.
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 Economies of Scale : The declining portion of the long
– run average cost (LRAC) curve is due to economies of
scale that arise out of the indivisibility of the inputs of
labour and physical capital goods or equipment.
Economies of scale can occur because of the greater
productivity of specialization in any of a variety of areas,
including technological equipment, marketing, research
and development, and management. As the output of an
enterprise increases will all inputs variable average costs
will decline because of the economies of scale
associated with increased specialization of labour,
management, plant, and equipment. Economies of scale
are present when equal percentage changes in the use
of inputs lead to larger percentage changes in output.
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 Constant Returns to Scale : Economies
of scale will become exhausted at some
point when expanding output no longer
increases productivity. The evidence
suggests that for a large range of outputs
there will be constant returns to scale,
where the average costs of production
remain constant. Constant returns to scale
are present when a given percent change
in all inputs result in the same percent
change in output.
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 Cost

Economies of Constant Return to Diseconomies of

Scale Scale Scale
0
Quantity of Output

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• C
 Diseconomies of Scale : As the enterprise continues to
expand its output, eventually all the economies of large –
scale production will be exploited and long – run average
cost will begin to rise. The rise in long – run average
costs as the capital stock of the enterprise expands due
to diseconomies of scale. Diseconomies of scale are
present when an equal percentage change in inputs
leads to a smaller percentage change in output.

The long – run average cost curve is the envelope of the

short – run average total cost curves. The long – run
average cost curve is U – shaped. The declining portion
shows economies of scale. The rising portion shows
diseconomies of constant returns to scale.

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 Application : Managerial decision making is facilitated
by information that shows the cost of each rate of output.
Consider a production process that combines variable
amounts of labour with a fixed capital stock, say, 10
machines. In this process, the rate of production is
changed by varying rate of labour input. Assume that the
firm can vary the labour input freely at a cost of $100 per
unit of labour per period. Therefore, the expenditure for
labour is the variable cost. Again, assume that the
variable cost equation is - TVC = 10Q + 0.9Q 2 + 0.04Q 3
Find :
i) Total Fixed Cost; ii) Total Cost Equation;
iii) The rate of output that results in minimum average
variable cost.
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