UNIT THREE

THEORY OF COST

INTRODUCTION
In this unit, you will study the meaning and behaviors of costs of production, the relationship between
production (output) and costs (i.e. cost function both in the short run and long run.)

To produce goods and services, firms need factors of production or simply inputs. To acquire these
inputs, they have to buy them from resource suppliers. Cost is, therefore, the monetary value of inputs
used in production of an item. We can identify two types of cost of production: social cost and private
cost.

Social cost: is the cost of producing an item to the society. This cost is realized due to the fact that most
resources used for production purpose are scarce and some production process, by their nature, emit
dangerous chemicals, bad smell, etc to surrounding society.

Private cost: This refers to the cost of producing an item to the individual producer. Private cost of
production can be measured in two ways:
i) Economic cost
In economics the cost of production to the individual producer includes the cost of all inputs used for the
production of the item. It consists of
 The actual or out- of- pocket expenditures that the firm incurs to purchase inputs from the market
are called explicit costs.
 The estimated cost of their non- purchased inputs which are called implicit costs.
Thus, in economics the cost of production includes the costs of all inputs used in the production process
whether the inputs are purchased from the market or owned by the firm himself that is:
Economic cost: Explicit cost plus Implicit cost

ii) Accounting Cost

For accountant, the cost of production includes the cost of purchased inputs only. Accounting cost is the
explicit cost of production only. Moreover, accountant’s doesn’t consider the cost of production from the
opportunity cost of the resources point of view.

COST FUNCTIONS
Cost function shows the algebraically 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. hence; cost function is a multivariable function. Symbolically,
C = f (x, T, pi)
Where C- is total cost of production x - is the amount of output
T – is the available technology of production. Pi – is the price of input
Economics theory distinguishes between short run costs and long run costs.

SHORT RUN COSTS

Short run costs are the costs over a period during which some factors of production (usually capital
equipments and management) are fixed. In the traditional theory of the firm, total costs are split into two
groups: total fixed costs and total variable costs:
TC = TFC + TVC
Where – TC is short run total cost TFC is short run total fixed cost
TVC is short run total variable cost
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By fixed costs, we mean a cost which doesn’t vary with the level of output. The fixed costs include:
salaries of administrative staff, expenses for building depreciation and repairs, expenses for land
maintenance and the rent of building used for production, etc. All the above costs are regarded as fixed
costs because whether the firm produces much output or zero output, these costs are unavoidable, and the
firm can avoid fixed costs only if he / she shuts down the business stops operation.

Variable costs, on the other hand, include all costs which directly vary with the level of output. The
variable costs include: the cost of raw materials, the cost of direct labor and the running expenses of fixed
capital such as fuel, electricity power, etc. All these costs are regarded as variable costs because their
amount depends on the level of output. For example, if the firm produces zero output, the variable cost is
zero.

Graphical presentation of short run costs.

Total fixed cost (TFC)
Graphically, TFC is denoted by a straight line parallel to the output axis. The point of intersection of the
TFC line with the cost axis (vertical axis) shows the amount of the fixed. For example if the level of fixed
cost is $ 100, it can be shown as.

$100
TFC

Total variable cost (TVC)

The total variable cost of a firm has an inverse s- shape. The shape indicates the law of variable
proportions in production. According to this law, at the initial stage of production with a given plant, as
more of the variable factor (s) is employed, its productivity increases. Hence, the TVC increases at a
decreasing rate. This continues until the optimal combination of the fixed and variable factors is reached.
Beyond this point, as increased quantities of the variable factors(s) are combined with the fixed factor (s)
the productivity of the variable factor(s) declined, and the TVC increases by an increasing rate. Thus, the
TVC has an inverse s-shape due to the law of diminishing marginal returns.
Graphically, the TVC looks the following.
TVC
C

X
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Total Cost (TC)

The total cost curve is obtained by vertically adding the TFC and the TVC i.e., by adding the TFC and the
TVC at each level of output. The shape of the TC curve follows the shape of the TVC curve. i.e. the TC
has also an inverse S-shape. But the TC curve doesn’t start from the origin as that of the TVC curve. The
TC curve starts from the point where the TFC curve intersects the cost axis.

TC

TVC

TFC

The TC and TVC curves have an inverse S- shape. The vertical distance between them (TFC) is
constant.
Per unit costs (average costs)
From total costs we can derive per-unit costs. These are even more important in the short run analysis of
the firm. Average fixed cost (AFC) - is found by dividing the TFC by the level of output.

Graphically, the AFC is a rectangular hyper parabola. The AFC curve is continuously decreasing curve,
but decreases at a decreasing rate and can never be zero. Thus, AFC gets closer and closer to zero as the
level of output increases, because a fixed amount of cost is being divided by increasing level of output.
C
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AFC
 Q

The average fixed cost curve is derived from the total fixed cost, and it represents the slope
of straight lines drawn from the origin to a given point on the TFC curve.

Average variable cost (AVC)

The AVC is similarly obtained by dividing the TVC with the corresponding level of output.
TVC
AVC=
X
Graphically, the AVC at each level of output is derived from the slope of a line drawn from the origin to
the point on the TVC curve corresponding to the particular level of output.
The following graph clearly shows the process of deriving the AVC curve from the TVC curve.
C C
TVC

AVC
d

d
a
b c b c
a

Q
0
Q1 Q1 Q2 Q3
Q2 Q3 Q4 Q4

Panel A Panel B

It is clear from this figure that the slope of a ray through the origin declines continuously until the ray
becomes tangent to the TVC curve at C. To the right of this point (Point c) the slope of the rays through
the origin starts increasing. Thus, the short run AVC (SAVC now on) falls initially, reaches its minimum
and then start to increase. Hence, the SAVC curve has a U-shape and the reason behind is the law of
variable proportions. Had the TVC not been inverse S-shaped, the SAVC would never assume a U-shape.

Generally, at initial stage of production, the productivity of each additional unit of a variable input
increases, thus, the variable input requires to produce each successive units of output decreases at this
stage, implying that the AVC (Variable Cost Incurred to produce a unit of output) decreases. This process
continues until the point of optimal combination between the fixed input and the variable input is reached.
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Beyond this point, the productivity of each additional unit of the variable combined with the existing
fixed input decreases because the fixed input is over utilized. As the productivity of such variables
decreases, more and more of the variables are required to produce successive units of the output, implying
that the VC incurred to produce each successive unit (AVC) increases.

Average total cost (ATC) or simply, Average cost (AC)

ATC (or AC, now on) is obtained by dividing the TC by the corresponding level of output. It shows the
amount of cost incurred to produce each unit of successive outputs.
TC TVC+TFC TVC TFC
AC= AC= = +
Q Or equivalently, Q Q Q
= AVC + AFC
Thus, AC can also be given as the vertical sum of AVC and AFC.
Graphically, AC curve can be obtained by vertically adding the AVC and AFC for each level of
successive outputs. Alternatively, the AC curve can also be derived in the same way as the SAVC curve.
The AC curve is U-shaped because of the law of variable proportions. Observe the figure that follows.
Q

TC

a SAC

b c

b d
c

Q Q2 Q3 Q4 Q
0
1 Q1 Q2 Q3 Q4

Fig 4.6 Panel-A Panel-B

From this figure (Panel A), the AC at any level of output is the slope of the straight line from the origin to
the point on the TC curve corresponding to that particular level of output. That is, for example, the AC of
producing Q1 level of output is given by the slope of the line 0a, the AC of producing Q2 level of outputs
is given by the slope of the line Ob and so on.

Marginal Cost (MC)

The marginal cost is defined as the additional cost that the firm incurs to produce one extra unit of the
output. In other words, the MC is the change in total cost which results from a unit change in output i.e.
MC is the rate of change of TC with respect to output, Q or simply MC is the slope of TC function and
given by:
dTC
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MC=
dQ
In fact MC is also the rate of change of TVC with respect to the level of output.
dTFC+dTVC dTVC dTFC
MC= = =0
dQ dQ , since dQ

Graphically, the MC the TC curve (or equivalently the slope of the TVC curve) obviously, the slope of
curved lines at a given point is measured by constructing a tangent line to the curve at each point. So, the
slope of the curve at a given point is equal to the slope of the tangent line at that specific point. Given the
inverse S-shaped TC (or TVC) curve, the MC curve will be U-shaped. Thus given inverse S-shaped TC or
TVC curve, the slope of the TC or TVC curve (i.e. MC) initially decreases, reaches its minimum and then
starts to rise.

From this, we can logically infer that the reason for the U-shapedness of MC is also the law of variable
proportion. That is, had the TC or TVC curve not been inverse S-shaped, the MC curve have would never
assumed the U-shape, and obviously, the TC or TVC is inverse S-shaped due to the law of variable
proportions. Observe the figure that follows for more discussion.

C C

TC
MC

Q Q

Qs Qs
Panel-1 Panel-2
In summary, AVC, ATC and MC curves are all U-shaped due to the law of variable proportions. The
simplest total cost function which would incorporate the law of variable proportions is the cubic
polynomial of the following form.
TC=bo+b 1Q−b 2Q 2 +b 3 Q3
Where Q- is the level of output and b0, b1, b2 &b3 – are none zero constants.
From this type of total cost function,
b0
bo- represents the TFC, and AFC = Q
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b 1 Q−b 2 Q 2 +b3 Q3 - represents TVC and

 b 1 Q−b2 Q 2 +b3 Q3
AVC= =b 1−b 2 Q+b3 Q2
Q
ATC = AFC + AVC
b0
= +b 1−b 2Q+b 3Q 2
Q
The relationship between AVC, ATC and MC

Given ATC = AVC + AFC, AVC is part of the ATC. Both AVC and ATC are u – shaped, reflecting the
law of variable proportions however, the minimum of ATC occurs to the right of the minimum point of
the AVC ( see the following figure) this is due to the fact that ATC includes AFC which continuously
decreases as the level of output increases.

After the AVC has reached its lowest point and starts rising, its rise is over a certain range is more than
offset by the fall in the AFC, so that the ATC continues to fall (over that range) despite the increase in
AVC. However, the rise in AVC eventually becomes greater than the fall in AFC so that the ATC starts
increasing. The AVC approaches the ATC asymptotically as output increases.

AC
MC

AVC

AFC

Q
Q1
Q2
The AVC curve reaches its minimum point at Q1 output and ATC reaches its minimum point at Q2. The
vertical distance between ATC and AVC (AFC) decrease continuously as output increases. The MC curve
passes through the minimum point of both ATC and AVC.

Finally, the MC curve passes through the minimum point of both ATC and AVC curves.
This can be shown by using calculus.
Suppose the TC = f (Q)
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d ( f (Q))
MC= =f (Q )
dQ
 TC f (Q)
AC= =
Q Q
d (f (Q)) ( f (Q))Q−Q. f (Q) Slope of
AC=d =
But f dQ Q2 (Q) is MC and Q1 (or dQ/dQ) =1
Thus, slope of
1 f (Q) MC f (Q )
( MC− AC ) , where = AC −
MC. Q-f (Q) Q Q
Slope AC = Q Q AC= =
Now, Q2 Q
i) when MC<AC, the slope of AC is negative, i.e.
AC curve is decreasing (initial stage of production)
ii) When MC >AC, the slope of AC is positive, i.e. the AC curve is increasing (after
optimal combination of fixed and variable inputs.
iii) When MC = AC, the slope of AC is zero, i.e. the AC curve is at its minimum point.
The relationship between AVC and MC can be shown in a similar fashion.
The relationship between short run per unit production and cost Curves
Now, let’s see the important relation that per unit production curves (i.e. AP and MP of the variable input)
and per unit cost curves (i.e. AVC and MC) have. The relationship is that the short runs per unit costs are
the mirror reflection (against the x-axis) of the short run production curves. That is the short run AVC is
the mirror reflection of the short run AP of the variable input. When AP variable input increases, AVC
decreases; when AP variable input reaches its maximum, the AVC reaches its maximum point, and finally
when AP variable input starts to fall, the AVC curve starts to rise. The same relationship exists between
the short run MP of variable input curve the MC curve. This can be shown algebraically by using a linear
short run cost function.

Suppose the firm uses two inputs, labor L (which is variable) and capital (which is fixed input). And
suppose that the prices of both factors are given and equal to w, and r respectively.

The total cost of production is then, TC=rK +wL . The first term (i.e. rk) is the fixed cost because both r
and k are constant and the second term (i.e.wL) represents the variable cost.
Thus, TVC = WL
1
TVC WL Q Q
AVC = Q = Q = W. L But, L represents APL
1
Therefore, AVC = W. APL
Hence, AVC and APL are inversely related. Similarly, MC and MPL,
dTC dTVC dTC
MC = dQ = dQ (Remember that MC = dQ
d (W . L )
MC = dQ
dL
MC = W. dQ ………………………… (Because w is constant)
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 dL
MC = W. dQ
1
dQ
MC = W. dL
1 dQ
MC = W. MPL ……………………………………………… (Because
dL = MPL)
Hence, MC and MPL have also an inverse relation.

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 Graphically

AP, MP

APL

MPL
L

MC

AVC

Short run AVC and MC curves are the mirror reflection (along the horizontal axis) of short run
APL and MPL curves.

COSTS IN THE LONG RUN

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The basic difference between long-run and short run costs is that in the short run, there are some fixed
inputs which results in some amount of fixed costs. However, in the long run all factors are assumed to
become variable. In the long run the firm can change the quantities of all inputs including the size of the
plant. This implies that all costs are variable in the long-run in the sense that it is always possible to
produce zero units of output at zero costs. That is, it is always possible to go out of business.
The long –run cost curve is a planning curve, in the sense that it is a guide to the entrepreneur in his
decision to plan the future expansion of his plant.
Derivation of the long- run average cost curve
The long run average cost curve is derived from the short run average cost curves. Each point on the long
run average cost (LAC, now on) corresponds to a point on the short run cost curve, which is tangent to the
LAC at that point. Now let us examine in detail how the LAC is derived from the short run average cost
(SAC) curves.

Assume that the available technology to the firm at a particular point of time includes three methods of
production, each with a different plant size: a small plant, medium plant and large plant. The operation
cost of the small plant is denoted by SAC1, the operating cost of the medium size plant is denoted by
SAC2 and that of the large size plant is denoted by SAC3 in the following figure.

If the firm plans to produce x1 units of output, it is well advised to choose the small size plant to
minimize its cost. For example, if the firm choose to use the medium size plant to produce x1 units of
output, the per unit costs will be C4 ( a point corresponding to x1 units of out put on the SAC2) but, the
firm can produce x1 units of output at a lower unit cost (c1) if it uses the small size plant. Similarly, if it
plans to produce x2 units of output, it will choose the medium size plant. If the firm wishes to produce x3
units, it will choose the large size plant.

If the firm starts with the small plant and its demand gradually increases, it will produce at lower costs
(up to x1 level of output). Beyond that level of output costs start increasing. If its demand reaches the
level x1” the firm can either continue to produce with the small plant or it can install the medium size
plant. The decision, at this point, whether to install the medium size plant or not depends not on the costs
but on the firm’s expectation about its future demand. If the firm expects that the demand will expand
further than x1” it will install a medium size plant because with this plant out puts larger than x1” are
produced with a lower cost.

Similar considerations hold for the decision of the firm when it reaches the level x2”. If the firm expects
its demand to stay constant at x2” level, the firm will not install the large plant, given that it involves a
large investment which is profitable only if demand expands beyond x2”. If the firm expects that its
demand will expand further, it will install the large size plant to reduce its cost. For example the level of
output x3 is produced at a cost c3 with the large plant, while it costs c2’ if produced with the medium size
plant (c2’ > c3).

Now if we relax the assumption of the existence of only three plant sizes and assume that the available
technology includes large number (infinite number) of plant sizes, each suitable for a certain level of
output, the points of intersection of consecutive plants cost curves (which are the crucial points for the
decision of whether to switch to a larger plant) are numerous and we obtain a continuous curve, which is
the planning LAC curve of the firm.

The LAC curve is then the tangent to these SATC curves of various plant sizes and shows the minimum
cost of producing each level of output.
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SAC1
 SAC2
C4
LAC
C1
C1’

C2’
SAC3
C2

C3

X1

X1’’’’ X2 X2’ X3

X1’’

The relationship between LAC and short run average costs. The long run AVC curve is the lower
envelope of the short run average costs of various plant sizes.
Assuming that there is infinite number of plant sizes, the LAC curve is a smooth curve tangent to each
and every SAC curves corresponding to different plant sizes. See the following figure.

LAC
1 6

5
2 3
4

The long run average cost curve, assuming that there are large number of plant sizes
In summary, the LAC curve shows the minimum per-unit cost of producing any level of output when the
firm can build any desired scale of plant in the sense that the firm chooses the short –run plant which
allows it to produce the anticipated (in the long run)output at the least possible cost.

Why is the LAC U-shaped?

Similar to the SAC curve, the LAC curve of a firm is also U-shaped, but the reason for the U-shape of
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LAC curve is different from that of the SAC curve.

The LAC curve is U-shaped due to the laws of returns to scale (i.e increasing and decreasing returns to
scale).that is, as output expands from a very low levels increasing returns to scale prevails (i.e., output
rises proportionally more than inputs), and so the cost per-unit of output falls (assuming that input prices
remain constant). As output continues expand, the forces of decreasing returns to scale eventually begin
to overtake the forces of increasing returns to scale and the LAC begins to rise.

In other words, the per unit costs of production decreases initially as the plant size increases, due to the
economies of scale which larger plant size makes possible.

Economies of scale are the cost dimension of increasing returns to scale and thus, they are like the two
sides of a coin. If a firm has increasing returns to scale in production (i.e., if it requires the firm less than
double inputs to produce double output) the firm will have economies of scale in costs (it will require the
firm less than double cost to produce double output). Thus, the reason for the decreasing part LAC curve
is increasing returns to scale or economies of scale. Economies of scale may prevail for various reasons
such as specialization of skills, lower prices for bulk-buying of raw materials, decentralization of
management system and etc.

The traditional theory of the firm assumes that economies of scale exists only up to a certain size of plant,
which is known as optimal plant size, because with this plant size all possible economies of scale are
fully exploited. If the plant size increases further than this optimal size diseconomies of scale will start to
prevent, arising from managerial in efficiencies, the price advantage from bulk-buying may also stop
beyond a certain limit etc. These diseconomies of scale will lead to increasing LAC curve. Thus, the
increasing portion of the LAC curve shows the existence of diseconomies of scale or decreasing returns to
scale.

In general, the reason for the U-shapedness of the LAC curve are the existence of increasing returns to
scale at initial stage of expansion and decreasing returns to scale at a later stage of expansion.
C

(Increasing returns to scale

Decreasing returns to scale

C0 constant returns to scale

Q
QO

The LAC curve is U-shaped due to the combined effects of increasing, constant and decreasing
returns.
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The long-run marginal cost curve.

The long-run marginal cost curve (LMC) is derived from the short run MC curve but does not envelope
them. The LMC is formed from points of intersection of the SMC curves with the vertical lines (to the x-
axis) drawn from the points of tangency of corresponding SAC curves and the LAC curve.

SAC1 SMC2
SMC1 SMC3 SAC3

LMC LAC
SAC2

Q1 Q2 Q3 Q

Long run marginal cost curve; it is derived from the short run marginal cost curves by connecting
the points of intersection of the vertical lines drawn from the point of tangency of SAC curves with
the LAC curves with and the corresponding SMC curves. Note that, the LMC curve passes through
the minimum of the LAC curve.
Dynamic changes in costs: the learning curve
So far we have suggested one reason why a large firm may have a lower long-run average cost than a
small firm: increasing returns to scale in production it is tempting to conclude that firms which enjoy
lower average cost over time are growing firms with increasing returns to scale .but this need not be true.

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. That is, as workers get
experience their efficiency increases which then reduces the average and marginal costs of producing a
unit of product.

As management and labor gain experience with production, the firm’s marginal and average costs of
producing a given level of output fall for four reasons:

1. Workers often take long-run to accomplish a given task the first few times they do it. As they
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become more adept, their speed increases.

2. Managers learn to schedule the production process more effectively.
 3. Engineers who are initially cautious in their product designs may gain enough experiences to be
able to allow for tolerances in design that save costs with though increasing defects. Better and
more specialized tools and plant organization may also lower cost.
4. Suppliers may learn how to process required materials more effectively and pass on some of this
advantage in the form of lower costs to the firm.

In general, a firm ’learns’ over time as cumulative output increases. Managers can use this learning
process to help plan production and forecast future costs. The following figure illustrates this process in
the form of learning curve: a curve that describes the relationship between the firms cumulative output
and the amount of inputs needed to produce each unit of output.
Number of labor required to produce one unit

Learning
curve

A
Cumulative
out put

Learning Curve: shows that at the firm’s cumulative output increases (as the firm gets
experienced), the amount of inputs (such as labor) required to produce one unit of output
decreases.
In the above graph, the per unit production costs decreases along with the amount of labor required to
produce a unit of the commodity. This happens because labor input per unit of output directly affects the
production costs. The fewer the hours of labor needed to produce a unit of the commodity, the lower the
marginal and average costs of production.

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