Microeconomics

Chapter Four
Theory of Cost
 4.1. Basic concepts
 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.
 Types of cost of production
A. 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.
 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
◦ A firm’s cost of production include explicit costs
and implicit costs.
 Explicit costs are input costs that require a direct outlay
of money by the firm.
 Implicit costs are input costs that do not require an
outlay of money by the firm.
 A firm’s cost of production includes all the
opportunity costs of making its output of
goods and services.
Economic Profit versus Accounting Profit
 Economists measure a firm’s economic profit
as total revenue minus total cost, including
both explicit and implicit costs.
 Accountants measure the accounting profit as
the firm’s total revenue minus only the firm’s
explicit costs.
 When total revenue exceeds both explicit
and implicit costs, the firm earns economic
profit.
◦ Economic profit is smaller than accounting profit.
 Figure 1 Economic versus Accountants

How an Economist How an Accountant

Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

Copyright © 2004 South-Western

 THE VARIOUS MEASURES OF COST
 Costs of production may be divided into fixed
costs and variable costs.
 Fixed costs are those costs that do not vary
with the quantity of output produced.
 Variable costs are those costs that do vary
with the quantity of output produced.
 Total Costs
◦ Total Fixed Costs (TFC)
◦ Total Variable Costs (TVC)
◦ Total Costs (TC)
◦ TC = TFC + TVC
Table 2 The Various Measures of Cost:

Copyright©2004 South-Western
 Average Costs
◦ Average costs can be determined by dividing the
firm’s costs by the quantity of output it produces.
◦ The average cost is the cost of each typical unit of
product.
 Average Costs
◦ Average Fixed Costs (AFC)
◦ Average Variable Costs (AVC)
◦ Average Total Costs (ATC)
◦ ATC = AFC + AVC
Average Costs
Fixed cost FC
AFC  
Quantity Q

Variable cost VC
AVC  
Quantity Q

Total cost TC
ATC  
Quantity Q
Table 2 The Various Measures of Cost:

Copyright©2004 South-Western
 Marginal Cost
◦ Marginal cost (MC) measures the increase in total
cost that arises from an extra unit of production.
◦ Marginal cost helps answer the following
question:
 How much does it cost to produce an additional unit
of output?

(change in total cost) TC

MC  
(change in quantity) Q
Cost Curves and Their Shapes
 Marginal cost rises with the amount of
output produced.
◦ This reflects the property of diminishing
marginal product.
Cost Curves and Their Shapes
 The average total-cost curve is U-shaped.
 At very low levels of output average total
cost is high because fixed cost is spread
over only a few units.
 Average total cost declines as output
increases.
 Average total cost starts rising because
average variable cost rises substantially.
Cost Curves and Their Shapes

 The bottom of the U-shaped ATC curve

occurs at the quantity that minimizes
average total cost. This quantity is
sometimes called the efficient scale of the
firm.
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.
 By fixed costs, we mean a cost which doesn’t
vary with the level of out put. The fixed costs
include:
◦ Salaries of administrative staff
◦ Expenses for building depreciation and repairs
◦ Expenses for land maintenance
◦ The rent of building used for production , etc
 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
◦ The running expenses of fixed capital such as fuel,
electricity power, etc.
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
Typical Cost Curves
 Three Important Properties of Cost
Curves
◦ Marginal cost eventually rises with the
quantity of output.
◦ The average-total-cost curve is U-shaped.
◦ The marginal-cost curve crosses the average-
total-cost curve and average variable cost at
the minimum of average total cost and
average variable cost, respectively.
 The above graphical presentation can also
be shown by using calculus.
◦ Suppose the TC = f (Q), then
◦ Slope AC = Q MC  AC 
1

◦ 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 
AP MPL

M r
Labo
How?
Unit
cost P
MC

AVC

minimum minimum
AVC Quan
MC
tity
 4.3.The LR Cost Function
 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.
 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.
 The long – run refers to the fact that
economic agents – producers 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. Small, medium and large
 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

29
 Figure 7 Average Total Cost in the Short and Long Run

Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory

$12,000

ATC in long run

0 1,200 Quantity of
Cars per Day
Copyright © 2004 South-Western
Economies and Diseconomies of Scale
 Economies of scale refer to the property
whereby long-run average total cost falls as
the quantity of output increases.
 Diseconomies of scale refer to the property
whereby long-run average total cost rises
as the quantity of output increases.
 Constant returns to scale refers to the
property whereby long-run average total
cost stays the same as the quantity of
output increases
 Figure 7 Average Total Cost in the Short and Long Run

Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory ATC in long run

$12,000

10,000

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

Cars per Day
Copyright © 2004 South-Western
 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-shapes of
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.
 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-shaped of the
LAC curve are the existence of increasing returns
to scale at initial stage of expansion decreasing
returns to scale at a later stage of expansion.
Shape of the LRAC.

The LAC curve is U-shaped due to the combined effects of increasing,

constant and decreasing returns.
 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
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.
 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.
Cont.
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 -----