Deriving Total Cost: 2 Key Points

A profit-maximising firm clearly has to produce its chosen output level at a minimum
cost. To determine the minimum total cost of producing any level of output (i.e. the
firms total cost function), the firm has to bear in mind two key points.
1.
Costs are measured as economic (opportunity) costs. Recall that to
maximise economic profit the firm must calculate its total economic, not accounting,
cost.
2.
Short Run & Long Run Periods. The input choices open to the firm depend
on whether it is considering a short or long run decision. Hence the cost of using
those inputs will vary accordingly. We need to distinguish therefore between short
and long run costs.

Cost in the Short Run

Recall that the short run production function shows the maximum output the firm can
produce with any amount of the variable factor (labour) together with the fixed amount
of the other factor (capital). Turning this around, its clear that the short run production
function also shows the minimum amount of variable input required (with the given
amount of fixed factor) to produce any chosen level of output. So the firm can use its
short run production function to determine the minimum total cost of each level of
output - i.e. the firms short run total cost function.

Calculating Total Cost

To calculate the short run total cost of a given level of output the firm would need to
take the following steps:
1.
Use the short run production function to determine the minimum amount of
labour input required to produce the output.
2.

Multiply the quantity of labour by the wage rate to get the total labour cost

Should the firm then add on the cost of using the fixed amount of capital? NO! Because
in the short run, expenditures on capital are a sunk expenditure - they are therefore
NOT an economic cost. Why is this? Because capital is a fixed factor in the short run,
and therefore, by definition, there is no alternative use for it. Hence, the short run
economic (opportunity) cost of capital is zero.

So, short run total economic cost consists only of the firms expenditure on
its variable factors (here labour), and thus excludes expenditure on the fixed factor
(capital)

Example: Short Run Total Cost Curve

Using the short run production function from topic 6, and assuming a daily wage rate
per worker of 30 we can calculate the firms total costs as shown in the table below.
Units of
Labour per
day

Total Product
per day

0
1
2
3
4
5
6
7

0
10
22
37
52
67
78
86

Wage Rate
per day ()

Total Cost
per day ()

30
30
30
30
30
30
30
30

0
30
60
90
120
150
180
210

250
CSR

per day

200
150
100
50
0
0

20

40

60

80

100

Output per day

Note that this total cost curve has the same shape as the one in topic 5 (The Firm & its
Goals). But this time we have explicitly derived total cost from the firms short run
production function. Its clear, then, that the shape of the total cost curve depends on
the shape/properties of the underlying production function. To examine this relationship
between production and cost we need to look more closely at the concept of marginal
cost, first introduced in topic 5.

Marginal Cost
Recall the definition of marginal cost:

Short run marginal cost (MCSR) is the change in short run total cost due to the
production of one more unit of output.
As MC is derived from total cost which in turn ,as weve seen, is derived from the
firms short run production function, its clear that MC also depends on the production
function. Lets see how.

If the firm wants to produce one more unit of output it will need to employ some extra
units of the variable input (labour). How many extra units. To answer this the firm
needs to look at the MPP of labour. If the MPP of another unit of labour is 4 units of
output, then to produce one extra unit of output the firm would need to employ 0.25
(i.e. 1/4) extra units of labour. So, in general:

Extra units of variable factor required to produce one more unit of output =
1/MPP
Now the MC of this extra unit of output will equal the cost of employing these extra
1/MPP units of variable input. To calculate this the firm needs to multiply 1/MPP by the
cost of employing each extra unit of input. This latter amount is known as the marginal
factor cost; i.e.

The marginal factor cost (MFC) is the additional amount that the firm has
to pay for a factor when it hires one more unit of the factor.
So, have deduced the following relationship between short run MC and the firms
technology (represented by the MPP):
MCSR MFC

1
MFC

MPP MPP

Remembering that, in the short run, the wages paid to labour are the only economic
cost, we can write the formula for short run marginal cost as follows:
MCSR

MFC L
MPPL

Finally, we can simplify this key formula still further if we assume that the firm is a
price-taker in the market for its labour - i.e. it takes the market price of labour (the
wage rate) as a constant, outside of its control, at which it can purchase as much labour
as it wants. In this case, the MFC of labour must equal the going wage rate (w), as
every time the firm hires another worker it costs it an extra w.
Thus when the firm is a price-taker in the labour market, short run MC is equal to the
given wage rate ( w ) divided by the MPP of labour; i.e.
MCSR

w
MPPL

This formula tells us that, ceteris paribus, the higher the marginal physical product
(MPP) of labour, the lower the marginal cost of output. It also makes explicit the
relationship between the slope of the short run production function (MPP L) and the
slope of the short run total cost curve (MCSR)

Marginal Cost & Marginal Returns to Labour

Lets look at this relationship by using the formula to calculate short run MC for the
total cost example curve shown above.
Units of
Labour
per day

Total
Product
per day

Margina
l
Physical
Product

Wage
Rate
per day
()

Total
Cost
per day
()

Marginal
Cost ()

30

10
1

10

30

30

12
2

22

37

2.5
30

60

30

90

15

15
4

52

30

120

15
5

67

78

86

2
30

150

30

180

30

210

11

2.73

3.75

Its immediately apparent from the table that when the marginal product of labour rises
(increasing returns), short run marginal cost falls; when MPP L is constant (constant
returns) so too is MCSR; and when the MPPL falls (diminishing returns), MCSR rises.
This, of course, is exactly what the formula for MCSR shows would happen.
This relationship between MPP and MC makes sense. With diminishing marginal
returns to labour, for example, as the level of total output rises, producing an additional
unit of output requires increasingly large increments of labour. Hence the extra
(labour) cost of producing more output becomes increasingly large too.
If we graph the short run MC curve and display below the MPP L curve the inverse
relationship between the two is made even clearer - see the graphs below.
Marginal Product Curve
16
14
12
Output

10
8
MPP

6
4
2
0
0

5
6
7
Units of labour

Short Run Marginal Cost Curve

5
4.5
MCSR

per day

3.5
3
2.5
2
1.5
1
0.5
0
0

10

20

30

40

50

60
70 80
Units of Output

Average Cost
Recall from topic 5 that the firms average cost plays a crucial role in determining
whether or not a firm should shut down rather than produce. When making a short run
shutdown decision, the relevant measure of average cost is short run average cost,
defined as follows:

Short run average cost (ACSR) is the short run total cost divided by the
number of units of output: i.e.
ACSR

CSR
Q

The following table (and graph) shows short run average cost for our total cost curve
example, together with the MCSR figures calculated earlier.
Total Product
per day
0

Total Cost Average

per day () Cost ()

Marginal
Cost ()

0
3

10

30

22

60

2.73

2.5
2
37

90

2.43
2

52

120

2.31

67

150

2.24

78

180

2.31

2
2.73

3.75
86

210

2.44

Short Run Average Cost Curve

4.5
4
3.5
per day

ACSR

2.5
2
1.5
1
0.5
0
0

10

20

30

40

50

60 70 80 90
Units of Output

As the table and graph both show, short run average cost initially falls as output
increases, but eventually, as the firm continues to raise output average cost in the short
run starts to increase. Why this particular shape for the short run average cost curve
here? The answer lies with marginal cost.

Relationship between Marginal Cost & Average Cost

From the table, its apparent that when MC < AC, AC falls; but when MC > AC, then
AC rises. The reason for this relationship is intuitively clear. If producing an additional
unit of output adds less to total cost than the previous unit (MC is falling) then the total
cost per unit (average cost) must go down. For example, if 10 units cost 100 to
produce (AC = 10), and 11 units cost 108 (MC = 8), the AC falls to 9.82 (=
108/11). Conversely, if producing an additional unit of output adds more to total cost
than the previous unit (MC is rising) then the total cost per unit (average cost) must
rise.
Recall that the shape of the MC curve depends on the firms technology via the MPP of
labour. Weve just seen that AC is related to MC, hence it follows that the shape of the
AC curve is also related to the firms underlying short run production function. How?
If, for example, the MPP of labour is increasing, then as the firm produces more output
it needs fewer and fewer units of labour per additional unit of output. Since each
additional unit of output requires less labour than did the earlier units of output, the
average amount of labour per unit of output falls as the output level rises. But short run
AC equals the given wage rate multiplied by the average amount of labour per unit of
output (remember in the short run labour is the only economic cost). Hence when the
firm experiences increasing marginal returns to labour, short run average cost falls as
output rises.
In summary, the relationship between marginal and average cost is as follows:

Whenever marginal cost is below average cost, average cost falls

Whenever marginal cost is above average cost, average cost rises

Hence, we can also conclude that:

The short run marginal cost curve crosses the short run average cost curve at
the point where average cost is at a minimum.
The following diagram (where output varies continuously - hence smooth curves)
illustrates these three points.

ACSR
MCSR

Q1

Units of output

Cost in the Long Run

The firms costs in the long run differ in two key ways from the short run:
1.
Since all factors are variable in the long run, the (explicit and imputed)
expenditures on all inputs are economic costs in the long run.
2.
Since the levels of more than one factor can be varied, it may be possible for
the firm to substitute quantities of one factor for another.
Factor substitution means that the firm has to choose the particular combination (mix)
of factors which minimises the cost of producing the desired level of output: i.e. from
all the possible technologically efficient combinations shown by the isoquant it has to
choose the economically efficient mix of inputs.

An input combination is economically efficient when it has the lowest

opportunity cost of those input combinations that can be used to produce the desired
output.
To choose the minimum cost mix of inputs, the firm needs to know the total cost of
each possible combination - this is shown by isocost lines.

Isocost Lines

An isocost line shows all the combinations of the inputs (e.g. capital and
labour) which have the same total cost.

To draw an isocost line we need to know the values of three parameters: the price per
unit of capital (user cost, r), the price per unit of labour (wage rate, w) and the total cost
of using the quantities of the two inputs (C) (N.B. It is assumed that the firm is a pricetaker in the input markets, hence the prices of capital and labour are taken as given by
the firm)
The equation of an isocost line is thus:
C wL rK
i.e. the total cost of the inputs (C) equals the amount spent on labour (wage rate, w,
times the units of labour employed, L) plus the amount spent on capital (user cost per
unit, r, times the units of capital employed, K).
Numerical example: Isocost Line
Assume: w = 20 per day, r = 50 per day, C = 500 per day
Then, the isocost line equation is:
500 20 L 50 K
Using this equation, we can construct the following table and graph which shows
various combinations of capital and labour which have the same total cost of 500 per
day:
Units of labour
per day

Units of capital
per day

10

10

15

20

25

An Isocost Line
12

Capital per day

10
8
6
4
2
0
0

10

15

20

Labour per day

25

30

Slope of an Isocost Line

Note that the two endpoints of the isocost line are equal to total cost divided by the
respective input price, as they represent the units bought of one input when total
expenditure is only on that input. Hence, we can easily deduce the slope (in absolute
value) of an isocost line to be as follows:

( Absolute) Slope ( )

C
K
w
r
L C
r
w

Thus, the (absolute) slope of the isocost line is equal to the ratio of the input prices; i.e.
the relative price of labour to capital.
Numerical Example
The slope of the example isocost line shown above is:
w 20

0.4
r 50

i.e. in order to buy purchase one more unit of labour, the firm has to forego 0.4 units of
capital.
Notice the similarity between this and the slope of the households budget line (see
topic 2: Consumer Choice). This, of course, is no coincidence. Clearly, the firms
isocost line is the equivalent of the households budget line. Both show the available
trade-off between the two inputs (the firm) or goods (the household) whilst keeping
total expenditure constant.

The slope of an isocost line shows the amount of one input the firm needs to
forego in order to purchase one more unit of the other input whilst keeping total cost
the same.

Isocost Map
As weve seen, an isocost line can be drawn for given factor prices and a given total
cost. If the factor prices remain constant, then for different levels of total cost there will
be a set of parallel isocost lines each one representing a specific level of total cost. This
set of isocost lines is called an isocost map. Obviously, the higher the total cost, the
further the isocost line will be firm the origin, as more of both inputs can be purchased
by the firm at the given factor prices.
Numerical Example: An Isocost Map
Assume the same factor prices as before (w = 20, r = 50), and consider two total
costs: C1 = 500, C2 = 300.
C1 = 500

C2 = 300

Units of
labour per
day

Units of
capital per
day

Units of
labour per
day

Units of
capital per
day

10

10

10

15

15

20

25

An Isocost Map
12

Capital per day

10
8
6
4
2

IC500

IC300

0
0

10

15
Labour per day

20

25

30

Cost Minimisation: Economically Efficient Input Mix

To find the economically efficient input mix (i.e. the particular combination of inputs
which minimises the cost of producing the desired level of output) the firm has to find
the point on the isoquant which is on the isocost nearest to the origin. This is shown in
the following diagram.
Capital

K*

L*

Q1

Labour

To produce output level Q1 at minimum cost in the long run, the firm should operate at
point E; i.e. it should use K* units of capital and L* units of labour. To see why note
that any other feasible input mix, e.g. points B and D, is necessarily on an isocost line
further from the origin which, by definition, implies a higher total cost.
Point E represents the firms equilibrium input choice - given its desired output and
technology (represented by the isoquant) and the factor prices, having chosen input mix
K*, L* there is no incentive for it to change.

Equilibrium Condition
At point E the isoquant is tangential to the isocost line, i.e. they have the same slope.
Thus the condition for cost minimisation in the long run is:
MRTS K , L

w
r

In other words, to minimise long run cost the firm should operate at a point where the
marginal rate of technical substitution between capital and labour equals the factor
price ratio.
Recall that the MRTS is equal to the ratio of the marginal physical products of labour
and capital: i.e.
MRTS K , L

MPPL
MPPK

Hence, we can also write the equilibrium condition as:

MPPL w

MPPK
r

This says that to minimise long run cost the firm should operate at a point where, at the
margin, the ratio of marginal physical products is equal to the ratio of the factor
prices.
Finally, rearranging the last equation, we can express the equilibrium condition in
another useful way as follows:
MPPL
MPPK

w
r

This states that to minimise long run cost, the firm should choose the combination of
inputs such that the marginal product of the last pound spent on an input is the same
for each input.
Notice that this condition is very similar to the equilibrium condition for utility
maximisation for a household (where the marginal utility per last pound spent was the
same for each good).

Deriving the Long Run Total Cost Curve

To derive the firms long run total cost (C LR) curve, we simply need to use the
equilibrium condition to find the minimum cost of producing each level of output. The
relationship between (minimum) total cost and output is then the firms long run total
cost schedule/curve. The following diagram illustrates the derivation of CLR for three
output levels.
Capital

IC1500

IC1400
expansion path
IC1000

Q200
Q150
Q100
Labour

From the diagram we get the following long run total cost schedule:
Output per
period

Long Run Total Cost

( per period)

100

1000

150

1400

200

1500

Properties of Long Run Costs

What can we deduce about the shape of the long run total cost curve? Obviously it is
positively sloped - more output implies using more inputs that, with given factor prices,
must increase total cost. To say more about the properties of the long run total cost
curve, we need to consider the two associated cost concepts: long run average cost
(ACLR) and long run marginal cost (MCLR).

Long Run Average Cost

Long run average cost (ACLR) is the long run total cost (CLR) divided by the
number of units produced (Q): i.e.
AC LR

C LR
Q

What happens to long run average cost as the firm increases its output level? Note first
that since, in the long run, the firm will vary all its inputs simultaneously, the firm will
be altering the scale of its operations. Do average costs rise or fall as the firm gets
bigger and produces more output?

If long run average cost falls as output rises, costs are said to exhibit
economies of scale.

If long run average cost rises as output rises, costs are said to exhibit
diseconomies of scale.
A major determinant of economies (or diseconomies) of scale is the degree of returns
to scale of the firms underlying long run production function.
For example, if the firm experiences increasing returns to scale when it, say, doubles
the amount it uses of all its inputs then it will more than double its output level. But,
with given factor prices, doubling the inputs will double the total cost. Hence, long run
average cost, which is total cost divided by output, must fall as total cost has doubled
but output has more than doubled.
Thus we can state the following conclusions:

When the production function exhibits increasing returns to scale, long run
average cost declines as output rises.

When the production function exhibits constant returns to scale, long run
average cost stays constant as output rises.

When the production function exhibits decreasing returns to scale, long run
average cost increases as output rises.
Numerical Example
Lets calculate ACLR for the total cost curve derived above.
Output per
period
100

Long Run Total Cost

( per period)
1000

Long Run Average

Cost ( per unit)
10

150

1400

9.33

200

1500

7.5

Its apparent that this long run total cost curve exhibits economies of scale, as long run
average cost is declining as the firm increases its output level.
A fairly typical situation would be where the firm experienced economies of scale at
first, then ACLR remained constant, and finally diseconomies of scale would start to
occur. Such a situation would give rise to a long run average cost curve similar to the
one illustrated in the following diagram.

ACLR

Output per period

Long Run Marginal Cost

Long run marginal cost (MCLR) represents the slope of the long run total cost curve. It
is obviously defined as follows:

Long run MC is the change in long run total cost due to the production of one
more unit of output: i.e.
MC LR

C LR
Q

Recall that marginal cost is related to average cost. Thus we can deduce that:

When the firm experiences economies of scale (ACLR is falling), long run
MC must be below average cost.

When the firm experiences diseconomies of scale (ACLR is rising), long run
MC must be above average cost.
Numerical Example
The following table shows long run MC (and average cost) for our example total cost
curve.
Output
per period

Long Run
Total Cost
( per period)

Long Run
Average Cost
( per unit)

100

1000

10

Long Run
Marginal Cost
( per unit)

8
150

1400

9.33

200

1500

7.5

Comparing Long Run & Short Run Total Cost

The firms input choices differ in the long run and the short run. Hence(prin urmare) the
total cost of producing a given level of output may also differ. How do short and long
run costs compare? There are two key differences:

In the short run, any expenditures on the fixed factors (capital) are sunk they are not economic (opportunity) costs. However, in the long run, all factors are
variable and there are no sunk expenditures - everything counts as an economic cost.
Because there are more costs, long run total cost will be larger than short run total
cost.

The possibility of factor substitution in the long run enables the firm to
produce a given output at a lower cost than in the short run.
In terms of their effects on the relationship between long run and short run total cost,
these two differences work in opposite directions. Consequently, in some cases, the
short run total cost of a given level of output may be greater then the long run total cost,
and in other cases less.