Topic Theory of

6 Costs
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Define the types of costs according to economics;
2. Formulate the production costs in the short- and long-run;
3. Appraise average costs in the long-run;
4. Explain the economies of scale and diseconomies of scale; and
5. Combine the shape of long-run average cost with economies of
scale and diseconomies of scale.

INTRODUCTION
In continuation with the theory of production in Topic 5, this topic will discuss
cost associated with production. As mentioned previously, firms will use
different combinations of inputs in order to produce the output. Firms must pay
for the input used in production while the expenditures for inputs are considered
costs of production. In this topic we will look at the explanation for the different
types of costs classified in economics as opposed to the standard accounting
terms of costs. As in the case of production where there are fixed input and
variable inputs, the short-run costs will involve fixed cost and variable costs as
well. The concept of economies and diseconomies of scale will also be discussed.

Now, let us begin.

Copyright Open University Malaysia (OUM)

112 TOPIC 6 THEORY OF COSTS

6.1 COST CLASSIFICATION

What is production cost and how do we differentiate explicit cost and implicit
cost?

6.1.1 Production Costs

Production costs refer to all expenditures incurred to attain factors of production
and intermediate goods which will then be used to produce goods and services.

Fundamentally, these costs can be classified into two as shown in Figure 6.1.

Figure 6.1: Production costs

Let us read more about each of these costs.

(a) Explicit Costs

Explicit costs are actual expenses incurred by a firm to acquire inputs for
the production of output. It involves direct payment for the input, for
example, wages, rent for land or building, interest on borrowed capital, and
payments for purchase of raw materials.

(b) Implicit Costs (Hidden Cost)

Implicit costs are expenses for factors of production owned by the firm,
which are utilised in the production process. It does not however involve
direct payment. Examples of implicit costs for a privately owned factory are
entrepreneurial membership fees, and interest not paid on privately owned
capital. To explain further, let us say, Ahmad uses a machine that he owns
in the production of shoes. Since he owns the machine, he is not going to
pay the rental on capital. However, if he is not producing the shoes himself,
he can actually rent out the machine and earn the rental. This forgone
income on rental is considered implicit cost to Ahmad. From an accounting
perspective, implicit costs are not taken into account in the expense
accounts of a firm.

Copyright Open University Malaysia (OUM)

 TOPIC 6 THEORY OF COSTS 113

ACTIVITY 6.1

Cite examples of implicit costs other than the examples of implicit

costs stated above.

6.2 PRODUCTION COSTS IN THE SHORT-RUN

This section will discuss several production costs incurred in the short-run. These
production costs can be seen in Figure 6.2.

Figure 6.2: The production costs in the short-run

Now let us look at each production cost.

6.2.1 Fixed Costs

Fixed costs (total fixed cost, TFC) do not change even though the level of output
changes. For example, rent and insurance costs. These costs are constant
regardless of the quantity of goods produced. It must be paid by the firm even if

Copyright Open University Malaysia (OUM)

114 TOPIC 6 THEORY OF COSTS

there is no production. A firm will only stop incurring these costs if it ceases its
business operations.

With reference to Table 6.1, fixed costs (second column) for the firm is RM40
regardless of the level of output produced. The firm has to pay the total fixed cost
even when it does not produce any goods (Q = 0), or when the level of output
increases.

6.2.2 Variable Cost

Total variable cost (TVC) will change directly with changes in the level of output,
for example, fees, wages, and raw materials. These costs will increase if the level
of output increases.

With reference to the third column in Table 6.1, total variable costs increases
when the level of output increases. If the firm does not produce any goods (Q =
0), the total variable cost is zero because there is no labour or raw material used.

6.2.3 Total Cost

Total cost (TC) is derived from total fixed cost (TFC) and variable cost (TVC) per
the following formula:

TC = TFC + TVC (6.1)

With reference to Table 6.1, total cost is derived by adding fixed costs (second
column) to variable costs (third column). For example, when the level of output
is 2 units, the total cost is RM108, where fixed cost is RM40 and variable cost is
RM68.

The data from Table 6.1 can be illustrated in the form of a curve as shown in
Figure 6.3:

Copyright Open University Malaysia (OUM)

 TOPIC 6 THEORY OF COSTS 115

Table 6.1: Fixed Costs, Variable Costs and Total Cost

Total Fixed Total Variable Total Costs,
Output Costs, TFC Costs, TVC TC
(RM) (RM) (RM)
0 40 0 40
1 40 40 80
2 40 68 108
3 40 88 128
4 40 102 142
5 40 120 160
6 40 140 180
7 40 165 205
8 40 194 234
9 40 232 272

10 40 290 330

Figure 6.3: Fixed costs, variable costs and total costs

In Figure 6.3, total fixed cost (TFC) does not change when the output level
changes. Therefore, it is a straight horizontal line at RM40 which begins where
the level of output is zero.

Total variable cost (TVC) begins at the initial point (0). This shows that when the
output is zero there is no variable cost incurred. Then, TVC will rise as output
increases.

Copyright Open University Malaysia (OUM)

116 TOPIC 6 THEORY OF COSTS

Total cost (TC) is TFC added to TVC. Hence, TC begins at RM40, even though
there is no output produced.

6.2.4 Marginal Cost (MC)

Marginal cost is the increase in costs as a result of an increase in one unit of
output.

TC TFC TVC
MC =
Q Q Q (6.2)

The symbol indicates change.

As fixed cost does not change at a specific output level produced by a firm
(which is fixed at RM40), marginal cost is the increase in variable cost as a result
of the increase of one unit of output, and can be shown as follows:

TC TVC
MC = (6.3)
Q Q

With reference to Table 6.2, when the level of output changes from 1 unit to 2
units, the total cost (TC) increases from RM80 to RM108. Therefore,

TC 108 80 28
MC = = = = 28
Q 2 1 1

Alternatively, we can also use the formula (6.3), where the change in TVC is
divided by the change in output. At the level where output rises from 1 unit to 2
units, the total variable cost (TVC) increases from RM40 to RM68. Therefore,

TVC 68 40 28
MC = = = = 28
Q 2 1 1

The answer for MC is the same (RM28) although the calculation is based on the
change in variable costs.

Copyright Open University Malaysia (OUM)

 TOPIC 6 THEORY OF COSTS 117

Table 6.2: A Firms Production Costs in the Short-run

Average Average
Fixed Variable Total Marginal Average
Fixed Variable
Cost Cost Cost Cost Cost
Output Cost Cost
(TFC) (TVC) (TC) (MC) (AC)
(AFC) (AVC)
(1) (2) (3) (4) (5)
(6) (7)
0 40 0 40 - - - -
1 40 40 80 40 80.00 40.00 40.00
2 40 68 108 28 54.00 20.00 34.00
3 40 88 128 20 42.67 13.33 29.33
4 40 102 142 14 35.50 10.00 25.50
5 40 120 160 18 32.00 8.00 24.00
6 40 140 180 20 30.00 6.67 23.33
7 40 165 205 25 29.29 5.71 23.57
8 40 194 234 29 29.25 5.00 24.25
9 40 232 272 38 30.22 4.44 25.78
10 40 290 330 58 33.00 4.00 29.00

SELF-CHECK 6.1

What do you understand by the following costs? Write the

formula to calculate these costs:
(a) Total cost; and
(b) Marginal cost.

6.2.5 Average Cost (AC)

Average cost is cost per unit of output and the formula is total cost divided by
level of output.

TC
AC (6.4)
Q

With reference to Table 6.2, where the level of output is 5 units, the average cost
is equal to RM32, which is RM160 divided by 5 units of outputs.

Copyright Open University Malaysia (OUM)

118 TOPIC 6 THEORY OF COSTS

If average cost and output level are given, total cost can be derived by
multiplying output quantity (Q) with average cost (AC). For example, at the
output level of 5 units and average cost of RM32, total cost is RM160, that is
RM32 x 5 units.

The concept is as follows:

Assume that you are taking 3 subjects: economics, marketing, and management.

The scores for your examination Economics = 80

are: Marketing = 75
Management = 64
Total = 219

What is the average score for the 3 subjects? The answer is 219 3 = 73.

Assume that you do not know the total scores you received for the 3 subjects but
you are given the average score of 73. You can calculate the total scores by using
the formula [Average x Quantity] = [Total] that is, 73 x 3 = 219.

6.2.6 Average Fixed Cost (AFC)

Average fixed cost is the fixed cost per unit at different levels of output. It can be
derived by dividing the total fixed cost with the level of output:

TFC
AFC (6.5)
Q

As fixed costs are constant regardless of the total output produced, AFC will
diminish if the level of output increases.

ACTIVITY 6.2
Why does AFC diminish when output increases? Can AFC be
negative? Why? Discuss with your coursemates.

Copyright Open University Malaysia (OUM)

 TOPIC 6 THEORY OF COSTS 119

6.2.7 Average Variable Cost (AVC)

Average variable cost is the variable cost per unit at different levels of output. It
can be derived by dividing the total variable cost at each level of output:

TVC
AVC (6.6)
Q

Marginal cost, average cost, fixed average cost, and average variable cost can be
drawn as shown in Figure 6.4:

Figure 6.4: Average cost, average fixed cost, average variable cost,
and marginal cost curves

Observe Figure 6.4. As fixed cost is the same or constant at RM40, the average
cost curve (AFC) is continuously sloping downward towards the horizontal axis.

The shapes of other curves, such as, marginal cost, average cost, and average
variable cost are determined by the relationship between marginal cost (MC) and
average cost (AC).

When MC is below AC, the AC curve is decreasing. But when MC is above AC,
the AC curve will rise. When AC is at the minimum point, MC is equal to AC, or
the two curves cross (Point G).

Copyright Open University Malaysia (OUM)

120 TOPIC 6 THEORY OF COSTS

Similarly, when MC is below AVC, the AVC curve is decreasing. But when MC is
above AVC, the AVC curve will rise. When AVC is at a minimum, MC is equal to
AVC, and the two curves cross.

Observe that the AVC curve is at a minimum point earlier than that of curve AC.
This is because MC = AVC (at minimum point AVC), and MC = AC (at minimum
point AC). As AC is always bigger than AVC and the MC curve rises, the
minimum point of AC must be above and on the right of the minimum point of
AVC.

EXERCISE 6.1

An accounts clerk has entered some costing data for Syarikat TNBC Sdn.
Bhd. into the computer and the data is shown in the table below. The
accounts clerk has resigned and you have been assigned to complete his
work.

Total Total Average Average

Total Average Marginal
Fixed Variable Variable Fixed
Output Cost Cost Cost
Cost Cost Cost Cost
(TC) (AC) (MC)
(TFC) (TVC) (AVC) (AFC)
0 24 - - - -
1 16
2 50
3 108
4 52
5 39.2
6 47

Calculate and fill in the costing data in the table above.

6.3 LONG-RUN PRODUCTION COSTS

Production costs in the long-run refer to duration of time when there are only
variable costs and no fixed costs. In the long-run, the firm can expand or shrink
its level of output by changing its variable costs. Therefore, with regard to the
concept of time duration, it does not involve an actual time period. On the other
hand, it depends on whether fixed costs can be changed to variable costs. If this is
true, the firm is said to be producing in the long-run.

Copyright Open University Malaysia (OUM)

 TOPIC 6 THEORY OF COSTS 121

Figure 6.5: Total cost curve in the long-run

Figure 6.5 shows the long-run total cost curve (LRTC) of a firm. This curve begins
from the initial point because in the long-run, there are no fixed costs. In the
beginning, LRTC will rise at a decreasing rate and then subsequently at an
increasing rate due to the law of economies of scale.

SELF-CHECK 6.2

What is the difference between the long-run total cost curve

(LRTC) and the short-run total cost curve?

6.4 LONG-RUN AVERAGE COST (LRAC) AND

LONG-RUN MARGINAL COST (LRMC)
Long-run average cost can be defined as total cost per unit of output in the long-
run. It can be derived by using the following formula:

LRTC
LRAC = (6.7)
Q

Copyright Open University Malaysia (OUM)

122 TOPIC 6 THEORY OF COSTS

Meanwhile, long-run marginal cost (LRMC) is the increase in cost as a result of

an increase in one unit of output during the long-run period. It can be calculated
using the following formula:

LRTC
LRMC = (7.8)
Q

Both curves are shown in Figure 6.6.

Figure 6.6: Long-run average cost curves

With reference to Figure 6.6, the LRAC curve is an envelope of the short-run
average cost curves (SRAC1, SRAC2, SRAC3, etc) of the respective factories. The
LRAC curve is plotted by connecting the minimum points of all the SRAC
curves. Point E, the minimum point for LRAC, is also the minimum point for
SRAC3.

LRAC curve is U-shaped but is flatter compared to the SRAC curve. This shape is
influenced by economies and diseconomies of scale, which will be explained
further in the following section.

6.5 LONG-RUN AVERAGE COSTS AND

ECONOMIES OF SCALE
Economies of scale refer to a situation when the size of a factory or its scale of
operations is enlarged. Thus, the total output increases but cost per unit
decreases. This is shown in Figure 6.7, before the output level reaches Q1. This
situation will result in an increase in the scale of returns (cost decreases).
Copyright Open University Malaysia (OUM)
 TOPIC 6 THEORY OF COSTS 123

Several factors which contribute towards economies of scale are as follows:

(a) Higher level of specialisation in the labour force.
(b) Cost savings on raw materials and factors of production.
(c) Improved efficiency in management and administration.
(d) Use of modern production technology.
(e) Ease of obtaining capital and financial resources.

Figure 6.7: Relationship between the scale of economic returns and

long-run average cost

When output increases continuously and reaches level Q1, LRAC is constant as a
result of constant economies of scale. Constant economies of scale mean that
when the scale of operations of a firm increases, it does not affect cost per unit.
This can be seen at the flat part of the LRAC in Figure 6.7, and this situation also
refers to the constant scale of economic returns or constant cost.

When output increases beyond level Q1, the LRAC curve will rise due to
diseconomies of scale. This shows that when the total output produced increases,
the cost per unit also increases. This can be seen where the LRAC curve rises as
in Figure 6.7. This situation is related to the decrease in the scale of economic
returns. Diseconomies of scale are caused by:
(a) Inefficient administration of management.
(b) Congestion in the area of production operations which results in a high cost
of living. This will contribute to an increase in wages, price of land, house
rent, etc. This situation will cause the cost of production per unit to
increase.

Copyright Open University Malaysia (OUM)

124 TOPIC 6 THEORY OF COSTS

ACTIVITY 6.3

Have a look at this website:

http://tutor2u.net/economics/revision-notes/a2-micro-economies-
diseconomies-of-scale.html

1. What do you understand by:

(a) Economies of scale; and
(b) Diseconomies of scale.

2. Can you give one example of economies of scale and diseconomies

of scale?

EXERCISE 6.2

1. What type of cost is included in the definition of cost according

to economist but not according to accountant?
A. Explicit cost.
B. Implicit cost.
C. Direct cost.
D. Depreciation cost.
E. None of the above.

2. The short run marginal cost curve intersects the average cost
curve when:
A. Marginal cost is at its maximum.
B. Marginal cost is at its minimum.
C. Average cost is at its maximum.
D. Average cost is at its minimum.
E. Total cost is at its maximum.

Copyright Open University Malaysia (OUM)

 TOPIC 6 THEORY OF COSTS 125

3. Which of the following is true about the fixed costs?

A. Fixed costs are fixed with respect to changes in wages.
B. Fixed costs are fixed with respect to changes in rental on
capital.
C. Fixed costs are fixed with respect to changes in price.
D. Fixed costs are fixed with respect to changes in output.
E. Fixed costs are fixed with respect to changes in Expenditure
on raw materials.

4. Which of the following is false about marginal cost?

A. The increase in total cost resulting from an increase in one
unit of output.
B. The increase in variable cost as a result of the increase of one
unit of output.
TC
C. MC
Q
VC
D. MC
Q
E. The increase in average cost resulting from an increase in one
unit of output.

5. Which of the following is true?

TC
A. AFC
Q
B. AFC AVC ATC
C. AFC ATC AVC
D. AFC VC TC
TC
E. AFC
Q

Copyright Open University Malaysia (OUM)

126 TOPIC 6 THEORY OF COSTS

Production has a relationship with costs.

The objective of producers is to achieve maximum profit, to minimise costs,

and to maximise sales revenue.

The costs discussed in this topic are variable costs, fixed cost, total cost,
marginal cost, and average cost. These costs can be divided into short-run
cost and long-run cost.

A firm experiences economies of scale when if the scale of operations is

increased, average cost per unit decreases in the long-run.

If the opposite occurs, i.e. where average cost increases, the firm is said to be
experiencing diseconomies of scale.

Diseconomies of scale Implicit cost

Economies of scale Long-run costs
Explicit cost Short-run costs

Copyright Open University Malaysia (OUM)