Chapter 6 The Theory Of Cost

6.1 Introduction Of Cost

Scarcity  has to make ___________ to allocate the scarce resources  choose an

option and forgo others  ___________ .

A. Definition
The __________________________________________ forgone.

Exercise 1
Identify the following into true or false statements.
(a) If you go to have a haircut, the barber carelessly cut off your hair. The cost of
haircut becomes higher. _____
(b) Whenever there is no choice, there is no cost. _____
(c) I have spent $50 for the movie ticket and 2 hours in watching the movie, hence
my cost in watching the movies is $50 and 2 hours. _____
(d) Cost does not exist if there is no price. _____

B. Types of costs
1. Historical / Sunk cost
- ‘Cost’ of ___________ action and it represents only the highest-
valued alternative forsaken in the __________. Hence, it is
_____________ to any present or future decision making.
Strictly speaking, historical cost is not a cost.
Example:
Mary waits for a bus at 7:00am. 20 minutes pass but the bus doesn’t
come. At 7:20 am, Mary needs to decide if she will go no waiting 
cost and benefit analysis.
Benefit :
Cost :
 Mary has already given up the highest-valued alternative use of
that 20 minutes (the option of using these 20 minutes no longer

1
 exists)
 past cost is irrelevant for __________________ and is no
______ at all !
- Historical cost data could be relevant for decision making only
through influencing a person’s way of formulating ___________
___________ benefit.
Example :
Mary may learn from her past experience that a bus will come at
7:22 am. At 7:20 am., she goes on waiting because she expects the
bus to come in _____ minutes.

2. Explicit and implicit (imputed) cost

- ___________ cost (out-of-pocket expense) actually involves a
transfer of fund.
- ___________ cost does not involve an actual transfer of funds.
E.g. cost of holding money ( ___________ forgone)
cost of special advantage (returns from __________ or __________ it
to others)

3. Fixed and variable cost

- In production of goods and services, if the cost doesn’t vary with
output, it is ___________ cost. If it varies with output, it is
___________ cost.

4. Alchian’s classification
(a) Acquisition cost (cost of _____________ )
cost of acquiring title to an asset
= original price – immediate ___________ value
(b) Continuing possessing cost (cost of _____________ )
cost of possessing an asset without using it
(c) Operating cost (cost of ___________ )
cost of using an asset
(d) Obsolescence cost
cost of becoming outdated

Exercise 2
1. Peter rent a flat as a clinic. John owns his own flat and uses it as the clinic
when one occurs higher cost of operating a clinic ?

2
 2. Identify if each of the following costs belongs to the cost of owning or the
cost of using a motor car.
(a) insurance cost
(b) cross harbour tunnel toll
(c) battery and tyre replacement cost

**Application -- ways to solve the problem of traffic congestion in HK :

(a) Raising the first registration tax
- It raises the cost of __________ a car through raising prices  no.
of new cars in HK will _________  ___________ traffic
congestion.
- Little effect on raising cost of _________ a car  ineffective in
discouraging people from using their cars.
- If total no. of cars are reduced  traffic flows more ________ 
people tend to use their cars more intensively, i.e., the average rate
of car utilization will _________.
(b) Raising the annual licence fees
- It doesn’t affect the cost of __________ a new car  little effect
on reducing the no. of new cars.
- It raises the cost of ___________ a car  people may give up their
existing cars  total no. of cars may still fall.
(c) Increasing the tax on petrol and diesel
- It affects neither the cost of ___________ nor the cost of
__________ a car  little effect on reducing the total no. of cars.
- It raises the cost of __________ a car directly  people are
discouraged from using their cars  effective in reducing traffic
congestion .
(d) Adopting the electronic road pricing scheme
- It doesn’t affect the cost of _________ and __________ a car 
total no. of car doesn’t change
- It raises the cost of __________ the metered roads  less traffic
there  there will be ________ traffic on the non-metered roads
 the network of road should be ___________ so as to make this
system effective.

Q. What will be the effect on the proportion of luxurious cars in HK if annual

licence fees are increased ?
Ans. There will be a ___________ proportion of luxurious cars in HK.

3
6.2 Introduction Of Production

A. Definition
It is the process of combing _____________ for creating ____________.

B. Some terms
1. __________ factors
- factors that do not vary with output

2. __________ factors
- factors that vary with output

3. Short run
- a production stage with some ___________ factors and some ___________
factors

4. Long run
- a production stage with all factors being ___________

B. The input-output relationship (in short run)

1. Assumptions :
(a) There are 2 factors – capital (K) is fixed factor, labour (L) is variable
factor
(b) The producer is a price taker in the factor market so the market wage rate
will not be affected by his employment decisions.
(c) The producer aims at maximizing wealth.

2. Total, average and marginal products

(a) Total product (TP)
It is the entire amount of output produced by all factors employed
(b) Average product (AP)
It is the output per unit of variable factor employed.
AP = ---------------
(c) Marginal product (MP)
It is the change in output resulting from employing an ___________

4
 unit of variable factor.
MP= --------------

3. Law of diminishing marginal productivity / product / returns

__________________________________________________________
__________________________________________________________
__________________________________________________________
Think about this :
What happens if this law is violated ?

(a) Numerical illustration

K L TP MP AP
1 0 0
1 1 10
1 2 24
1 3 39
1 4 52
1 5 61
1 6 66
1 7 66
1 8 64
(b) Graphical representation
Refer to fig. on p.

4. How AP, MP & TP are related

- It can be illustrated numerically and graphically.
(a) If MP > AP, AP is ______________ .
It is because the AP would be pulled up by the additional output of the
extra worker.
(b) If MP < AP, AP is ______________ .
(c) AP reaches its maximum when AP ____ MP.
(d) When MP = ________ , TP is at its maximum.
- To discover more graphically.
Both AP and MP curves are _____________ u-shaped.
(a) Deriving AP curve from TP curve
It is found by _________________________________________
____________________________________________________ .
(b) Deriving MP curve from TP curve
It is found by _________________________________________
____________________________________________________ .

5
 Exercise 3
Units of output
D TPL
C

A B

0 Units of input (labour)

(a) Show on the graph the amount of labour at which the APL is at its maximum.
(b) At which point will MPL be at its maximum ? ________
(c) At which point will MPL be at zero ? __________

6.3 Production & Cost

A. Different cost items

1. Total cost (TC)
- TC is the entire amount of payments to all factors used in producing a given
level of output (Q).
- It can be sub-divided into : total fixed cost (TFC) and total variable cost
(TVC)
TC =
2. Average cost (AC)
- AC is the cost per unit of output ( = ------------- )
- It can be sub-divided into :
AC =
3. Marginal cost (MC)
- MC is the __________ in TC for producing an _____________ unit of
output.
MC = ----------------- =

- Note : ∵ MFC = ∴ MC =

B. Short run (SR) cost analysis

1. Numerical illustration

6
 Given a hypothetical production schedule, the cost schedule
can be derived.
K L TP
10 0 0
10 2 6
10 4 12
10 6 20
10 8 30
10 10 42
10 12 52
10 14 60
10 16 66
10 18 70

Given the price of K = $10, L = $10 then

TFC TVC TC MC AC AFC AVC
100 0 100 - - - -
100
100
100
100
100
100
100
100
100

Q. Do you know how AC and MC are related ?

Ans. (a) If MC < AC, AC is _____________.
(b) If MC > AC, AC is _____________.
(c) AC is at its maximum / minimum when AC < / > / = MC.

2. Graphical illustration
Both AC and MC curves are in a shape of ______ .
Its shape can be explained by the _____________________________ . This
law is equivalent to the law of ________________ MC.
(a) Deriving SRAC curve from the SRTC curve
It is found by ________________________________________
___________________________________________________ .

7
 (b) Deriving SRMC curve form the SRTC curve
It is found by ________________________________________
___________________________________________________ .

Exercise 4
1. Cost ($) SRTC
C

B
A

0 No. of output (Q)

(a) Show on the graph the output level at which the AC is at its minimum.
(b) At which point will MC be the minimum ? ________

2. Cost ($) SRTC

SRTVC

100

0 No. of output (Q)

(a) What is the amount of fixed cost ? __________
(b) Show on the graph the SRTFC curve ?
(c) If SRTFC is zero, what happens to the SRTVC and SRTC curves ?
____________________________________________________________

C. Cost curves in the long run (LR)

The LR cost curves is also _____-shaped.
Explanation :
1. Returns to scale
- Initially cost per unit declines because ____________ of scale
takes place  output rises at a ___________ rate than inputs.
- Finally, cost per unit ________ because _____________________
takes place  output rises at a ________ rate than inputs.
- The combination of factors at the output level where the LRAC is

8
 the lowest is called the ___________ scale.

2. Theory of production cost by Alchian

(a) Rate effect
For a given volume of output, the faster the rate, the _________ the
AC and MC since more resources are drawn form elsewhere in the
economy at higher cost.
(b) Volume effect
For a given rate of production, the larger the volume of output, the
________ the AC and MC since machines can be used more
economically and larger volume enables learning by replicating the
techniques.
(c) At lower output levels, ____________ effect dominates.
At higher output levels, ____________ effect dominates.

C. Equilibrium conditions of a wealth-maximizing firm

1. A rule to decide whether or not to produce
(a) short run : TR ≧ ________ or AR ≧ _________
Explanation – assuming fixed factor has no resale value  the fixed cost is
_________ cost  so long as the price (AR) is above the
_______, the firm will continue to produce.
(b) long run : TR ≧ ________ or AR ≧ _________

2. A rule to ensure that wealth is at a maximum

(a) The 1st order condition : =
nd
(b) The 2 order condition : MC curve cuts the MR curve from ______
$
MC - At point A, MR ____ MC, ____
_________________________
A B MR _________________________
- At point B, MR ____ MC, ____
_________________________
0 Q __________________________

C. Efficiency in production
- Condition for efficiency in production : the values of _______ are equalized
among producers.
- Refer to the example on p.

9
 Exercise 5
For each of the statements below, determine whether it is true or false.
(a) If there is no competition, there is no cost. _____
(b) I have spent time and resources in doing this task. Even if there are no other
choices, it still incurs cost. _____
(c) The longer I have been waiting in the line at the bus stop, the more costly it
would be for me to quit the line. _____
(d) If the total product curve is increasing, the marginal product curve must also be
increasing. _____
(e) If the AVC curve is horizontal, the MC curve must also be horizontal and
coincide with the AVC curve. ______
(f) When the average cost curve is rising, the marginal cost curve is rising, too. ___
(g) When the total value increases, the average also increases. _____

**THE END**

10