Theory of Cost

Shakil Ahmed
Senior Lecturer & Head
Department of Development Studies
North Western University-Khulna

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 Theory of Cost
 Cost of a firm is incurred to establish the production unit and to
purchase different factors of production. A firm’s cost of
production includes all the opportunity costs of making its
output of goods and services.
 Concept of a firm (TC) is classified into two different
categories- Fixed Cost and Variable Cost i.e. TC= TFC+TVC
 However, nothing is fixed in the long run.
 Cost functions are the pecuniary relationships between outputs
and the costs of production; Cost = f(QX
{inputs, technology} , prices of inputs, . . . )
• Cost Function – Derived Function: C= f(X, T, Pf, K)
• Where C is total cost, X is the output, T is technology, Pf is
price of FOP, K is fixed factor (capital)
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 Explicit Cost and Implicit Cost
• Based on payment, costs are classified into two categories; they are
Explicit Costs and Implicit Costs. 
• Explicit Cost is the cost which is actually incurred by the organization,
during production.
 Explicit costs are input costs that require a direct outlay of money by the
firm. payments to non-owners of a firm for the supply of their resources
(wages paid to labour, costs of electricity, the rental charges for plant
usage, the cost of other raw materials used in the production process,
etc.)
• Implicit costs are input costs that do not require an outlay of money by
the firm.
 The opportunity costs of using the resources already owned by the firm,
where no payment is made to outsiders (use of the factory by giving up
renting out for the same purpose, input of the owner / manager to give up
the opportunity to earn a salary at another firm)
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 Sunk Cost

• A sunk cost, also known as a stranded cost, is

an expense that has already occurred and
can’t be changed or avoided. In other words,
it’s a cost that has already been paid and
can’t be refunded or reduced. It’s in the past
and has no bearing on any future decision
making processes.

4
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 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.
• Formula: Total Cost = fixed cost + variable
cost
• TC = TFC + TVC

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 The Short Run Cost Function

• Average total cost (ATC) is the average

per-unit cost of using all of the firm’s inputs
(TC/Q) TC
ATC 
Q
• Average variable cost (AVC) is the average
per-unit cost of using the firm’s variable inputs
(TVC/Q) TVC
AVC 
Q

• Average fixed cost (AFC) is the average per-

unit cost of using the firm’s fixed inputs (TFC/Q)
TFC
AFC 
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 The Short Run Cost Function

• ATC = AFC + AVC

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 Marginal Costs (MC)

• Marginal Cost
• Marginal cost (MC) measures the increase in total
cost that arises from an extra unit of production.
• Marginal cost is the change in total cost (ΔTC)
divided by the change in output (ΔQ)
• Marginal cost helps answer the following
question:
ΔTC
• How muchMC
does itcost to produce an additional unit of
ΔQ
output?
• Tells us how much cost rises per unit increase in output

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EXAMPLE: Farmer Golib’s Total Cost Curve

Q (bags of Total $12,000

cotton) Cost
$10,000

0 $1,000 $8,000

Total cost
1000 $3,000 $6,000

1800 $5,000 $4,000

2400 $7,000 $2,000

2800 $9,000 $0
0 1000 2000 3000
3000 $11,000
Bags of cotton
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 EXAMPLE: The Marginal Cost Curve

Q
(bags of TC MC MC usually rises
cotton) $12as Q rises,

0 $1,000 $10
as in this example.
$2.00

Marginal Cost ($)

1000 $3,000 $8
$2.50
1800 $5,000 $6
$3.33
2400 $7,000 $4
$5.00
2800 $9,000 $2
$10.00
3000 $11,000 $0
0 1,000 2,000 3,000
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Q
 Total Fixed Cost (TFC) & Total
Variable Cost (TVC)
TC = TFC + TVC
 Total Fixed Cost (TFC): Costs that do not vary with output and
must be paid even if output is zero. These types of costs are
beyond managerial control. Examples: Depreciation of machinery,
rent, mortgage payments, interest payments on loans, and monthly
connection fees for utilities. The level of total fixed costs is the
same at all levels of output (even when output equals zero).
 Total Variable Cost (TVC): Costs that vary as output changes. If a
firm uses more inputs to produce output, total variable costs will
rise. These types of costs are within management control.
Examples: labour costs, raw material costs, and running expenses
such as fuel, ordinary repair & routine maintenance. Variable costs
are equal to zero when no output is produced and increase with the
level of output.

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 Relation among
TC, TVC, TFC
• The table below contains a listing of a
hypothetical set of total fixed cost and total
variable cost schedules. As this table indicates,
total fixed costs are the same at each possible
level of output. Total variable costs are expected
to rise as the level of output rises.
• As the table below indicates, we can use the
TFC and TVC schedules to determine the total
cost schedule for this firm. Note that, at each
level of output, TC = TFC + TVC.
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 EXAMPLE 2:
Costs $800 FC
Q FC VC TC $700 VC
TC
0 $100 $0 $100 $600
1 100 70 170 $500

Costs
2 100 120 220 $400
Fixed Cost
3 100 160 260 Area
$300
4 100 210 310 Variable Cost
$200
5 100 280 380
$100
6 100 380 480
$0
7 100 520 620 0 1 2 3 4 5 6 7
Q

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 EXAMPLE 2: Average Fixed Cost

Q FC AFC $200
Average fixed cost (AFC)
0 $100 n/a
is$175
fixed cost divided by the
quantity
$150 of output:
1 100 $100
AFC
$125 = FC/Q

Costs
2 100 50
$100
3 100 33.33
Notice
$75 that AFC falls as Q rises:
4 100 25 The firm is spreading its fixed costs
$50
5 100 20 over a larger and larger number of
$25
units.
6 100 16.67 $0
7 100 14.29 0 1 2 3 4 5 6 7
Q

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 EXAMPLE 2: Average Variable Cost

Q VC AVC $200
Average variable cost (AVC)
is$175
variable cost divided by the
0 $0 n/a
quantity
$150 of output:
1 70 $70
AVC
$125 = VC/Q

Costs
2 120 60
$100
3 160 53.33 As$75
Q rises, AVC may fall initially.
4 210 52.50 In most cases, AVC will eventually
$50
rise as output rises.
5 280 56.00 $25
6 380 63.33 $0
7 520 74.29 0 1 2 3 4 5 6 7
Q

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 Average Total Cost
Q TC ATC AFC AVC
0 $100 n/a n/a n/a
Average total cost
1 170 $170 $100 $70 (ATC) equals total cost
2 220 110 50 60 divided by the quantity
of output:
3 260 86.67 33.33 53.33
ATC = TC/Q
4 310 77.50 25 52.50
5 380 76 20 56.00
Also,

6 480 80 16.67 63.33 ATC = AFC + AVC

7 620 88.57 14.29 74.29

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 The Various Cost Curves Together
$200
ATC
$175 AVC
As Q rises: AFC
The combination of increasing $150 MC
and then decreasing MP also
make the AVC U- shaped $125

Costs
Both MC and AVC fall initially
before rising with increase in $100
output
$75
Note how MC hits both ATC
and AVC at their minimum $50
points.
$25
Marginal Cost declines at first
and then increases due to $0
diminishing marginal product. 0 1 2 3 4 5 6 7
AFC, a short-run concept, Q
declines throughout.
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 Relationship between MC &
ATC
• If the MC is less than the ATC, then the ATC
must be falling. This follows from the fact that if
you add a quantity to the average costs that is
less than the average, the average must fall.
• If the MC exceeds the ATC, the ATC must be
rising. This follows from the fact that you are
adding a quantity to the average costs that is
greater than the average. Hence the average
must rise.
• It should also be noted that when MC cuts the
ATC and the AVC at their minimum points.

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 Relationship Between Marginal and Average
Costs
$200 ATC
MC
$175
When MC < ATC,
$150
ATC is falling.
$125
When MC > ATC,

Costs
$100
ATC is rising.
$75
$50
$25
$0
0 1 2 3 4 5 6 7
Q

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 ATC and MC Cost Curves
• AFC declines as output increases but AVC increases as
output increases- explains ATC’s U-shape
• The bottom of the U-shape occurs at the quantity that
minimizes ATC. This quantity of output is called the
efficient scale of the firm
• MC<ATC= ATC is falling
• MC>ATC= ATC is rising
• MC crosses ATC at the efficient scale of the firm
• The MC curve crosses the ATC curve at
the ATC curve’s minimum.

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 Relationship Between Marginal
and Average Costs
$90
ATC MC
80
70 Area A Area C
60 AVC Area B
Costs per unit

50 ATC
40 AVC
30 B
20
A
10 MC Q0 Q1
0
1 2 3 4 5 6 7 8 9

Quantity of output
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 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 the fixed cost is spread over only the
few units that are produced.
• Average fixed cost declines as output increases.
• Average variable cost rises as output increases.
• These features of a firm’s costs explains the U-
shape of the ATC curve
• Recall that ATC = AFC + AVC

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 Why ATC Is Usually U-Shaped?

$200
$175
As Q rises:
$150
Initially, $125

Costs
falling AFC
$100
pulls ATC down.
$75
Eventually,
$50
rising AVC
$25
pulls ATC up.
$0
Efficient scale: 0 1 2 3 4 5 6 7
The quantity that Q
minimizes ATC.
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 Long-Run Average Costs Curve
• The LRAC is a curve that is tangent to the set of SRACs. When the
LRAC curve falls the tangency points are to the left of the minimum
points on the SRAC and when the LRAC curve is rising the
tangency points are to the right of the minimum points of the SRAC
curves.
• With a great variety of plant sizes, the corresponding short-run
average total cost curves trace a smooth LRAC curve.
• The plant size selected in the long-run depends on the expected
level of production
• The long-run average cost curve LAC is the envelope of the short-
run average cost curves SAC1, SAC2, and SAC3.
• With economies and diseconomies of scale, the minimum points of
the short-run average cost curves do not lie on the long-run average
cost curve.
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 The Long-Run Cost Function
• The long-run average cost curve
LAC is the envelope of the short-
run average cost curves SAC1,
SAC2, and SAC3.
• With economies and
diseconomies of scale, the
minimum points of the short-run
average cost curves do not lie on
the long-run average cost curve.
• LRAC is made up for SRACs
• SRAC curves represent
various plant sizes
• Once a plant size is chosen,
per-unit production costs are
found by moving along that
particular SRAC curve
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 Relationship Between Long-Run and
Short-Run Average Cost Curves
ATC in short
run with ATC in Long
small factory run
Dollars
ATC1 LRATC
$4.00 ATC3
ATC0 ATC2
3.00
C
D
2.00 B
A E
1.00

0 30 90 130 161 184 250 300

175 196

Use 0 Use 1 Use 2 Use 3

automated lines automated lines automated lines automated lines

Economies of Scale Constant Returns Diseconomies

to Scale Scale Of Scale
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 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.
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 Thank You

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