Adigrat University Department of Economics Microeconomics 2010 EC

Chapter Three
Theory of cost of production
Introduction
Cost in economics plays a very important role in decision-making exercise of business firms. To
optimize economic resource utilization business firms opt for cost minimization, which is the mirror
reflection of output maximization. It is important for the firms to know the cost of acquiring inputs in
producing commodities so as to make rational decision that optimize their objective (i.e.…, profit
maximization). The concepts of production and costs are inseparable. Production cannot take place
with out incurring cost and costs with out production are economically meaningless.
3.1 The Nature of Production Costs
Definition: cost of production refers to the expenditure (aggregate price paid) incurred for the factor
of production used in producing commodity.
The term cost can be defined in various ways:-
I. Explicit costs (Accounting/ Money cost):-
These are the actual monetary payments of cash outlays that business firms make to outsiders’ who
are suppliers of inputs to them. Precisely, explicit costs are the outright monetary expenses made for
the factors of production. Examples of explicit costs are: cost of raw materials purchased, wage and
salaries, taxes, rent miscellaneous business expenses (e.g advertising cost, transport costs, etc).
Interest on capital invested …etc.
II. Implicit Costs
The value of non-purchased inputs owned and used by a firms in its own production activities are
said to be implicit costs. There are costs of the firm’s owned and self-employed resources in carrying
out production activities. Examples included:
a. Rent of land belonging to the entrepreneur and used in his/her production.
b. Interest on capital supplied by him/her self.
c. Wages for the entrepreneur … etc
The implicit costs are unrecorded in practice. But in economic sense we have to consider them.
III. Opportunity Cost
Refers to the value of the best alternative forgone in order to produce the goods or under take the
service. Briefly, it is the cost of choosing to use resources for one purpose that is measured by the

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sacrifice of the next best alternative for using these resources. Opportunity cost reflects both explicit
and implicit costs. It is also known as economic costs.
The distinction between explicit and implicit costs is important in analyzing the concept of profit. In
the accounting sense profit is calculated as the difference between total revenue and total explicit
costs. In an economic sense, however, normal profit is include in total cost of production, which
consists of explicit and implicit expenses all taken together, under implicit costs, normal profit-return
to the entrepreneur’s management function included. So, economic profit is the difference between
revenue and total economic cost.
Accounting profit = Total revenue – total explicit costs
Economic profit = Total revenue –total economic costs
Cost function
Cost function is a functional relationship between cost of production and output flows per unit of
output. Analogous to the production function the time period is quite important in the analysis of cost
function. Therefore, we will have both short run and long run cost function.
I. Short Run Costs
As you may recall short run is a period of time over which the firm is unable to vary all its inputs.
Some inputs are fixed where as others are variable in the short run costs.
II. Long Run Costs
In the theory of production we defined long run as a period of time over which the firm can later
employ any input. Hence, there does not exist dichotomy of inputs in to fixed and variable inputs.
Therefore, long run costs are costs that the firm incurs in its planning output in the long run period of
time.
3.2. Behavior of costs in the short run
Short run costs are cost incurred over a period during which some factors of production are fixed.
Short run costs and their relationship to output can be best analyzed by classifying them into: total
costs and per unit costs.
A) Total Costs in the short run
I. Total Fixed costs (TFC) - are those costs which in total do not vary with changes in output. They
must be paid even if the firm’s output is zero. Example: - Rent of Building
TFC – Pfi X Qfi Where TFC – is total fixed Cost
Pfi – price of the fixed input.
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Qfi – is quantity of fixed input.

II. Total variable costs (TVC) – are those costs which vary /change with the level of output. Costs
incurred for the variable inputs. Example: labor costs (wage and salary).
TVC = Pvi X Qvi where TVC – is total variable cost
Pvi – is price of the variable input
Qvi – is quantity of variable input
III. Total cost (TC) – is the sum of total fixed and total variable cost at each level of output.
Arithmetically: TC = TFC + TVC
Total cost identifies the cost of all the inputs, fixed and variable, used to produce a certain output.
B. Per unit costs in the short Run
There are four measures of cost per unit output.
1. Average fixed Cost (AFC)- is the amount of fixed cost incurred for producing an output. It is
calculated by dividing total fixed cost by the corresponding output level.
Mathematically: AFC = TFC
Q
Where: TFC-is total fixed cost
AFC – is average fixed cost
Q – level of output
2. Average variable cost (AVC) – refers to the amount of variable cost expended by the firm to
produce an output. It is computed by dividing total variable cost by the corresponding amount of
output.
Algebraically: AVC = TVC
Q
Where: AVC – refers to average variable cost
Q- Level of output
TVC – Total variable cost
3. Average total cost (ATC) - is the overall cost of producing one output. It is found by dividing
total cost to total output or by summing the average fixed cost and the average variable cost.
Arithmetically: ATC = TC
Q
ATC = AFC + AVC
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Where: ATC – represents average total cost

TC- refers to total cost
4. Marginal Cost (MC) - is the extra or additional cost of producing one more unit of output. Or it is
the change in total cost that results from a one-unit change in output. Marginal cost can also be
defined as the change in total variable cost that results from one unit change in output. Basically, the
marginal cost relationship shows how much additional cost a firm will incur if it increases output by
one- unit, or how much cost saving it will realize if t reduces output by one-unit.
 TC  VC
Mathematically: MC =  Q
or MC =  Q

Table 5.1 Hypothetical firm’s cost schedule

Quantity Total Total Total cost Marginal cost Average Average Average total
of output fixed cost variable (TC) (MC) MC = fixed variable cost (ATC)
(Q) (TFC) cost (TVC) TC = TFC +  TVC
cost cost ATC= AFC + AVC
TVC  Q (AFC) (AVC) AATC = TC/Q
0 30 0 30 - - - -
1 30 20 50 20 30 20 50
2 30 30 60 10 15 15 30
3 30 45 75 15 10 15 25
4 30 80 110 35 7.5 20 27
5 30 145 175 65 6.0 19 25

Careful observation of the above cost schedule shows the following interesting points regarding the
behavior of total costs and unit costs:
 The first column shows various levels of output
 In the second column, TFC remains constant at output levels (in this case 30). It is 30 when output
is nil and still 30 when the output is 5 units. Thus, fixed costs are independent of output.
 TVC is given in the third column it varies with the output. TVC is nil when there is no output and
rises when output rises but at varying rate (it change at different proportions). TVC increases at a
decreasing rate initially (till Q=2 units), and then after increases at an increasing rate. This
behavior of total variable cost follows from the law of diminishing marginal returns, which
states. That as more and more variable input is employed, keeping fixed input and state of
technology constant, the additional output derived from one unit input initially rises, reaches
maximum, and eventually falls.

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 Looking in the fourth column, TC behaves in the same manner as TVC but is above TVC by TFC
amount (i.e., 30) at each level of output, since TC equals the sum of TFC and TVC.
When we look the unit costs from the table:
 AFC continuously falls as the level of output increases. This is “the outcome of
spreading the fixed cost over more units.”
AFC = TFC,
Q
Since it is a pure arithmetical result that the numerator remaining unchanged, the
increasing denominator causes diminishing result. TFC thus spreads over on each unit
of output with the increase in output (Q). Hence, AFC diminishes continuously.
 AVC decreases first, reaches minimum then after begins to rise as the level of output
increases.
 ATC, which is the sum of AFC and AVC, initially declines, reaches minimum, and then
rises as output increases.
 MC decreases at the very beginning, reaches minimum (at Q=2), and then after increase
as the level of output increases.
From the cost schedule we can draw the firm’s cost curves. The behavior of costs and their
relationship with output in the short run become more explicit when we plot the cost data on a graph
and draw the respective cost curves.

TC MC ATC

TVC AVC
60 Cost
30

20 AFC

0 Q 0
2 Q1 Q2
Panel (a) Panel (b)
Fig 5.1 Cost curves
Having a look at the fig-5.1 the following points can be observed: In panel “a”, TFC is the total fixed
cost curve. It is horizontal line parallel to the output axis (since it is constant).

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The curve TVC represents total variable cost. It reflects the typical behavior of total variable costs, as
initially rises, gradually, becomes steeper denoting a sharp rise in the total variable cost. From the
graph, up to Q=2 units, the firm uses so little of the variable inputs with the fixed inputs that the low
of diminishing marginal return (LDMR) is not yet operating. As a result, the TVC rises at a
decreasing rate (hence TVC becomes flatter). Past this point, the LDMR operates and the TVC rises
at an increasing rate (hence TVC becomes steeper).
The curve TC indicates total costs. Vertical summing up the TFC and TVC curves derives it (TC). In
panel “a”, you can easily see that the shape of TVC largely influences the shape of TC. The TC curve
initially rises at a diminishing rate, and the rises at an increasing rate. Moreover, TC originates in the
cost axis and is equal to TFC at zero level of output. The vertical distance between TC and TVC
curve equals to the amount of TFC and is constant through out, since TFC is constant.
Coming to panel “b”, we can see the unit cost curves that tell the relationship between unit cost and
output. Economic analysis relies more heavily on the per unit cost curves.
When we look to AFC curve, it consciously falls. It has a rectangular hyperbola shape, it approaches
both axis asymptotically, i.e., it gets very close but never touches either axis.
The AFC progressively declines since the total fixed cost is spread over ever-larger rates of output.

The MC curve is U-shaped (parabola opening up wards). With the cost of additional units of output
first falling, reaching a minimum, and then rising. MC falls first because the fixed plant and
equipment are not designed to produce very low rates of output, and production is very expensive
when output is low. Eventually, MC must rise because the plant will ultimately be over utilized as
output expands beyond the level for which it was designed. To exactly reason out why this is so, let’s
see the relationship between MC and MPvi. Because the reason for the inverted U-shapedness
(parabola opening down ward shape) of the MPvi is still the reason behind the U-shaped ness of MC.
You recall that MC can be computed as change in total variable cost divided by change in total
output.
 TVC
Arithmetically: MC =  Q

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(Pvi x Qvi) Since 

 
 Q TVC  Pvi x qvi
=

1
= Pvi x MPvi

The last equivalence states that MC equals to the price of the variable input divided by its marginal
product. From the equivalence, we see that MC is inversely related to MPvi. In the theory of
production, we know that MPvi rises first, reaches a maximum and then falls, it follows that MC first
falls, reaches a minimum and then rises.
The AVC curve is U-shaped give in panel “b”. The reason behind this is the same reason for inverted
U-shaped APvi. Consequently, the reason that AVC curve is U-shaped can be explained in terms of
relationship between AVC and APvi.
With the variable input in the short run, TVC for any output level (Q) equals price of variable input
times quantity of variable input used, then:
AVC = TVC = Pvi x Qvi
Q
= Pvi x 1 Since
APvi = Q
APvi’ Qvi

The last equality reveals that AVC is reciprocal of APvi. From our knowledge of the production
theory, APvi first rises, reaching a maximum and then after falls; it follows that the AVC curve (which
is the reciprocal of APvi) first falls, reaching a minimum, and then rises. Thus AVC curve is the
inverse or reciprocal of the APvi curve. ATC is the sum of AFC and AVC. Hence, ATC curve is
derived by the super imposition of the AVC curve over AFC curve. Analogous to the MC and AVC
curves, ATC curve is U-shaped.

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The ATC curve continues to fall after the AVC begins to rise because for a while, the decline in AFC
exceeds the rise in AVC. Eventually, the rising AVC exceeds the falling AFC. Thus, ATC begins to
rise.
Finally, let’s see the relationship between MC ad AVC and ATC curve. The MC curve intersects the
AVC and ATC curves from below and the AVC and ATC curves are at their minimum the reason is
that the marginal-average relationship discussed in the last chapter (theory of production).

The Geometry of cost curves

Geometrically speaking, the shape of a ray drawn from the origin to each point on TFC, TVC and TC
curves gives the AFC, AVC and ATC, curves respectively at the level of output. While the slope of the
tangent line to TVC or TC curves gives the MC curve at the corresponding level of output.
3.3. Cost of production in the long run
As you remember it from our discussion of the theory of production, the long run production period is
a production period when all inputs are variable. i.e. whenever the time period is long enough to
change the type as well as the amount of all inputs employed in the production period, then the firm is
said to be in the long run production period.
Similar to the short run production period, there is a definite relationship between the quality of goods
and services produced and the cost of producing goods and services in the long run. In order to
understand this basic relationship between costs and production in the long run we can use an
approach which is very similar to the approach used in order to explain the relationship between costs
and output in the short run. i.e. first we will explain how each of these measurements are going to
respond to changes in the quantity of goods and services produced by the firm in the long run.
Measurements of costs in the long run
The measurements of costs that we will use to measure costs in the long run are very much similar to
the measurements used in the long run production period. Some of these are:
i. The long run total cost (LTC)- Which measures the smallest overall cost that a rational
producer will incur so as to produce a given level of output in t he long run production
period.
ii. The long run average cost (LAC)- which measures the per unit cost that a firm will incur
so as to produce each unit of the product in the long run production period. Symbolically
LAC = LTC
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Q
i. The long run marginal cost (LMC) - which measures the smallest additional cost the a firm
will incur in order to produce each additional unit of a product in the long run production
period. i.e., similar to the short run marginal cost, the long run marginal cost can be
calculated as:
LMC =  LTC Where:
Q Q--- Change in quantity of goods and services produced.
LTC --- Change in long run total cost
LMC --- Long run marginal cost
In addition to the description that we provided for each of the measurements of costs in the long run it
will help you very much if we compare and contrast the short and long run production periods.
Dear student! As you know it in the short run we have both fixed as well as variable inputs and one
can influence output only by changing the amount of the variable input employed in the production
period. i.e. in the short run the scale of production cannot be changed because the amount of at least
one input will remain constant. Therefore whatever adjustment made in the production process during
the short run production period, it will be with in a given scale of production. However, in the long
run all inputs are variable. Therefore, the scale of production by itself is a factor that can be used to
influence the amount of goods and services produced in the long run. i.e. in the long run production
period the firm can construct the most appropriate scale of production to produce the desired level of
output. Now given those measurements and a summary about the nature of the short run and long run
production periods, let’s try to discuss about the behavior of costs in the long run by using the
definitions that we provided for each of the measurements and the behavior of production in the long
run discussed in earlier sections. Let’s start with the long run average cost.
A. The long run average cost (LAC)
By definition the LAC measures the smallest per unit cost that the firm will incur in order to produce
each unit of the product in the long run. Now in order to understand the nature of the LAC lets
assume that there is a hypothetical firm that can only construct three different plant sizes, say A, B
and C. since in the short run the size of the plant or the scale of production is constant, each plant size
or scale of production is represented by its own set of short run cost curves. Accordingly let’s assume
that the three different plant sizes that our hypothetical firm can construct are represent by the
following short run average cost curves.
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LAC & SACA SACB

SAC
A
SACC
B

Q
Q1 Q2 Q3

As discussed above, SACA, SACB, and SACC represent the three plant sizes the firm can construct. In
the short run since the size of the plant remains fixed, the firm will use either plant A, B or “C. i.e the
firm will not enjoy the privilege of shifting from one plant size to the other. However, in the long run
the firm can easily shift from one plant size to the other without any problem. Therefore the relevant
question in the long run is to select the most appropriate plant size that must be used by the rational
producer in order to produce the product at the minimum cost possible. The decision as to which plant
must be used depends on the amount of goods and services that the firm is planning to produce in the
long run production period. Accordingly we can use the above graph to understanding the process
through which the firm selects the appropriate plant sizes in the long run. For instance let’s assume
that the firm selects to produce Q1. This level of output can be produced by using either plan A or B or
C. however, the decision as to which of the three plants must be used depends on the cost that will be
incurred to produce the given level of output by the three plant sizes under consideration. For
instance, if plant A is used to produce Q1, then the firm will incur a per unit cost of OB, while the
same level of output can be produced at a higher per unit cost of OA if the plant B is used. On the
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other hand if plant C is going to be used in order to produce Q1 the per unit cost will be much larger
than what it is when plant A and B are used. Therefore given this three alternatives rational producer
will select plant A in order to produce Q1 because it is the only plant size that can produce that level
of output at the smallest per unit cost. However, this does not mean that plant A is always preferable.
For instance if the firm decides to produce Q3, plant A will no more be the preferable plant size.
Rather the firm will prefer to use plant B to produce Q3 since the per unit cost of producing Q3 by
using the second plant size (OC) is quite smaller than the per unit cost of producing the same level of
output by using plant A (which is OA) or plant C.
From the above analysis, we can conclude that plant A is the most preferable plant size in the long run
for any level of output smaller than Q2, plant B is preferable in order to produce an output larger than
Q2 but smaller than Q4, and plant C is preferable in order to produce any level of output larger than
Q4. Graphically, in the long run the firm will operate along SAC A if and only if it is going to produce
an output smaller than Q2, while it will operate along SACB if the firm is planning to produce an
output between Q2 and Q4 and it will operate along SACc if the planned output is more than Q 4.
therefore, the bold portions of these SAC’ represents noting but the long run average cost curve,
which measures noting but the smaller per unit cost that the firm will incur in order to produce each
unit of the product in the long run production period.

The most important point we can learn from the above derivation process is that the LAC is
comprised of SAC’s that represent different plant sizes. In the above case because we assumed that
there are only three different plant sizes that the firm can construct, the LAC is not as smooth as the
SAC’s. However when we relax the assumption that the firm can construct only three different plant
sizes that the firm can construct, the LAC is not as smooth as the SAC’s as shown below.

16 SAC5 LAC
SAC1
SAC2
SAC3 SAC4
12

10

8 M 11

0 Q
1 2 3 4 5 6 7 8 9 10 11 12
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As we can see it in the above graph, when we assume the firm can construct infinitely large number
of plant size, each of the short run average cost curves representing different plant sizes will be
tangent to the LAC at one point. In a sense the LAC will support the SAC’s from the below. Due to
this feature the LAC is sometimes known as the envelope curve.
I think you are now clear with the process of deriving the LAC from the SAC’s. However before we
conclude our discussion about the LAC lets try to see one basic relationship between the LAC and the
SAC’s that comprise it.
As you can see it from the graph above, the point of tangencies between the LAC’s and the SAC’s
will occur in the negatively slopped portions of the SAC’s if the LAC is falling and in the rising
portions of the SAC’s if the LAC is increasing. It is only at the point where the LAC is the minimum
that the corresponding SAC will be tangent to the LAC at its minimum point. This relationship
between the LAC and the SAC’s that comprises it has its own economic interpretation.

When the LAC and the SAC’s are tangent in their negatively slopped portions, it implies that the
corresponding plant sizes are going to be underutilized because a given plant size is said to be utilized
optimally only when the plant is used to produce an out put corresponding to the point where the
SAC representing that plant size is the minimum. Similarly, when the LAC and SAC’s are going to be
tangent in their rising portions, then this implies that the plants corresponding to those SAC’s will be
over utilized because their point of tangency with the LAC will occur at a level of output larger than
the level of output where their respective SAC’s are the minimum. In the long run the firm will utilize
optimally only that plant size the SAC of which is tangent to the LAC at its minimum point.
What is the reason that the LAC is “U” shaped like the SAC’s?

Do you remember what makes the SAC’s a “U” shaped curves? It was the law of diminishing
marginal returns. Can we use the same explanation for the LAC? Definitely not! This because the law
of diminishing returns can be valid if and only if there is at least one fixed input. But as know it
already there is no fixed input in the long run. Therefore the law is not valid in the long run
production period. Then can you think of any concept in the theory of production that can be used to
explain the behavior of the LAC? We hop you can. Any way lets try to explain the behavior of the
LAC.
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The explanation behind the shape of the LAC curve

The main explanation behind the “U” shape of the LAC curve is the concept of returns to scale.
Assuming that there are infinitely large numbers of plant sizes that the firm can construct in the long
run production period, the movement from one point on the LAC to another point implies a change in
the scale of production. Therefore, as we move from one point to another point on the LAC what will
happen to the LAC depends on the returns to scale. As you remember it from the discussion of the
concept of returns of scale, as the scale of production changes, output, may change by the same or
different proportion to the change in the amount of all inputs. Given our understanding of the concept
of returns to scale and the formula for the LAC, we can easily explain why the LAC is a “U” shaped
curve.
Now let’s assume that the amount of all inputs is changed by x and output has changed by y. as we
change the amount of all inputs by x cost of production also changes by x, provided that the price of
inputs remains the same. For instance as we double the amount of all inputs we use in the production
process, cost of production also double. This simple fact can help you understand the relationship
between the concept of returns to scale and the shape of the LAC curve. Now as we change the
amount of all inputs by x and output change by y in the long run, LTC after the change in the amount
of all inputs will be x times the LTC before the change in the amount of all inputs. Accordingly, the
new LAC will be
LAC = xLTC
yQ
Now what will happen to the LAC depends on the value of x and y accordingly:
 If x<y [i.e when the rate of change in the numerator (LTC) is smaller than the rate of change in
the denominator (Q)], the LAC will fall. In other words when there is increasing returns to
scale, the LAC will decrease.
 If x>y [i.e. when the rate of change in LTC is larger than the rate of change in Q], then the
LAC will increase. In other words when there is decreasing returns to scale, the LAC will be
positively slopped.
 At last if x=y [i.e. when the rate of change in LTC is equal to the rate of change in Q], the
LAC will remain constant.
So as you can understand it easily from the above discussion, all the factors that cause increasing
returns to scale (like division of labor and specialization) are also the factors that cause a reduction in
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the LAC up to certain level of output. Similarly when decreasing returns to scale sets in, due to
factors like managerial inefficiency, lack of coordination, bureaucratic, red tape etc, the LAC will
start to increase and when there is constant returns to scale the LAC will remain constant.
In short, the shape of the LAC is the result of the concept of returns to scales.

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