Introduction to Economics

(Econ. 101)

By Eyasu kumera

April, 2010
2.4. Theory of Cost
Costs in the Short-Run and Long-Run
•Short Run Relationship Between
Production and Cost
•Short-Run Costs and Short-Run Cost
Curves
•Long Run Relationship Between
Production and Cost
•Long-Run Costs and Long-Run Cost
Curves
Costs for Decision making
2.4.1. Short Run Relationship Between
Production and Cost
Example
• A firm’s short run cost
Total
function tells us the
minimum cost Input TVC
necessary to (L) Q (TP) MP (wL)
produce a particular 0 0 0
output level. 1 1.000 1.000 500
• Total variable cost 2 3.000 2.000 1.000
(TVC) is the cost 3 6.000 3.000 1.500
associated with the 4 8.000 2.000 2.000
variable input, in this
case labor. Assume 5 9.000 1.000 2.500
that labor can be hired 6 9.500 500 3.000
at a price of w=birr 500 7 9.850 350 3.500
per unit. 8 10.000 150 4.000
9 9.850 -150 4.500
Short run Relationship …
• Plotting TP and TVC illustrates that they are
mirror images of each other.
• When TP increases at an increasing rate, TVC
increases at a decreasing rate.
 2.4.2. Short run costs
 Short-run Cost Categories
– Total Cost = Total Fixed Cost + Total Variable Cost
– TC=TFC+TVC
• TVC is the cost associated with the variable input
• TFC is the cost associated with the fixed inputs.
• TC is the cost associated with all of the inputs.
– AFC=TFC/Q
– AVC=TVC/Q
– ATC = TC/Q
– Marginal cost (MC) is the change in total cost
associated a change in output.
• MC =  TC/  Q=  TVC/Q
=  (TFC+TVC)/Q = TFC/ Q +  TVC/ Q
= 0 +  TVC/ Q
 For analyzing the short run cost, the
following assumptions are made
– the firm employs two inputs, labor and
capital
– labor is variable, capital is fixed
– the firm produces a single product
– technology is fixed
– the firm operates efficiently
– the firm operates in competitive input
markets
– the law of diminishing returns holds
 Example
 Example
Important Observations
– AFC declines steadily over the
range of production.
– In general, AVC, AC, and MC are
u-shaped.
– MC measures the rate of change
of TC
– When MC<AVC, AVC is falling
When MC>AVC, AVC is rising
When MC=AVC, AVC is at its AFC
minimum
– The distance between AC and
AVC represents AFC
2.4.3.Long run Relationship Between
Production and Cost
 In the long run, all inputs are variable and
there are no fixed costs
 The long run cost structure of a firm is related
to the firm’s long run production process.
 The firm’s long run production process is
described by the concept of returns to scale.
 Economists hypothesize that a firm’s long-run
production function may exhibit at first
increasing returns, then constant returns, and
finally decreasing returns to scale.
Short run costs $ per time period
Total
Cost cost

Increasing Decreasing
returns returns

Output per time period (units)

Output per
time period (units)

Total product
Decreasing
returns

Increasing
returns Production
Input per time period (units)
Long run Relationship …
 2.4.4.Long run Production Cost
We have seen how a firm's short-run cost curves tend to look U-shaped when a fixed factor such as
capital or land limits the firm's production capacity. But what will happen when firms can replace their
worn out capital, adjust the size of their plants, or even build new firms? What is the relation between the
short - run cost curves and those holding for the long run?

Suppose that a petroleum refinery located in the Gulf coast has a plant of so much capacity perhaps
100,000 barrels per day of refining capacity. For this size plant, it has a short - run U-shaped AC curve,
call it SAC in order to emphasize its short - run nature. If the firm builds a larger refinery, its cost
minimizing output will be larger, so the new SAC curve must be drawn farther to the right. Now, suppose
the firm is still in the planning stage, with no obligations not having decided exactly what size plant to
build. The firm's engineers can estimate different U-shaped SAC curves. For each design capacity, or
planned out put level, the firm would choose a different plant size and a different SAC curve.

Long run marginal cost (LRMC) measures the change in long run costs associated with a
change in output.
Long run average cost (LRAC) measures the average per-unit cost of production when all inputs
are variable.
In general, the LRAC is u-shaped.
When LRAC is declining we say that the firm is experiencing economies of scale.
Economies of scale implies that per-unit costs are falling.
When LRAC is increasing we say that the firm is experiencing diseconomies of scale (it implies
that per-unit costs are rising)
Long run Production Cost
Long run …
• Reasons for Economies of Scale
– Increasing returns to scale
– Specialization in the use of labor and capital
– Indivisible nature of many types of capital equipment
– Productive capacity of capital equipment rises faster
than purchase price
– Economies in maintaining inventory of
replacement parts and maintenance personnel
– Discounts from bulk purchases
– Lower cost of raising capital funds
– Spreading promotional and R&D costs
– Management efficiencies
Long run …
• Reasons for Diseconomies of Scale
– Decreasing returns to scale
– Disproportionate rise in transportation costs
– Input market imperfections
– Management coordination and control
problems
– Disproportionate rise in staff and indirect labor
 Long run …
• In the short run, the
firm has a fixed level
of capital equipment
or plant size.
• The figure illustrates
the SRAC curves for
various plant sizes.
• Once a plant size is
chosen, per-unit
production costs are
found by moving
along that particular
SRAC curve.

Capacity and short run

average costs
$ per unit
of output

SRAC
A
SRAC
B SRAC
C
M SRAC
D

Q1 Q2 Q* Q3
Output per time period (units)
 Long run costs
$ per unit
of output

Long-run
average cost
(envelope curve)

Minimum
LRAC

Least-cost plant

Q*
Output per time period (units)
Long run …
• In the long run the firm is able to adjust its plant
size.
• LRAC tells us the lowest possible per-unit cost
when all inputs are variable.
• What is the LRAC in the graph?
– The LRAC is the lower envelope of all of the SRAC
curves.
– Minimum efficient scale is the lowest output level for
which LRAC is minimized.

• Economies of Scope is achieved when the

reduction of a firm’s unit cost by producing two
or more goods or services jointly rather than
separately.
 2.4.5. Costs for Decision Making
 At least three different concepts of costs can be distinguished: opportunity cost, accounting cost and economic cost.
For economists the most important of these is social or opportunity cost.

Accounting costs are monetary costs only they do not include costs like pollution damage that are social costs and
do not enter into firm's accounts. Economists include all costs whether they reflect monetary transactions or not,
business accountants generally exclude non-monetary transaction. An economist would insist that the wages of
management to an owner's effort or the return on contributed capital are real economic costs; they use real live
managers and tangible capital. The concept that can help us understand this distinction between monetary costs and
true economic costs is opportunity cost. The opportunity cost of a decision consists of the things that are given up by
making that particular decision rather than the best alternative decision. Hence, the major difference between the view
points of the economist and the accountant is that the accountant generally prefers actual historical cost as a
technique for measuring the value of goods while the economist prefers to use the market value of a good in
measuring its value. The market value as indicated above, measures the value of a good in its highest and best use or
the opportunity cost. If we take a practical example, the owner of a small business is also its manager; but takes
himself no salary, but takes out his share of the profits at the end of each year. If he were to be employed he could
have earned say 20,000 birr a year. That is his market value as a manager. Thus the income statement understates
the "true" economic cost of management by 20,000 birr. To point out that accountants do not use the same concept as
economists do, does not imply any criticism of the accounting profession, for there are good reasons why accountants
might be reluctant to use the economists' approach.
However, economists widely use their approach particularly in project evaluation and project appraisals and in cost
benefit analysis of projects.
For business decision making we use economic costs (implicit & explicit costs)
Economic costs include accounting costs
Accounting costs are historic costs (the cost incurred at the time of procurement & not opportunity costs)
Historic costs match to some extent explicit costs, implicit costs are opportunity costs
 Economic Profit = Accounting Profit – Opportunity Costs
Incremental and Sunk Costs in Decision Analysis
A. Incremental Cost
 Incremental cost is the change in cost tied to a managerial decision.
• Ex: Night shift, New production line, New production plant, New
(additional) product
 Incremental cost can involve multiple units of output.
– (Marginal cost involves a single unit of output.)
 Incremental analysis is used to analyze business opportunities.
 Incremental cost varies with the range of options available in the decision
making process.
 Incremental analysis uses only decision relevant revenues and cost

B. Sunk Cost
 Irreversible expenses incurred previously.
 Sunk costs are irrelevant to present decisions.
• Cost of bidding for contract
• Cost of failed project
 A cost is relevant if it is affected by a management decision and not if it is
not affected by a management decision.
• Incremental Analysis Process :
– Define relevant revenues and costs
– Define incremental revenues and costs
– If incremental revenues exceed incremental
costs, take the decision, otherwise reject it

• Examples of Incremental Analysis

– Outsourcing opportunities for small businesses:
A quantitative analysis
Classification of Costs
Classification of Revenues
 Examples of Incremental
Analysis
• Outsourcing opportunities for small
businesses: A quantitative analysis
References

1.Robert Frank & Ben Bernake Principles of

Economics. Mc Graw-Hill, Irwiv 2001
2.Arhold, Roger Economics USA 1996
Chapter one and two
3.Care, K. Principles of Economics USA 1996
4.Samuelson, Paul. Economics N.Y. 1995
5.Any other text-book on Economics or
Principles of Economics is helpful