2.4.theory of Cost

INTRODUCTION TO ECONOMICS
(ECON. 101)
Dec, 2015
2.4. Theory of Cost
Costs in the Short-Run and Long-Run
•Short Run R/n Between production and Cost
•Short-Run Costs and Cost Curves
•Long Run R/n Between production and Cost
•Long-Run Costs and Cost Curves
Costs for Decision making

2.4. Theory of Cost
Why do firms care about costs?
Firms will decide how much of a good to
produce and sell depending on the price and
cost of the good (supply depends upon incremental
or MC)
The general name for the relation between

costs and output is "cost function".
The production function of a firm and the

prices it pays for its inputs determine the
firm's cost function.
2.4.1. SHORT RUN RELATIONSHIP BETWEEN
PRODUCTION AND COST
 Short-runcosts - costs over a period during which
some factors of production are fixed
 Long-run costs - costs over a period long enough to
permit the change of all factors of production. In the
long-run all factors become variable
 The SC function as C = ƒ(X, T, Pf, Ǩ)
 The LC function C = ƒ(X, T, P )
f
Where
 C= Total,
 X= Output,
 T= Technology,
 P = Prices of Factors
f
 Ǩ= Fixed Factor
2.4.1. SHORT RUN RELATIONSHIP BETWEEN
PRODUCTION AND COST
 In the short - run, the
Example
Total
costs of the firm are
divided into fixed costs Input TVC
and variable costs. (L) Q (TP) MP (wL)
0 0 0
 Total variable cost 1 1.000 1.000 500
(TVC) is the cost 2 3.000 2.000 1.000
associated with the 3 6.000 3.000 1.500
variable input, in this case 4 8.000 2.000 2.000
labor. Assume that labor 5 9.000 1.000 2.500
can be hired at a price of
w=birr 500 per unit. 6 9.500 500 3.000
7 9.850 350 3.500
8 10.000 150 4.000
9 9.850 -150 4.500
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 with fixed inputs & TC is associated with all inputs.
Fixed Costs Variable costs

Salaries of administrative staff The raw materials
Depreciation of machinery The cost of direct labor
(wear and tear) The running expenses of fixed
Expenses for building capital, such as fuel ordinary
depreciation and repairs repairs and routine maintenance
Expenses for land maintenance
and depreciation
 For analyzing the short run cost, the
following assumptions are made
1. the firm employs two inputs (ex: labor & capital)
2. At least one factor input is fixed (ex: labor is
variable, capital is fixed)
3. the firm produces a single product
4. technology is fixed
5. the firm operates efficiently and in competitive
input markets
6. the law of diminishing returns holds
2.4.2. Short run costs
– AFC=TFC/Q
– AVC=TVC/Q
– ATC = TC/Q
– Marginal cost (MC) is the change in total cost
associated with a change in output
• MC =  TC/Q
=  TVC/Q
=  (TFC+TVC)/Q
= TFC/Q + TVC/Q
= 0 + TVC/Q
SHORT-RUN COST FUNCTIONS-EXAMPLE
Q TFC TVC TC AFC AVC ATC MC
0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
Average Total Cost = ATC = TC/Q
Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
9
Marginal Cost = TC/Q = TVC/Q
FILL THE FOLLOWING TABLE
FC TC MC? AC? AVC? AFC?

0 50 50
1 50 70
2 50 80
3 50 95
4 50 130
5 50 250
Graphical Presentation
TFC
11
Important Observations
– AFC declines steadily over the
range of production.
– In general, AVC, AC, and MC
are u-shaped.
 The U-shape in the short run
is attributed to increasing and
diminishing returns from a
fixed-size plant
 (fixed factor such as capital
has limited production AFC
capacity of the firm)
– MC measures the rate of
change of TC
– When MC<AVC, AVC is falling – The distance between
AC and AVC
When MC>AVC, AVC is rising represents AFC
When MC=AVC, AVC is at its
minimum
Graphical Presentation
$ MC will intersect the AVC at the

minimum of the AVC [always].
MC
ATC
AVC
ATC* R MC will intersect the ATC
at the minimum of the ATC.
AVC* TC = ATC* x Q** J The vertical distance between
TVC = AVC* x Q* ATC and AVC at any output is
the AFC. At Q** AFC is RJ.
Q* Q** Q
At Q* output, the AVC is at a minimum AVC* [also max of APL].
At Q** the ATC is at a MINIMUM.
13
Mathematical example
C(Q)=Q²+10Q+10
Find, VC, FC, ATC,
AVC,AFC,MC?
14
Mathematical examples
• C(Q) = Q3 – 7Q2 + 111Q + 50

Where C= total cost
Q = output
Find MC
Find AC, AVC, AFC
2.4.3.Long run Relationship Between
Production and Cost
The long run is the period of time during which:

Technology is constant & all inputs and costs are
variable
The long run cost structure of a firm is related to the
firm’s long run production process
The long run period is a series of SR periods.
The firm’s long run production process is

described by the concept of returns to scale
Long run Relationship …
 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.
2.4.4.Long run Production Cost
the long-run costs curve is a planning curve (it is a
guide to the firm in his decision to plan the future expansion
of his output)
LRMC = LTC/ Q
LRAC = LTC/ Q
In general, the LRAC is u-shaped
Is derived from SRACs

.Long run …
When LRAC is declining , the firm is experiencing
economies of scale (implies that per-unit costs are
falling).
When LRAC is increasing , >>>>>diseconomies
of scale (it implies that per-unit costs are rising)
Long run …
• Reasons for Economies of Scale
– IRTS
– Specialization in the use of labor and capital
– 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
Possible Shapes of the LAC Curve
A B C
‘A’ shows a U-shaped LAC curve which indicates first

decreasing and then increasing returns to scale.
‘B’ shows a nearly L-shaped LAC curve which shows that
economies of scale quickly give way to constant returns
to scale or gently rising LAC.
‘C’ shows an LAC curve that declines continuously, as in
the case of natural monopolies
22
(diseconomies of scale).
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
The nature of costs
 Costs are incurred as a result of production
 Economists define cost in terms of
opportunities that are sacrificed when a choice
is made. Therefore, economic costs are simply
benefits lost
 Accountants define cost in terms of resources

consumed. Accounting costs reflect changes in
stocks (reductions in good things, increases in
bad things) over a fixed period of time
24
2.4.5. COSTS …
 For business decision making we use
economic costs (explicit/accounting & Implicit
/opportunity costs)
Explicit costs - are actual expenditures of the
firm to hire, rent, or purchase the inputs it
requires in production
It includes the wages to hire labor, the rental price
of capital, equipment, and buildings, and the
purchase price of raw materials and semi finished
products.
2.4.5. COSTS …
 Implicit costs/opportunity costs - refers to the
value of the inputs that are owned and used by
the firm in its own production activity.
These includes the highest salary that the
entrepreneur could earn in his or her best alternative
employment and the highest return that the firm
could receive from investing its capital in the most
rewarding alternative use or renting its land and
buildings to the highest bidder.
2.4.5. COSTS …
 For business decision making >> economic costs
 Economic cost refers the sum of explicit and
implicit costs. These costs must be
distinguished from accounting costs, which refer
only to the firm’s actual expenditures, or explicit
cost, incurred for purchased or hired inputs.
Economic Profit = Accounting Profit –

Opportunity Costs
THE MAKEUP OF TOTAL COST IN THE
SHORT AND LONG RUN
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2.4.theory of Cost

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2.4.theory of Cost

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INTRODUCTION TO ECONOMICS

Costs for Decision making

The general name for the relation between

The production function of a firm and the

Fixed Costs Variable costs

FC TC MC? AC? AVC? AFC?

$ MC will intersect the AVC at the

At Q** the ATC is at a MINIMUM.

• C(Q) = Q3 – 7Q2 + 111Q + 50

The long run is the period of time during which:

The firm’s long run production process is

Is derived from SRACs

‘A’ shows a U-shaped LAC curve which indicates first

 Economies of Scope is achieved when the reduction

 Accountants define cost in terms of resources

Economic Profit = Accounting Profit –

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