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2.4.theory of Cost
2.4.theory of Cost
(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
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.
TFC
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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
Q* Q** Q
At Q* output, the AVC is at a minimum AVC* [also max of APL].
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Mathematical example
C(Q)=Q²+10Q+10
Find, VC, FC, ATC,
AVC,AFC,MC?
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Mathematical examples
Find MC
Find AC, AVC, AFC
2.4.3.Long run Relationship Between
Production and Cost
LRMC = LTC/ Q
LRAC = LTC/ Q
In general, the LRAC is u-shaped
A B C
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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.
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