CHAPTER THREE

THEORY OF COSTS OF PRODUCTION

Definitions of cost

To produce goods and services, firms need factors of production or simply input. To acquire
these inputs, they must buy them from resource suppliers. Cost is, therefore, the monetary
value of inputs used in production of an item.

3.1. Cost Related concept

private cost and social cost

Private cost: This refers to the cost of producing an item to the individual producer. It is the
cost that the beer factory incurs to produce the beer. Private cost of production can be
measured in two ways: such as economic cost and accounting cost.

Economic cost and accounting cost

Economic cost in economics the cost of production to the individual producer includes the
cost of all inputs used for the production of the item. The producer may buy part of the
inputs from the market. For example, he/ she hires workers, buy raw materials, the
necessary machines, etc. the actual or out- of- pocket expenditures that the firm incurs to
purchase these inputs from the market are called explicit costs.

But the producer can also use his/ her own inputs which are not purchased from the market
for the production purposes. For example, the producer may use his/ her own building as a
production place, he/she may also manage his firm by himself instead of hiring another
manager, etc. Since these inputs are used for the purpose of production, their value has to be
estimated and included in the total cost of production. As to how to estimate the cost of
these non- purchased inputs is concerned, we usually estimate their cost from what these
inputs could earn in their best alternative use. For instance, if the firm uses its own building
for production purpose, the cost of using this building for production is estimated by the rent
income foregone. If the producer is a teacher with salary of 1000 birr per month and fruits
his job to manage his factory, then the next best alternative of his labor is the salary that he
sacrificed to be the manager of his factory. The estimated cost of these non- purchased
inputs are called implicit costs.
1
Thus, in economics the cost of production includes the costs of all inputs used in the
production process whether the inputs are purchased from the market or owned by the firm
himself that is: Economic cost: Explicit cost + Implicit cost

Accounting Cost

For accountants, the cost of production includes the cost of purchased inputs only.
Accounting cost is the explicit cost of production only. Moreover, accountants don’t
consider the cost of production from the opportunity cost of the resources point of view. To
clarify the difference between accounting cost and economic cost in this regard, consider the
following example.

Suppose Bedele Brewery factory purchases 1000 quintals of barely for 200 birr per quintal
in 2008 to use this barley for production purpose in the year 2009. However, suppose that
the price of the barely has been increased to 300 birr per quintal in the year 2009.

-Now shall we use the actual price with which the barely was bought in 2008 or the current
price (2009 price) to estimate the cost of barely in 2009?

In economics, the 2009 price should be taken because, though the barley was bought for 200
birr per quintal in 2008, the cost of using this barely for the production purpose in 2009 is
the 300 birr per quintal, the amount of income that could be obtained if the barely were sold
in the market. However, accountants use the 2008 price to estimate the cost of production in
the year 2009.

External costs: are those costs not borne by the firm, but are incurred by others in the
society; drainage system; and the disutility created through air, water and noise pollution are
some of the examples.

Social cost: is the cost of producing an item to the society. This cost is realized due to the
fact that most resources used for production purposes are scarce and some production
processes, by their nature, emit dangerous chemicals, bad smell, etc to surrounding society.

For example, when a certain beer factory wants to produce beer in Ethiopia, the society as a
whole also incurs a cost. Because the next- best alternative of the raw material (such as
barely) used for the production of beer is sacrificed. When the beer factories buy barley
from the market, the amount of barely available for consumption by society may be reduced
2
and the price may become dearer. Hence, the production of beer imposes an indirect cost on
the society, moreover, by its nature; the production of beer emits bad chemicals to the
environment, which pollutes waters, air, etc. To control the understandable consequences of
the production process on the environment and their property, the society incurs cost.

Social Cost = private Cost + External Cost

Increment and Sunk costs

Increment costs: are the additions to costs resulting from a change in product lines,
introduction of a new product replacement of obsolete plant and machines etc.

Sunk costs are those which cannot be altered, increased or decreased by changing the rate of
output and the level of business activity. All the past costs are considered as sunk costs
because they are known and given and cannot be revised as a result of changes in market
conditions

3.2 Cost functions

Cost function shows the algebraically relation between the cost of production and various
factors which determine it. Among others, the cost of production depends on the level of
output produced, technology of production, prices of factors, etc.; hence, cost function is a
multivariable function. Symbolically,

C = f (x, t, pi)

Where c- is total cost of production

x - is the amount of output

T – is the available technology of production.

Pi – is the price of input

Graphically, cost functions can be illustrated by using a two- dimension diagrams. To do so,
first we observe the relationship between the total cost of production and the level of output
(the most factor determining the cost of production), by assuming that all other factors are

3
constant. Then, the impact of change in “other factors” such as technology on the cost of
production will be handled by shifting the total cost curves upward or down- ward.

3.3 – Short run vs. long run costs

Economics theory distinguishes between short run costs and long run costs. Short run costs
are the costs over a period during which some factors of production (usually capital
equipment’s and management) are fixed. The long- run costs are the cost over a period long
enough to permit the change of all factor of production.

Short run costs in the traditional theory of the firm, total costs are split into two groups:
total fixed costs and total variable costs:

TC = TFC + TVC

Where – TC is short run total cost

TFC is short run total fixed cost

TVC is short run total variable cost

By fixed costs, we mean a cost which doesn’t vary with the level of output. The fixed costs
include:

a. Salaries of administrative staff

b. Expenses for building depreciation and repairs
c. Rent of land
d. The rent of building used for production , etc
All the above costs are regarded as fixed costs because whether the firm produces much
output or zero output, these costs are unavoidable, and the firm can avoid fixed costs only if
he / she shut down the business stops operation.

Variable costs, on the other hand, include all costs which directly vary with the level of
output. The variable costs include:

e. The cost of raw materials

f. The cost of direct labor
g. The running expenses of fixed capital such as fuel, electricity power, etc.

4
All these costs are regarded as variable costs because their amount depends on the level of
output. For example, if the firm produces zero output, the variable cost is zero.

Total fixed cost (TFC):

Graphically, TFC is denoted by a straight line parallel to the output axis. The point of
intersection of the TFC line with the cost axis (vertical axis) shows the amount of the
fixed. For example if the level of fixed cost is $ 100, it can be shown as below figure.

$100 TFC

5
Total variable cost (TVC)

The total variable cost of a firm has an inverse s- shape. The shape indicates the law of
variable proportions in production. According to this law, at the initial stage of production
with a given plant, as more of the variable factor (s) is employed, its productivity increases.
Hence, the TVC increases at a decreasing rate. This continues until any point(up to tfc=tvc),
beyond this point, as increased quantities of the variable factors(s) are combined with the fixed
factor (s) the productivity of the variable factor(s) declined, and the TVC increases by an
increasing rate. Thus, the TVC has an inverse s-shape due to the law of variable proportions in
production.
Graphically, the TVC looks like the following figure.

TVC
C

Total Cost (TC)

The total cost curve is obtained by vertically adding the TFC and the TVC i.e., by adding the
TFC and the TVC at each level of output. The shape of the TC curve follows the shape of the
TVC curve. i.e. the TC has also an inverse S-shape. But the TC curve doesn’t start from the
origin as that of the TVC curve. The TC curve starts from the point where the TFC curve
intersects the cost axis.
The figure shown below implies that the TC and TVC curves has an inverse S- shape. The
vertical distance between them (TFC) is constant.

6
 C

TC

TVC

TFC

Per unit costs (average costs)

Average fixed costs
From total costs we can derive per-unit costs. These are even more important in the short run
analysis of the firm. Average fixed cost (AFC) - is found by dividing the TFC by the level of
output.
Graphically, the AFC is a rectangular hyper parabola. The AFC curve is continuously
decreasing curve, but decreases at a decreasing rate and can never be zero. Thus, AFC gets
closer and closer to zero as the level of output increases, because a fixed amount of cost is
being divided by increasing level of output.
c

AFC

The figure suggests that the average fixed cost curve is derived from the total fixed cost
7
 Average variable cost (AVC)

The AVC is similarly obtained by dividing the TVC with the corresponding
level of output.
TVC
AVC=
X
Graphically, the AVC at each level of output is derived from the slope of a line
drawn from the origin to the point on the TVC curve corresponding to the particular
level of output.
The following graph clearly shows the process of deriving the AVC curve from the
TVC curve

in the figure above, the AVC at Q1 from panel A is given by the slope of the ray
0a, the AVC at Q2 is given by slope of the ray 0b, and so on. The slope of the rays
decreases until Q3 and starts to rise beyond Q3.
It is clear from this figure that the slope of a ray through the origin declines continuously until
the ray becomes tangent to the TVC curve at C. To the right of this point (Point c) the slope

8
 of the rays through the origin starts increasing. Thus, the short run AVC (SAVC now on) falls
initially, reaches its minimum and then start to increase. Hence, the SAVC curve has a U-
shape and the reason behind is the law of variable proportions. Had the TVC not been inverse
S-shaped, the SAVC would never assume a U-shape.
Generally, at initial stage of production, the productivity of each additional unit a variable

input increases, thus, the variable input requires to produce each successive units of

output decreases at this stage, implying that the AVC (Variable Cost Incurred to produce a

unit of output) decreases. This process continues until the point of optimal combination

between the fixed input and the variable input is reached. Beyond this point, the productivity

of each additional unit of the variable combined with the existing fixed input decreases

because the fixed input is over utilized. As the productivity of such variables decreases, more

and more of the variables are required to produce successive units of the output, implying that

the VC incurred to produce each successive unit (AVC) increases.

Average total cost (ATC) or simply, Average cost (AC)

ATC (or AC, now on) is obtained by dividing the TC by the corresponding level of output. It

shows the amount of cost incurred to produce each unit of successive outputs.

TC
AC=
Q
TVC +TFC
=
Q
TVC TFC
= +
Q Q
=AVC+AFC
Thus, AC can also be given as the vertical sum of AVC and AFC. Graphically, AC
curve can be obtained by vertically adding the AVC and AFC for each level of
successive outputs. Alternatively, the AC curve can also be derived in the same way as
the SAVC curve. The AC curve is U-shaped because of the law of variable
proportions. Observe the figure that follows.

9
 Panel-A Panel-B
From this figure (Panel A), the AC at any level of output is the slope of the straight line
from the origin to the point on the TC curve corresponding to that particular level of
output. That is, for example, the AC of producing Q1 level of output is given by the
slope of the line 0a, the AC of producing Q2 level of outputs is given by the slope of
the line Ob and so on.

Marginal Cost (MC)

The marginal cost is defined as the additional cost that the firm incurs to produce one extra
unit of the output. One thing to be noted here is that, the additional cost that the firm incurs to
th th
produce the 10 unit of output is no0t equal to the additional cost of producing the 1000 unit.
They would be equal if the TC curve is straight line.

To sum up, the MC is the change in total cost which results from a unit change in output i.e.
MC is the rate of change of TC with respect to output, Q or simply MC is the slope of TC
function and given by:
dTC
MC=
dQ

10
In fact the marginal cost is the rate of change of total variable cost with respect to the level of
output.

dTVC +dTFC dTVC dTFC

MC= = since =0
dQ dQ dQ
Graphically, the MC the TC curve (or equivalently the slope of the TVC curve)
obviously, the slope of curved lines at a given point is measured by constructing a tangent line
to the curve at each point. So, the slope of the curve at a given point is equal to the slope of
the tangent line at that specific point. Given the inverse S-shaped TC (or TVC) curve, the MC
curve will be U-shaped. Thus given inverse S-shaped TC or TVC curve, the slope of the TC
or TVC curve (i.e. MC) initially decreases, reaches its minimum and then starts to rise.
From this, we can logically infer that the reason for the U-shaped ness of MC is also the law
of variable proportion. That is, had the TC or TVC curve not been inverse S-shaped, the MC
curve would never have assumed the U-shape, and obviously, the TC or TVC is inverse S-
shaped due to the law of variable proportions. Observe the figure that follows for more
discussion. Fig 4.6

In Panel 2 the slope of the tangent lines to the TC curve ( MC) decreases up to point S and

11
then starts to rise.

In summary, AVC, ATC and MC curves are all U-shaped due to the law of
variable proportions. . The simplest total cost function which would incorporate the
law of variable proportions is the cubic polynomial of the following form.

TC=b0+b1Q+b2Q2 +b3Q3
Where Q- is the level of output and b0, b1, b2 &b3 are none zero constants.

From this type of total cost function’s

b0
bo- represents the TFC, and AFC =
Q
TVC= b1Q+b2Q2 +b3Q3
b 1Q+ b 2Q 2+b 3 Q 3
AVC=
Q
ATC=AFC+AVC
b 0 b 1Q+ b 2Q 2+b 3 Q 3
= +
Q Q

3.5 The relationship between AVC, ATC and MC

Given ATC = AVC + AFC, AVC is part of the ATC. Both AVC and ATC are u shaped,
reflecting the law of variable proportions however, the minimum of ATC occurs to the right of
the minimum point of the AVC ( see the following figure) this is due to the fact that ATC
includes AFC which continuously decreases as the level of output increases.

After the AVC has reached its lowest point and starts rising, its rise is over a certain range
is more than off set by the fall in the AFC, so that the ATC continues to fall (over that range)
despite the increase in AVC. However, the rise in AVC eventually becomes greater than the
fall in AFC so that the ATC starts increasing. The AVC approaches the ATC asymptotically as
output increases.

From fig 4.8 below AVC curve reaches its minimum point at Q1 output and ATC reaches its
minimum point at Q2. The vertical distance between ATC and AVC (AFC) decrease
continuously as output increases. The MC curve passes through the minimum point of both

12
ATC and AVC Finally, the MC curve passes through the minimum point of both ATC and
AVC curves.

The figure shows AVC, AFC, AC and MC curves

Now, from the above figure 4.8 there is the following relationship:
i) When MC<AC, the slope of AC is negative, i.e.
AC curve is decreasing (initial stage of production)
ii) When MC >AC, the slope of AC is positive, i.e. the AC curve is
increasing (after optimal combination of fixed and variable inputs.
iii) When MC = AC, the slope of AC is zero, i.e. the AC curve is at its
minimum point.
The relationship between AVC and MC can be shown in a similar fashion that of AC.
3.6 The relationship between short run production and cost curves
Earlier in this chapter we have said that cost function is derived from production
function. Now, lets see the important relation that per unit production curves (i.e. AP and MP
of the variable input) and per unit cost curves (i.e. AVC and MC) have. The relationship
is that the short run per unit costs is the mirror reflection (against the x- axis) of the short

13
run production curves. That is the short run AVC is the mirror reflection of the short run AP of
the variable input. When AP variable input increases, AVC decreases; when AP variable input
reaches its maximum, the AVC reaches its minimum point, and finally when AP variable input
starts to fall, the AVC curve starts to rise. The same relationship exists between the short run
MP of variable input curve the MC curve. This can be shown algebraically by using a linear
short run cost function.
Suppose the firm uses two inputs, labor L (which is variable) and capital (which is fixed input).
And suppose that the prices of both factors are given and equal to w, and r respectively.
The total cost of production is then, TC= rK+Wl
The first term (i.e. rk) is the fixed cost because both r and k are constant and the second term
(i.e.wL) represents the variable cost.
Thus, TVC = WL
Graphical representation:

14
 As indicated in the above figure, short run AVC and MC curves are the mirror reflection
(along the horizontal axis) of short run APL and MPL curves
3.7 Costs in the long run(Long run costs)
In this section we will discuss the long run costs of a firm. The basic difference between long-
run and short run costs is that in the short run, there are some fixed inputs which results in
some amount of fixed costs. However, in the long run all factors are assumed to become
variable. In the long run the firm can change the quantities of all inputs including the size of the
plant. This implies that all costs are variable in the long run in the sense that it is always
possible to produce zero units of output at zero costs. That is, it is always possible to go out
of business.
The long run cost curve is a planning curve, in the sense that it is a guide to the entrepreneur
in his decision to plan the future expansion of his plant.
Derivation of the long- run average cost curve
The long run average cost curve is derived from the short run average cost curves. Each point
on the long run average cost (LAC, now on) corresponds to a point on the short run cost curve,

15
which is tangent to the LAC at that point. Now let us examine in detail how the LAC is
derived from the short run average cost ( SAC) curves.
Assume that the available technology to the firm at a particular point of time includes three
methods of production, each with a different plant size: a small plant, medium plant and large
plant. The operation cost of the small plant is denoted by SAC1, the operating cost of the
medium size plant is denoted by SAC2 and that of the large size plant is denoted by SAC3 in
the following figure.
If the firm plans to produce x1 units of output, it is well advised to choose the small size plant
to minimize its cost. For example, if the firm choose to use the medium size plant to produce x1
units of output, the per unit costs will be C4 ( a point corresponding to x1 units of output on
the SAC2) but, the firm can produce x1 units of output at a lower unit cost (c1) if it uses the
small size plant. Similarly, if it plans to produce x2 units of output, it will choose the medium
size plant. If the firm wishes to produce x3 units, it will choose the large size plant.
If the firm starts with the small plant and its demand gradually increases, it will produce at
lower costs (up to x1 level of output). Beyond that level of output costs start increasing. If its
demand reaches the level x1 the firm can either continue to produce with the small plant or it
can install the medium size plant. The decision, at this point, whether to install the medium
size plant or i t depends on the firm s expectation about its future demand. If the firm
expects that the demand will expand further than x1 it will install a medium size plant
because with this plant out puts larger than x1 are produced with a lower cost.
Similar considerations hold for the decision of the firm when it reaches the level x2. If the
firm expects its demand to stay constant at x2 level, the firm will not install the large plant,
given that it involves a large investment which is profitable only if demand expands beyond
x2. If the firm expects that its demand will expand further, it will install the large size
plant to reduce its cost. For example the level of output x3 is produced at a cost c3
with the large plant, while it costs c2. If produced with the medium size plant (c2 > c3).
Now if we relax the assumption of the existence of only three plant sizes and assume that the
available technology includes large number (infinite number) of plant sizes, each suitable for a
certain level of output, the points of intersection of consecutive plants cost curves (which are
the crucial points for the decision of whether to switch to a larger plant) are numerous and
we obtain a continuous curve, which is the planning LAC curve of the firm.

16
The LAC curve is then the tangent to these SATC curves of various plant sizes and shows the
minimum cost of producing each level of output.

The figure shows the relationship between LAC and short run average costs. The long run AVC curve
is the lower envelope of the short run average costs of various plant sizes.
In summary, the LAC curve shows the minimum per-unit cost of producing any level of output
when the firm can build any desired scale of plant in the sense that the firm chooses the
short run plant which allows it to produce the anticipated (in the long run) output at the least
possible cost.
Why is the LAC U-shaped? Similar to the SAC curve, the LAC curve of a firm is also U-
shaped, but the reason for the U-shapes ness of LAC curve is different from that of the SAC
curve. The LAC curve is U-shaped due to the laws of returns to scale(i.e increasing and
decreasing returns to scale).that is, as output expands from a very low levels increasing returns
to scale prevails (i.e., output rises proportionally more than inputs), and so the cost per-unit of
output falls(assuming that input prices remain constant).As output continues expand, the forces
of decreasing returns to scale eventually begin to overtake the forces of increasing returns to
scale and the LAC begins to rise. In other words, the per unit costs of production decreases

17
initially as the plant size increases, due to the economies of scale which larger plant size makes
possible.
Economies of scale are the cost dimension of increasing returns to scale and thus, they are like
the two sides of a coin. If a firm has increasing returns to scale in production (i.e., if it requires
the firm less than double inputs to produce double output) the firm will have economies of
scale in costs (it will require the firm less than double cost to produce double output).
Thus, the reason for the decreasing part LAC curve is increasing returns to scale or economies
of scale. Economies of scale may prevail for various reasons such as specialization of skills,
lower prices for bulk-buying of raw materials, decentralization of management system and etc.
The traditional theory of the firm assumes that economies of scale exists only up to a certain
size of plant, which is known as optimal plant size, because with this plant size all possible
economies of scale are fully exploited. If the plant size increases further than this optimal
size diseconomies of scale will start to prevent, arising from managerial inefficiencies, the price
advantage from bulk-buying may also stop beyond a certain limit etc. These diseconomies of
scale will lead to increasing LAC curve. Thus, the increasing portion of the LAC curve shows
the existence of diseconomies of scale or decreasing returns to scale.
In general, the reason for the U-shaped ness of the LAC curve are the existence of increasing
returns to scale at initial stage of expansion decreasing returns to scale at a later stage of
expansion.

18
As indicated in the figure above, the LAC curve is U-shaped due to the combined effects of
increasing, constant and decreasing returns.
The long-run marginal cost curve
The long-run marginal cost curve (LMC) is derived from the short run MC curve but does not
envelope them. The LMC is formed from points of intersection of the SMC curves with the
vertical lines (to the x-axis) drawn from the points of tangency of corresponding SAC curves
and the LAC curve.

19
The figure shows the long run marginal cost curve; it is derived from the short run marginal
cost curves by connecting the points of intersection of the vertical lines drawn from the point
of tangency of SAC curves with the LAC curves with and the corresponding SMC curves.
Note that the LMC curve passes through the minimum of the LAC curve.
3.8 Dynamic changes in costs: the learning curve
So far we have suggested one reason why a large firm may have a lower long-run average
cost than a small firm: increasing returns to scale in production it is tempting to conclude
that firms which enjoy lower average cost over time are growing firms with increasing returns
to scale .but this need not be true.
In some firms, long-run average cost may decline over time because workers and managers
absorb new technological information as they become more experienced at their job. That
is, as workers get experience their efficiency increases which then reduces the average and
marginal costs of producing a unit of product.
As management and labor gain experience with production, the firm s marginal and
average costs of producing a given level of output fall for four reasons:

1. Workers often take long-run to accomplish a given task the first few times they do it. As
20
they become more adept, their speed increases. For example, a worker packing 20 dozens of
soups per hour in the first few months can pack more than 20dozens of soups in latter months
when he/she gains experience.
2- Managers learn to schedule the production process more effectively.
3- Engineers who are initially cautious in their product designs may gain enough experiences to
be able to allow for tolerances in design that save costs with though increasing defects. Better
and more specialized tools and plant organization may also lower cost.
4- Suppliers may learn how to process required materials more effectively and pass on some of
this advantage in the form of lower costs to the firm.

In general, a firm learns over time as cumulative output increases. Managers can use this
learning process to help plan production and for cast future costs. The following figure
illustrates this process in the form of learning curve: a curve that describes the relationship
between the firms cumulative output and the amount of inputs needed to produce each unit of
output. Number of labor required to produce one unit of output.

Learning
curve

A
Cumulative
out put
the figure above shows Learning Curve: shows that at the firm’s cumulative output increases
(as the firm gets experienced),the amount of inputs(such as labor)required to produce one unit
of output decreases.
In the above graph, the per unit production costs decreases along with the amount of labor
required to produce a unit of the commodity. This happens because labor input Per unit of out
put directly affects the production costs. The fewer the hours of labor needed to produce a unit
of the commodity, the lower the marginal and average costs of production.
Learning vs Economies of scale A firm’s average cost of production can decline

21
 overtime because of growth of sales (output) when increasing returns to scale prevails in the
firm (a move from A to B on curve AC,), or it can decline because there is a learning curve ( a
move from A on AC, to C on AC2).Thus, increasing returns to scale reduces average
cost of production with increase in output, whereas learning shifts the average cost curve
down ward.

As indicated above, Learning shifts the average cost curve down wards.
Review Exercise
1. Given a total cost function TC=100+55Q-10Q2+Q3 , find
A. TFC and TVC when Q=0?
B. AVC and AFC when Q=1?
C. AC and MC when Q=1?
D. The level of output when MC reaches minimum?
E. The level of output when MC = AVC and MC=AC
2. Consider a cost minimizing firm facing price of labor birr 20 and price of capital birr
100. If it uses labor and capital so that MPK = 50, calculate MPL.
3. Assume the production function is given by:Q=L0.5K0.5; where Q is the quantity of output,
L is the amount of labor, and K is the amount of capital. Let the price of labor be w=10
(per unit of labor) and the price of capital be r = 20 (per unit of capital). What amount of
labor and capital can minimize the cost of production given the total cost constraint of C
= 4000.

22