Chapter Four: Theory of Costs

 To produce goods and services, firms need

factors of production or simply inputs.
 To acquire these inputs, they have to buy
them from resource suppliers.
 Thus, costs are monetary value of
inputs used in the production of an item.
 In this chapter, we will study the meaning and
behaviors of costs of production, the
relationship between production (output) and
costs (i.e. cost functions both in the short run
and long run).
4.1 Basic Concepts
 We can identify two types of cost of production:
social cost and private cost.
i) 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 purpose are scarce and
some production process, by their nature, emit
dangerous chemicals, bad smell, etc. to surrounding
society.
Example:, when a certain beer factory wants to produce
beer in Ethiopia,
 There is opportunity cost of raw materials (Barely)
 Because of scarcity(or shortage) there might be
increase in price of barely.
 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.
ii) Private Cost: cost of producing an item to the
individual producer.
 It is the cost that the beer factory incurs to produce the
beer, in our example.
 Private cost of production can be measured in two
ways:
A) Economic cost
 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 hire 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 purpose.
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 production,
their value has to be estimated and included in the total
cost of production.
How to Estimate Implicit Costs?
 we usually estimate cost of non purchased
inputs(implicit costs) from what these inputs could
earn in their best alternative use.
For instance, if the firm uses his 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 there non- purchased inputs
are called implicit costs.
 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:

B) Accounting Cost
 For accountant, the cost of production includes the
cost of purchased inputs only.
 Accounting cost is the explicit cost of production
only.
 Moreover, accountant’s doesn’t consider the cost of
production from the opportunity cost of the
resources point of view.
Illustration: Suppose Bedele Brewery factory purchases
1000 quintals of barely for 200 birr per quintal in 1998 to
use this barley for production purpose in the year 1999.
 However, suppose that the price of the barely has been
increased to 300 birr per quintal in the year 1999. -Now
shall we use the actual price with which the barely was
bought in 1998 or the current price (1999 price) to
estimate the cost of barely in 1999?
 In economics, the 1999 price should be taken because,
though the barley was bought for 200 birr per quintal in
1998, the cost of using this barely for the production
purpose in 1999 is the 300 birr per quintal, the amount
of income that could be obtained if the barely were
sold in the market.
 But accountants use the 1998 price to estimate the cost
of production in the year 1999.
4.2 Cost Functions
 Cost functions are derived functions.
 They are derived from the production function in
which the firm employs the optimum input
combination.
 Cost function is defined as the minimum cost of
achieving a given level of output.
 Hence cost function shows the algebraic 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,

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 i
 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 important
factor determining the cost of production), by assuming that
all other factors remain fixed during the period of analysis.
 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 downward.
 Short-run and Long-run Costs
 Economic theory distinguishes between short-run and
long-run costs.
 Short-run costs are the cost over a period during which some
factors of production (usually land, capital equipment, and
management) are fixed.
 The long-run costs are the costs over a period long-enough to
permit the change of all factors of production.
 In the long-run all factors are variable.
 Both long-run and short-run costs are multivariable
functions; that is, determined by many factors:
 The long-run cost function; and
 The short-run cost function:
Where C is total cost, Q is total output, T is technology, Pi is
K
price of factor i and is the amount of fixed capital input.
4.2.1 Short Run Costs
 In the traditional theory of the firm total costs of
production are divided into two groups: total fixed cost
(TFC or simply FC) and total variable cost (TVC or
simply VC).
 Thus, total cost (TC or simply C) is equal to TFC plus
TVC; that is,
.
A) Fixed Cost (FC): is a cost that doesn’t vary with the
level of output.
 Fixed costs are of two types: Fixed and quasi-fixed costs
i. fixed: must be paid, whatever the output level is
ii. quasi-fixed: only paid when output is positive
(heating, lighting, etc.).
 Examples of fixed costs: expenditure on
administrative staff, depreciation of
machinery, expenses for land or building
maintenance and depreciation etc.
B) Variable Cost (VC): is a cost that varies as
output varies.
 The variable cost includes cost of raw
materials, the costs of direct labor, and
the running expenses of fixed capital such
as fuel, ordinary repairs, and routine
maintenance.
 Cost Curves
 Cost curves can be used to depict graphically the cost
function of a firm and are important in studying the
determination of optimal output choices.
 In the short run the total costs of the firm can always be
written as the sum of the variable costs, cv(y), and the
fixed costs, F, i.e.,

or

Per Unit Costs

i) Average Fixed Cost (AFC): is total fixed cost divided by the
level of output. Symbolically:
ii) Average Variable Cost (AVC): is total variable cost
divided by the corresponding level of output; that is,

iii) Average (total) Cost (AC): is total cost divided by the

level of output; or it is the sum of AFC and AVC.
 That is, .
iv) Marginal Cost (MC): is incremental cost that results
from producing one extra unit of output.
 Specifically, MC is the change in total cost which
results from a unit change in output.
 MC implies that how much it will cost to expand
the firm’s output by one unit.
 Note that fixed cost doesn’t change as the firm’s level of
output changes.
 Thus, MC is equal to the increase in variable cost that
results from an extra unit of output (since ); i.e. ).

Figure 4.1: Short run TC, TVC, and TFC

Figure 4.2: Short run AC, AVC, AFC and MC
Figure 4.3: Short run total and per unit costs
 Geometrically,
 AC and AVC is the slope of a ray from the origin to the
TC and TVC curves, respectively.
For instance, AVC at point A is equal to the slope of a ray (or
line) OA.
 Marginal Cost at any point on the TC or TVC curve is
equal to the slope of a tangent line drawn at that particular
point.
 In summary, the traditional theory of costs postulates that in
the short-run the unit cost curves (AVC, AC and MC) are U-
shaped, reflecting the law of variable proportions.
 In the short-run with fixed plant there is a phase of increasing
productivity (falling unit costs) and a fall of productivity
(increasing unit costs except AFC) of the variable factors.
 Between these two phases there is a single point at which
units costs are at minimum (Optimality).
 The Relationship between AC and AVC
 AVC is part of AC, since .
 Both AC and AVC are U-shaped, reflecting the law of
variable proportions.
 However, the minimum point of AC occurs to the right
of the minimum point of AVC; that is, AC reaches its
minimum at higher level of output than the AVC.
 This is due to the fact that ATC includes AFC and the latter
falls continuously with rise in output.
 But beyond Q2 units of output the rise in AVC > fall in
AFC and hence ATC starts rising.
 The distance between AC and AVC gets closer and closer
as output expands, because the gap between AC and AVC
(AFC) is continuously falling with the rise in output).
 Relationship between MC and AC
 The MC cuts the AC and AVC curves at their lowest
(minimum) points.
 That is,
 when AVC attains its minimum,
 Similarly, when AC attains its minimum, MC = AC
 Furthermore, MC lies below both AVC and AC over the
range in which the curves (AC & AVC) decline; it lies
above them when they are rising.
 Mathematically, we know that: , where
 Then . But MC is defined as: ,
, using a product rule, we will get:
 Therefore,

OR,

where AC and Q are positive.

 From this relation we can conclude the following:
 If slope of AC is negative (i.e. AC is falling), then
MC must be less than AC.
 If slope of AC is positive (i.e. AC is rising), then MC
must be greater than AC.
 If slope of AC is equal to zero (i.e. AC is at
minimum), then MC must equal AC.
 NOTE: similar relationship can be obtained between MC
and AVC.
Example: Given the total cost functions as:

Find the different cost functions/expressions.

SOLUTION:
The Relationship Between Short Run
Production and Cost Curves
 Suppose a firm in the short run uses labour as a
variable input and capital as a fixed input.
 Let the price of labour be given by w, wage, which is
constant.
 Given these conditions, we can derive the relation
between MC and MPL as well as the relation between
AVC and APL.
i) MC and MP of Labour
, Where
Thus, ; but =
 Therefore,
  shows that MC and are inversely related.
 When initially MPL increases, MC decreases; when
MPL is at its maximum, MC must be at a minimum
and when finally MPL declines, MC increases.
II) AVC and AP of Labour
AV, Where
Thus, ; but =
 Therefore,
 Shows inverse relation between AVC and APL.
 When APL increases, AVC decreases; when APL
is at a maximum, AVC is at a minimum and when
finally APL declines, AVC increases.
 Graphically,

 From the above figure, we can conclude that the MC curve

is the mirror image of MPL curve and AVC curve is the
mirror image of APL curve.
Long Run Costs
 The long-run cost curve is a planning curve, in
the sense that it is a guide to the entrepreneur in
his/her decision to plan the future expansion of
his/her output.
 We know that in the long-run all factors are
variable.
 In the long run a firm can choose the level of its
“fixed” factors—they are no longer fixed.
 In the long run there are no fixed costs, 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.
 In the long run we have two common costs: LAC and
LMC
A) Long-run average cost curve (LAC)
 is the envelope of the short-run cost curves.
 Thus, it is derived from short-run average cost
curves (SAC).
 Each point on the long-run average cost curve
corresponds to a point on the short-run cost curves,
which is tangent to LAC curve at that point.
 Assume, the fixed factor is plant size and assume
further that there are three plant sizes in the short run: a
small plant with short-run average cost curve of SAC1,
medium with SAC2, and large plant with SAC3
Figure 4.3: Short run AC curves
  If the firm plans to produce Q1 it will choose the small
plant because this plant is the one with the least cost.
 If it plans to produce Q2 it will choose the medium
plant.
 If it wishes to produce Q3 it will choose the large size
plant since other plant size leads to higher costs.
(Figure 4.3).
 If the firm starts with small size(SAC1) and its demand is
expected to increase, it will produce at lower costs up to
the level of output Q’1, beyond which costs start
increasing.
 If its demand reaches Q”1, the firm can either continue to
produce with the same plant or it can install the medium-
size plant(SAC2).
 The decision at this juncture(i.e. which plant to use)
depends not on costs but on the firm’s expectations about
its future demand.
 If the firm expects that the demand will expand
further than Q”1 it will install medium plant,
because with this plant outputs larger than Q1” are
produced with a lower cost.
• Similar considerations hold for the decision of the
firm when it reaches the level of output Q”2.
 If we assume an infinite number of plants, we
obtain a continuous curve, which is a planning
LAC curve of the firm (Figure 4.4).
 The firm chooses the short run plant which allows it
to produce at a least cost(in the long run).
 Thus it is a planning curve.
 The LAC is also a “U” shaped curve like the
SAC curve and it is often called “envelop”.
Figure 4.3: Long run AC curve derived from SAC curves
Note: each points on the LAC curve show the minimum (or
optimum) cost of producing the corresponding level of
output.
Economies and diseconomies of scale
 The U-shape of LAC curve reflects the laws of returns to
scale.
 According to this law, the unit cost of production
decreases as plant size increases (due to the economies of
scale) up to the minimum point on the LAC curve.
 This economy of scale arises from division of labor and
specialization.
 If the plant increases beyond this plant (optimal plant size
or minimum LAC curve), there are diseconomies of scale
arising from managerial inefficiencies.
Reasons:
 management becomes highly complex,
 managers are over-worked and the decision making
process becomes less efficient and
 Thus, LAC curve starts rising.
 Therefore, at the falling part of the LAC curve the plants are
not worked at full capacity; at the rising part it
overworked; and only at the minimum point, m, the plant is
optimally employed (see Figure 4.5).

Figure 4.3: Economies and diseconomies of scale

B) Long-Run Marginal Cost (LMC):
 is formed from points of intersection of the short-run marginal
cost (SMC) curves with vertical lines (to the X-axis) drawn from
the points of tangency of the corresponding SAC curves and the
LAC curves (Figure 4.6).

Figure 4.3: LMC Curves(

NOTE: To the left of minimum point on the
LAC(point m), LMC curve is less than the LAC
curve.
 To the right of point m, the LMC curve lies
above the LAC curve.
 At the minimum of the LAC curve the LMC
curve intersects the LAC curve; i.e when
LAC curve is at its minimum.
 Thus, at the minimum LAC curve:
 The Learning Curve
 At smaller output level the LAC is larger but it declines
as the size of the firm expands due to advantages of
scale.
 The LAC also declines due to the experience gained by
workers and management.
 Workers at first may take longer time and more effort to
produce output.
 However when they stay longer in the production process,
they learn to do job easily.
 This will cause decline in the per-unit cost of production.
 The learning curve describes the extent to which the number
of units of inputs required per unit of output decline with
increasing cumulative output (Figure 4.7).
 Figure 4.3: The Learning Curve
 When the management and workers learn more effective
ways of using the fixed plant over time, the number of units
of labor required per unit of output will decline.
 This result in decline in AC and MC.
 Mathematically,

Where,
L = the number of units of labor per unit of
output
b = the degree of learning and
N= the total output (cumulative output).
 When the firm starts to produce the first unit of output,
the required labor amount is .
 Most of the time this is the maximum labor required.
 When and N keeps on increasing L approaches A
on the limit.
 ‘A’ is the number of units of L required per unit of
output.
 It is minimum labor requirement. after all the
benefits of learning is exploited.
 When , at all levels of output.
 In this case, learning does not have contribution to
productivity of labor.
 is the number of units of labor required to produce all
levels of output.
 The decline per unit costs due to learning effects are shown by
shift in the LACs.