CAPTER FOUR

THEORY OF COSTS OF PRODUCTION

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 CAPTER FOUR
4. THEORY OF COSTS OF PRODUCTION
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4.1 Basic concepts

 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.
 Cost is, therefore, the monetary value of inputs used in
production of an item.
 We can identify two types of cost of production: social cost
and private cost.
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.
 4.1 Basic concepts (Cont…)
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 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 and the price may become higher.
 4.1 Basic concepts (Cont…)
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 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.

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, in our example:
 Private cost of production can be measured in two ways:
 Economic cost
 Accounting cost
 4.1 Basic concepts (Cont…)
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i) 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.
 4.1 Basic concepts (Cont…)
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 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 production purpose, their value has to be
estimated and included in the total cost of production
 The estimated cost of there non- purchased inputs are
called implicit costs.
 4.1 Basic concepts (Cont…)
 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 plus Implicit cost
ii)Accounting Cost
 For accountant, the cost of production includes the cost of
purchased inputs only.
 Accounting cost is the explicit cost of production only.
 More over, accountant’s doesn’t consider the cost of
production from the opportunity cost of the resources
point of view.
 4.2 cost functions
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 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
 4.2 cost functions
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 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 constant.
 4.3 – Short run vs. long run costs
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 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
equipments 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
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 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 out put.
 The fixed costs include:
 Salaries of administrative staff
 Expenses for building depreciation and repairs
 Expenses for land maintenance
 The rent of building used for production , etc
 Short run costs (Cont…)
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 Variable costs, on the other hand, include all costs which

directly vary with the level of output.
 The variable costs include:
 The cost of raw materials
 The cost of direct labor
 The running expenses of fixed capital such as fuel, electricity power,
etc.
 All these costs are regarded as variable costs because their
amount depends on the level of out put.
 For example, when the firm produces zero output, the variable
cost is zero.
 Short run costs (Cont…)
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Total Fixed Cost (TFC)

 Graphically, TFC is denoted by a straight line
parallel to the out put 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,
C
TFC
$100

X
14
Short run costs (Cont…)
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 the optimal combination of the fixed and
variable factors is reached.
15
Short run costs (Cont…)
Total Variable Cost (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
diminishing marginal returns.
 Short run costs (Cont…)
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 Graphically, the TVC looks the following.

C
TVC

X
 Short run costs (Cont…)
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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.
 Short run costs (Cont…)
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 the TC and TVC curves has an inverse S- shape.

 The vertical distance between them (TFC) is constant.
C

TC

TVC
TFC

TFC

Q
19
Short run costs (Cont…)
Per unit costs:
 Average fixed cost (AFC): is found by dividing the TFC
by the level of output.
TFC
AFC 
Q

 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.
 Short run costs (Cont…)
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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.
 Short run costs (Cont…)
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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.
Or equivalently,

TC TVC  TFC TVC TFC

AC  AC   
Q Q Q Q
TC = AVC + AFC
 Thus, AC can also be given as the vertical sum of AVC
and AFC.
 Short run costs (Cont…)
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Marginal Cost (MC)

 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 produce the 10th unit of output is not equal to
the additional cost of producing the 1000th 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
 Short run costs (Cont…)
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 In fact MC is also the rate of change of TVC

with respect to the level of output.

dTFC  dTVC dTVC

MC  
dQ dQ

since dTFC
 0
dQ
 Hypothetical Total, Average and Marginal Costs
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Q TFC TVC TC = 2+3 AFC = 2/1 AVC= 3/1 ATC= 4/1 or 5+6 MC =∆4/∆1
1 2 3 4 5 6 7 8

0 60 0 60 - - - -

1 60 30 90 60 30 90 30

2 60 40 100 30 20 50 10

3 60 45 105 20 15 35 5

4 60 55 115 15 13.75 28.75 10

5 60 75 135 12 15 27 20

6 60 120 180 10 20 30 45
 Cost Functions
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 Cost of production is a function of output produced

(Q).
3 2
 Given the cost function, TC  3Q  2Q  10Q  100
 Find FC,VC, AFC, AVC, ATC and MC functions ?
FC  100 VC 3Q3  2Q2 10Q
AVC   3Q2  2Q 10
VC  3Q 3  2Q 2  10Q Q Q
FC 100 TC 3Q3  2Q2 10Q100 2 100
AFC   ATC   3Q  2Q10
Q Q Q Q Q
dTC
MC  9Q2  4Q10
dQ
 Graph of average cost curves
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cost
•The AVC curve reaches its minimum MC AC
point at Q1 output and AC reaches AVC

its minimum point at Q2.

• The vertical distance between AC

AFC
and AVC (AFC) decrease continuously
Q1 Q2 output
as out put increases.

•The MC curve passes through the

minimum point of both AC and AVC
 4.4 The relationship between
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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
 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.
 4.4 The relationship between
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AVC, ATC and MC
 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.
 4.5 The Relationship Between Short Run Per
Unit Production and Cost Curves
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 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 are the
mirror reflection (against the x-axis) of the short 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 maximum point, and finally when AP variable
input starts to fall, the AVC curve starts to rise.
 4.5 The Relationship Between Short Run
Per Unit Production Curves (Cont…)
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 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 k (which is
fixed input).
 And suppose that the prices of both factors
are given and equal to w, and r
respectively.
 4.5 The Relationship Between Short Run Per
Unit Production Curves (Cont…)
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 The total cost of production is

TC  rK  wL
 Then 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 1
TVC WL Q
 AVC = = =W .
Q But, represents APL
Q Q L L
1
 Therefore, AVC = W .
APL
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Cont…
 Hence, AVC and APL are inversely related.
 Similarly,
dTC
MC and MPL are inverserly related.
dTVC
MC  
dQ dQ
d ( WL )
MC 
dQ
dL
MC  W . .......... ( because W is cons tan t )
dQ
1
MC  W .
dQ
dL
1 dQ
MC  W . .......... we know that  MP
MP dL
Hence, MC and MPL have also an inverse relation.
 Cont….
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•short run AVC and MC
curves are the mirror AP, MP

reflection (along the

AP
horizontal axis) of short
MP
run APL and MPL curves
•Maximum of MP
corresponds to the labor MC

minimum of MC MC, AVC AVC

•The maximum of AP
corresponds to the
minimum of AVC
Q
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4.6 Costs in the long run

 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
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 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, 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.
 Cont…
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 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
out put 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.
 Cont…
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 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 not depends not on the costs but 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.
 Graph of long run average cost curve
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SAC1

SAC2
C4 LAC

C1’
C1

C2’
SAC3

C2

C3

X1

X1’’’’ X2 X2’ X3