CHAPTER 4

THEORY OF COSTS OF
PRODUCTION

02/18/2025 Micro I By: Jiffara. A 1

 4.1. Introduction
 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.
 Private cost: This refers to the cost of producing
an item to the individual producer. Private cost of
production can be measured
02/18/2025 Micro I
in two ways: Economic2
 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. 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.
 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
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 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.
 Accounting costs measure the monetary value of
taking an action. They are the explicit costs
involved with the business.
 For example, if a company wants to open a
satellite office in a new market, they must make
investments, such as new hires, computer
equipment, software systems, rent, and inventory.
If the total spent on all these areas is $700,000,
then that is the accounting cost.
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 4.2 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. The
relationship between output and costs is expressed in
terms of cost function. moreover; 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
 However, the nature of cost function depends on the
time horizon. In microeconomic theory, we deal with
short run and long run time.
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 4.2.1. 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
 Total fixed costs: 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.
 total variable costs: 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.
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 Con’t...
 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.

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 Total cost and sunk cost
TC=TVC+TFC.........(x)
 The total fixed cost can be sunk and non sunk
TFC= SFC+NSFC.............(xx)
 Sunk fixed cost(SFC): A sunk fixed cost is a fixed
cost that a firm cannot avoid if it temporarily
suspends operations and produces zero
out_x0002_put. For this reason, sunk fixed costs are
often also called unavoidable costs.
 Nonsunk fixed cost(NSFC): A nonsunk fixed cost
is a fixed cost that must be incurred if the firm is to
produce any output, but it does not have to be
incurred if the firm produces no output. Nonsunk
fixed costs, as well as variable costs, are also often
called avoidable costs.
TC= TVC+SFC+NSFC........(xxx)
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 Per unit costs (average costs)

 Average fixed cost (AFC) - is found by dividing

the TFC by the level of output. 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.
 Average variable cost (AVC): The AVC is
similarly obtained by dividing the TVC with the
corresponding level of output. 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.
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• Average total cost (ATC) or simply, Average

cost (AC): 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. The AC curve is U-shaped
because of the law of variable proportions.

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 con’t...
• The marginal cost is defined as the additional cost
that the firm incurs to produce one extra unit of the
output. 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.
• Given the inverse S-shaped TC (or TVC) curve, the
MC curve will be U-shapedand and given by:
dTC dTFC  dTVC dTVC dTFC
= MC  
dQ =
MC  0
dQ dQ dQ

 MC initially decreases, reaches its minimum and

then starts to rise.
 In summary, AVC, ATC and MC curves are all U-
shaped due to the law of variable proportions.

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 4.3 The relationship between AVC, ATC and MC
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.
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 Con’t...

#Example 1
 Given the following total cost function, Tc=10+2q. find
a) Fixed cost(FC)
b) Average fixed cost (AFC)
c) variable cost (VC)
d) Average variable cost (AVC)
e) Average total cost (ATC)
f) Marginal cost (MC)
#Example 2
 If the total cost function for product is given by:
TC=1500+5Q-10Q2+Q3
a) Fixed cost(FC)
b) Average fixed cost (AFC)
c) variable cost (VC)
d) Average variable cost (AVC)
e) Average total cost (ATC)
f) Marginal cost (MC) Micro I
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4.4 The relationship between short run per unit production and cost curves

 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
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. The same relationship exists between the short
run MP of variable input curve the MC curve.
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 4.5 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.
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 4.5.1 Long- run average cost curve

 To derive long- run cost curves, it would be

imperative to imagine that the long- run is
composed of a series of short-run production
decisions.
 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.
 It is crucial to make a note here that the short-run
average cost curve (SAC) cannot be below the long-
run average cost curve (LAC).
 This is because there are more constraints (capacity
constraint and constraints imposed by other fixed
factors) in the short-run than in the long- run and the
producer has an opportunity of minimizing the costs
of the chosen outputMicro
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with
I
respect to all factors. 18
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• The output corresponding to the minimum point on

the short-run average total cost (ATC) is called plant
capacity. Capacity is not the maximum possible
output. Instead, it is the largest output that can be
produced without encountering rising per unit costs.
A producer producing an output smaller than that
given by the minimum average total cost is said to
be operating with excess capacity. A producer may
also be producing an output greater than that
corresponding to the minimum average cost. In this
case, the producer is said to be operating above
capacity.
• There is a reason behind producing an output with
excess capacity. Firstly, the producer can build a
smaller plant and operate at capacity the point of
minimum average total cost.
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 Alternatively, the producer can build a bigger
plant and operate it below capacity. Clearly, the
larger plant with decreasing average cost will be
chosen and a profit-maximizing producer is
interested in producing a given output at
minimum average cost.
 If the LAC is increasing with increases in plant
size or output, the producer is operating above
capacity. Operating above capacity and below
capacity are inefficient methods of production.
Thus, the only efficient method of production
occurs when the producer is producing capacity
output. Capacity output is defined as the rate of
output at which the producer has no incentive to
change the plant capacity. Capacity output is
that output at whichMicro
02/18/2025 SAC I = LAC. 20
 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-shapesness
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 out put expands from a very low
levels increasing returns to scale prevails (i.e., out
put rises proportionally more than inputs), and so the
cost per-unit of out put falls(assuming that input
prices remain constant).As out put continues expand,
the forces of decreasing returns to scale eventually
begin to over take the forces of increasing returns to
scale and the LAC begins to rise.
 In other words, the per unit costs of production
decreases initially as the plant size increases, due to
the economies of scale which larger plant size makes
possible.
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 i. Economies of scale
 Economies of scale is 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 out put) the
firm will have economies of scale in costs (it
will require the firm less than double cost to
produce double out put). 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.
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 ii. Diseconomies of scale
 If the LAC increases as output expand, then we
have diseconomies of scale.
 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 in efficiencies, 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.
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 Finally, if LAC is constant, we have neither
economies nor diseconomies of 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 and
decreasing returns to scale at a later stage of
expansion.

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 The long-run marginal cost curve.

• Long run marginal 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.

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 4.6 Dynamic changes in costs: the
learning curve
 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 out put fall for four
reasons:
1. Workers often take long-run to accomplish a given
task the first few times they do it. As they become
more adept, their speed increases.

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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
out put increases. Managers can use this learning
process to help plan production and forecast
future costs.
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 Learning Curve: shows that at the firm’s
cumulative out put increases(as the firm gets
experienced),the amount of inputs(such as
labor)required to produce one unit of out put
decreases.

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 THE End

3/17/2020 MICRO-I