Cost Function,

Fixed and Variable Cost,

Total, Average and Marginal cost,
Short Run and Long Run Cost and
Their Relationships
 The Theory of Cost

 Aim:
we examine costs and their importance in decision making.
 Nature of costs:
Explicit - actual spending on inputs
Implicit - opportunity costs.
– Opportunity cost is foregone value.
– Reflects second-best use.

Explicit costs are cash expenses.

Implicit costs are non-cash expenses.
2
 Costs and Profits

 There is a difference between economists’

measure of profit and accountants’ measure of
profit.
 For economists, profit is the difference between
total cost and total revenue, where total cost
includes the opportunity cost of its capital - what
it must earn to induce it to keep its capital in its
present use.
3
 Profit and Loss Account for XYZ
Company For the Year Ending
31 Dec. 2011
Expenditure Income
Variable Costs Revenue from sales £1,000,000
Wages £200,000

Materials 300,000

Other 100,000

Total VC 600,000

Fixed Costs

Rent 50,000

Managerial salaries 60,000

Interest on loans 90,000

Depreciation allowance 50,000

Total FC 250,000

Total Costs 850,000

Profit 150,000
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 A Simplified Profit and loss Account

 Costs are divided between variable and

fixed.
 Total revenue minus total costs as
measured by the firm give profits in the
sense used by firms.

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 Calculation of Pure Profits

Profits as reported by the firm £150,000

Opportunity cost of capital

Pure return or risk-free return -£100,000

on the firm’s capital
Risk Premium -£40,000
Pure or economic rent £10,000

 The accounting definition of profits does not include the opportunity

cost of capital. Business (accounting) profit reflects explicit costs and
revenues
 To arrive at this figure, the opportunity cost of capital must be
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deducted from what the firm regards as its capital.
 Pure / Economic Profit

 So what firms call profit is the return to the owners’

capital. Economists deduct from this profit figure the
imputed opportunity cost of the owners’ capital and any
marketable special advantages owned by the firm to obtain
their concept of pure or economic profits.
– Economic profit.

 Profit
above a risk-adjusted normal return.
 Considers cash and non-cash items.

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 Profits and Resource Allocation

 Profits or losses play a crucial signalling role in the

workings of a free market system. There are long-term
and short-term variations in profit maximisation
because all inputs can not be changed with same level
of ease.
– Pure profits in an industry are the signal that resources can
profitably be moved into the industry.
– Losses are the signal that resources can profitably be moved
to elsewhere.
– Zero economic profit indicates no incentive either to move
8 into or out of an industry.
 Economic Profits

Economic TR – Economic Costs

Economic Cost = Explicit + Implicit costs

Economic if TR > TC)

Doing better than next best alternative.
Serves as a signal for resources.

Economic if TR < TC)

Doing worse than next best alternative.
May have positive Accounting.
Serves as a signal for resources.
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 Economic Profit versus Accounting Profit

How an Economist How an Accountant

Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs
Revenue
Total
opportunity
costs
Explicit Explicit
costs costs
 Cost functions

 Cost Functions: the lowest possible economic cost

to produce each possible output level.

 The firm’s cost functions are derived from the

optimal input combinations - the minimum cost of
producing various levels of output.

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 Cost Minimisation

 The firm will achieve its equilibrium capital-labour ratio when

there is no opportunity for cost reducing substitution.
dK w MPL
MRTS     .
dL r MPK
 Recall the optimal condition - the tangency condition –
dK/dL = -w/r
 slope of isoquant = slope of isocost line
– To produce a given level of output at least cost, a firm
should buy inputs until it has equalized the marginal
product per dollar spent on each input.
– Cost minimisation implies that a firm adjusts its input mix
until the technologically determined MRTS equals the
12 market determined price ratio for those inputs.
 Cost Minimization

K Point of Cost
Minimization

L
Slope of Isocost = Slope of Isoquant
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 Short-run and Long-run Costs

 How Is the Operating Period Defined?

– At least one input is fixed in the short run.
– All inputs are variable in the long run.
 Fixed and Variable Costs
– Fixed cost is a short-run concept.
– All costs are variable in the long run.

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 Short-Run & Long-Run cost functions

 The SR is a time period so short that the firm cannot

alter the quantity of some inputs. More specifically,
the firm’s fixed inputs - machinery and other capital
inputs.
 The LR is a time period within which a firm can
alter all of its inputs.

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 SR Costs:
Total Costs (TC)

Total cost is the lowest total expense needed to

produce at each level of output.
And TC rises as level of output rises.
Total costs (TC) consist of two categories of cost:
Total Fixed Costs (TFC);
Total variable costs (TVC);
•Total costs (TC = TFC+TVC);
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 Total fixed costs (TFC)

Total fixed costs (TFC) are costs that do not vary

with the level of output.
The level of total fixed costs is the same at all
levels of output (even when output equals zero).
These costs must be paid even if the firm
produces no output.
Examples:
• rent for office or factory, contractual
• payments for equipment,
• interest payment on debts,
• salary of stuffs etc,
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 Total variable costs (TVC)

Total variable costs (TVC) are costs that vary

with the level of output changes. Variable costs
are equal to zero when no output is produced and
increase with the level of output.
 examples :
 Labor costs,
 raw material costs. and
 energy costs.

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 Average Cost

 Average cost is the total cost divided by the

total number of units produced.

TotalCost
Average Cost 
Output

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 Average Cost

 Average total cost (ATC) is defined as:

ATC = TC / Q.
Note that ATC can also be measured as:
ATC = AVC + AFC
(since TC=TFC+TVC, TC/Q = TFC/Q + TVC/Q).

 Average Fixed Cost (AFC): It is the fixed cost divided

by the output or AFC=Fc/q

 Average Variable Cost(AVC): It is the variable cost

divided by the output or AVC=Vc/q
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 Marginal Cost
 Marginal cost (MC) denotes the extra or additional cost of
producing 1 extra unit of output.

 Say a firm is producing 110 pieces of burgers for a total

cost of Tk. 1000. If the total cost of producing 111 pieces
of burger is Tk. 1020, then the marginal cost of production
is Tk. 20 for the 111th burgers.

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 SR costs: MC

So MC is the addition to total cost resulting from

the addition of the last unit of input:
MC = TC/ Q
TC = [TFC + TVC]
However, TFC is zero in the SR, thus MC is
simply
MC = TVC/ Q
i.e., slope of the total cost curve.
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 Cost Summary

Q L VC FC TC MC AC AFC AVC
0 0 0 120 120 U U U U
1 4 40 120 160 40 160 120 40
2 7 70 120 190 30 95 60 35
3 9 90 120 210 20 70 40 30
4 10 100 120 220 10 55 30 25
5 12.5 125 120 245 25 49 24 25
6 18 180 120 300 55 50 20 30
7 28 280 120 400 100 57.14 17.14 40
8 40 400 120 520 120 65 15 50
9 54 540 120 660 140 73 12.5 60
10 70 700 120 820 160 82 12 70
24
25
 SR Costs and Law of Diminishing Returns

Shape of SR Cost Relationships is due to Law of

Diminishing Returns.

When MC is falling, MPL is rising. Likewise, MC is

rising as MPL is falling.

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 MC and MPL Graphically

MPL
Plugging L into
Q= ƒ(Kfixed ,L) gives
output. At L1, Q=Q1.
L
L1
MC Up to L1, MPL is rising,
so MC=w/MPL is falling.

Once diminishing returns

sets in, MC starts rising.
Q1 Q
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 So The Law of Diminishing Returns is the
Reason for the Shape of SR Cost Curves.

Why do LR Cost Curves have the

Shape they Do?

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 Long-run Costs

 LR: in the LR all inputs are variable, so the

firms can plan their scale of plants. So the
LR may be considered as a planning
horizon.
 LRAC shows the minimum cost per unit of
producing each output when any desired
level of plant can be built.

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 Long-Run Cost Curves

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = LTC/Q

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 The Long-Run Cost Function

 In the short run, the firm

has a fixed level of capital
equipment or plant size.
 The figure illustrates the
SRAC curves for various
plant sizes.
 Once a plant size is
chosen, per-unit production
costs are found by moving
along that particular SRAC
31
curve.
 The Long-Run Cost Function

 In the long run the firm is able to adjust

its plant size.
 LRAC tells us the lowest possible per-
unit cost when all inputs are variable.
 What is the LRAC in the graph?

32
 The Long-Run Cost Function

 The LRAC is the lower envelope

of all of the SRAC curves.

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The Envelope Long-run Average Cost Curve

 Each short-run curve shows how costs vary if

output varies, with the fixed factor held constant
at the level that is optimal for the output at the
point of tangency with LRAC.
 As a result, each SRATC curve touches the
LRAC curve at one point and lies above it at all
other points.
 This makes the LRAC curve the envelope of the
SRATC curves.
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 Long Run Average Cost Curve

 (LAC) shows the lowest average cost of producing

each level of output when the firm can build the
most appropriate plant to produce each level of
output.
– So the LAC is important for practical decision
making as it shows whether, and to what extent,
large plants have cost advantages over smaller
ones.
This is what we call, ECONOMIES OF SCALE.
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 Economies of Scale

 Economies of scale exist whenever LRAC

declines as output is increased.
– When we are operating under IRS, output is going up
faster than inputs.
 Diseconomies of scale exist whenever LRACs rise
as output is increased.
– When we are operating under DRS, output is going
up slower than inputs.

36
 The Long-Run Cost Function

 Reasons for Economies of Scale

• Economies in maintaining inventory of
replacement parts and maintenance personnel
• Discounts from bulk purchases
• Lower cost of raising capital funds
• Spreading promotional and R&D costs
• Management efficiencies

37
 The Long-Run Cost Function

 Reasons for Diseconomies of Scale

• Decreasing returns to scale
• Disproportionate rise in transportation costs
• Input market imperfections
• Management coordination and control
problems
•Disproportionate rise in staff and indirect
labor
38
39
40
 Scale Economies and LRAC

Scale Economies can also be defined in terms of a LRAC

curve. LRAC=LRTC/Q

$ CRS LRAC

IRS DRS

MES
QMES Q

41
 Possible Shapes of
the LAC Curve

42
 Economies of Scale: LRAC - U

 LRACs can take  LRAC -U

different shapes
LRAC
 U-shape: ES prevail at
small levels of output
 and diseconomies of
scale (cost increases - Economies Diseconomies
of scale of scale
decreasing returns)
prevail at larger levels
Q*
of output.
43
 Economies of Scale: LRAC - L

 L-shaped (more  LRAC -L

realistic): implies that
economies of scale are
rather quickly
exhausted and constant
or near constant RS
prevail for a long
period of time. Q
– So small firms coexist
44
with large firms.
 ES LRAC : Downward Sloping

 There are some industries  Examples:Natural

where the LAC curve monopolies, public
declines continuously as transport, electricity.
the firm expands output,
to the point where a LRAC
single firm could satisfy
the total market for the
product or service more
efficiently than two or
more firms Q
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 SUMMARY

 ‘Explicit costs’ refer to the actual

expenditure of the firm required to
purchase or hire inputs.
 ‘Implicit costs’ (opportunity costs) refer to
the value (imputed from their best
alternative use) of the inputs owned and
used by the firm. In managerial decisions
both explicit and implicit costs must be
considered.
46
 SUMMARY

In the SR we have fixed and variable costs. Total

costs equal total fixed costs plus total variable costs. In
the LR all inputs are variable.
LR AVC curve is based on the assumption that
economies of scale prevail at small levels of output and
diseconomies of scale prevail at larger levels of output.
 The firm can use cost-volume-profit or breakeven
analysis to determine the output and sales levels at
which the firm breaks even or earns a desired target
profit.
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