Scribd
Upload
61 views21 pages

Theory of Cost: Sonu Chowdhury

This document discusses the theory of cost. It explains that firms aim to maximize profits by minimizing costs for a given level of output. There are fixed and variable costs in the short-run. Fixed costs do not vary with output, while variable costs do. Total cost is the sum of total fixed and total variable costs. Marginal cost is the change in total cost from an additional unit of output. Average cost is total cost divided by units of output. In the long-run, all factors are variable and firms can adjust plant size and output level.

Uploaded by

zahra naheed
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
61 views21 pages

Theory of Cost: Sonu Chowdhury

This document discusses the theory of cost. It explains that firms aim to maximize profits by minimizing costs for a given level of output. There are fixed and variable costs in the short-run. Fixed costs do not vary with output, while variable costs do. Total cost is the sum of total fixed and total variable costs. Marginal cost is the change in total cost from an additional unit of output. Average cost is total cost divided by units of output. In the long-run, all factors are variable and firms can adjust plant size and output level.

Uploaded by

zahra naheed
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 21

THEORY OF COST

SONU CHOWDHURY
CHAPTER OUTLINE

 Rationale behind theory of cost


 Cost meaning
 Short run and Long run cost
INTRODUCTION

 Firm’s objective is to maximize profit for a given production

technology. (Assumption)

 How a firm will determine its profit-maximizing combination of

output by minimizing costs for this given level of output?

 Profit maximizing requires deciding

 How much output to produce

 How much of various inputs to use in producing this output


 Constraints on maximizing profit are
 Technological relationship between output and inputs (characterized by a
production function)
 Prices of inputs

 Prices of outputs

 Determining profit-maximizing combination of inputs and outputs may be decomposed


into two parts
 Firm will minimize cost for a given level of output

 Firm will determine its profit-maximizing output

 To determine profit-maximizing equilibrium, will first consider how to produce a given


level of output at least possible cost
 Minimizing cost for a given level of output is a necessary condition for profit
maximization
 Cost theory is related to production theory, they are often used

together. However, the question is usually how much to produce,


as opposed to which inputs to use.

 That is, assume that we use production theory to choose the

optimal ratio of inputs (eg. 2 fewer engineers than technicians),

 How much should we produce in order to minimize costs and/or

maximize profits?
MEANING OF COST

Cost means the amount of expenditure (actual or estimated)

which is to be incurred for obtaining any particular

commodity or advantage or facility.


 Economists are concerned with economic profit and hence

economic costs.

 Economic costs include both explicit costs and implicit costs.

 Explicit costs are costs that involve monetary payments such as

the costs of materials and labour.

 Implicit costs are costs that do not involve monetary payments

such as the costs of the owner’s labour and financial capital.


 An increase in output will require an increase in the

quantity of factor inputs which will lead to an increase in


costs.

 The theory of cost is the study of how the cost of

production changes as the output level changes.


SHORT-RUN THEORY OF COST

 Distinction between fixed costs and variable costs

 Fixed costs are costs that do not vary with the output level as they

are associated with fixed factor inputs

 Fixed costs will still be incurred even if the firm shuts down

production. Examples of fixed costs are interest payments on


loans for the purchase of capital goods (factories and machinery),
insurance premiums and rent.
 Variable costs are costs that vary directly with the output level as
they are associated with variable factor inputs. In other words, an
increase in the output level will lead to an increase in variable
costs
 Variable costs will not be incurred if the firm shuts down
production
 Examples of variable costs are the costs of materials and direct
labour.
Total cost

 Total cost (TC) is the cost of

all the factor inputs needed to


produce an amount of output.

 In the short run, total cost is

the sum of total fixed cost


(TFC) and total variable cost
(TVC) and is positively related
to the output level.
Marginal cost

 Marginal cost (MC) is the


additional cost resulting
from producing one more
unit of output.

 Marginal cost = change in


total cost / change in
output
Average cost

 Average cost (AC) is the


cost per unit of output.
 Mathematically,
 AC = Total
Cost/Quantity.
Marginal Cost and Average Cost
Total cost, Marginal Cost, Variable Cost
Optimum capacity

 If a firm produces the output level that corresponds


to the lowest point on the average cost curve, it is
producing at optimum capacity.
LONG-RUN THEORY OF COST

 In the long run all factors of production become


variable.
 the entrepreneur has number of choices to change
the plant size and level of output.
 the long run cost curve is also known as planning
curve.
 the long run average cost curves is derived from
short run average cost curves.
Characteristics:

 Also called envelope curve


 No portion of LAC can lie above any portion of SAC.
 If the plant size is increased further than the
optimum size, there will be diseconomies of scale
and cause LAC to move upwards.
Complete the short run cost schedule of a
hypothetical firm.

TFC TVC TC MC AFC AVC ATC


Output
1 50 25

15
2
3 20

4 135

5 35
End of The Topic

You might also like