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The Traditional Theory

of Costs (With Diagram)
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Traditional theory distinguishes between the short

run and the long run. The short run is the period
during which some factors) is fixed; usually capital
equipment and entrepreneurship are considered as
fixed in the short run.

The long run is the period over which all factors

become variable.

A. Short-Run Costs of the Traditional Theory:

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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

The fixed costs include:

(a) Salaries of administrative staff

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(b) Depreciation (wear and tear) of machinery

(c) Expenses for building depreciation and repairs

(d) Expenses for land maintenance and depreciation

(if any).
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Another element that may be treated in the same way
as fixed costs is the normal profit, which is a lump
sum including a percentage return on fixed capital
and allowance for risk.

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The variable costs include:

(a) The raw materials

(b) The cost of direct labour

(c) The running expenses of fixed capital, such as

fuel, ordinary repairs and routine maintenance.

The total fixed cost is graphically denoted by a

straight line parallel to the output axis (figure 4.1).
The total variable cost in the traditional theory of the
firm has broadly an inverse-S shape (figure 4.2)
which reflects the law of variable proportions.
According to this law, at the initial stages of
production with a given plant, as more of the variable
factors) is employed, its productivity increases and
the average variable cost falls.

This continues until the optimal combination of the

fixed and variable factors is reached. Beyond this
point as increased quantities of the variable factors(s)
are combined with the fixed factors) the productivity
of the variable factors) declines (and the A VC rises).
By adding the TFC and TVC we obtain the TC of the
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firm (figure 4.3). From the total-cost curves we
obtain average-cost curves.

The average fixed cost is found by dividing

TFC by the level of output:

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AFC = TFC / X

Graphically the AFC is a rectangular hyperbola,

showing at all its points the same magnitude, that is,
the level of TFC (figure 4.4).

The average variable cost is similarly

obtained by dividing the TVC with the
corresponding level of output:

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AVC = TVC / X

Graphically the A VC 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. For example, in figure 4.5
the AVC at X1 is the slope of the ray 0a, the A VC at
X2 is the slope of the ray Ob, and so on. It is clear
from figure 4.5 that the slope of a ray through the Privacy - Terms
origin declines continuously until the ray becomes
tangent to the TVC curve at c. To the right of this
point the slope of rays through the origin starts
increasing. Thus the SA VC curve falls initially as the
productivity of the variable factors) increases,
reaches a minimum when the plant is operated
optimally (with the optimal combination of fixed and
variable factors), and rises beyond that point (figure
4.6).

The ATC is obtained by dividing the TC by the

corresponding level of output:

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ATC = TC / X = TFC + TVC / X = AFC + AVC

Graphically the ATC curve is derived in the same way

as the SAVC. The ATC at any level of output is the
slope of the straight line from the origin to the point
on the TC curve corresponding to that particular level
of output (figure 4.7). The shape of the A TC is similar
to that of the AVC (both being U-shaped). Initially
the ATC declines, it reaches a minimum at the level of
optimal operation of the plant (XM) and subsequently
rises again (figure 4.8).

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The U shape of both the AVC and the ATC reflects the
law of variable proportions or law of eventually
decreasing returns to the variable factor(s) of
production. The marginal cost is defined as the
change in TC which results from a unit change in
output. Mathematically the marginal cost is the first
derivative of the TC function. Denoting total cost by C
and output by X we have

MC = ∂C / ∂X

Graphically the MC is the slope of the TC curve

(which of course is the same at any point as the slope
of the TVC). The slope of a curve at any one of its
points is the slope of the tangent at that point. With
an inverse-S shape of the TC (and TVC) the MC curve
will be U-shaped. In figure 4.9 we observe that the
slope of the tangent to the total-cost curve declines
gradually, until it becomes parallel to the X-axis (with
its slope being equal to zero at this point), and then
starts rising. Accordingly we picture the MC curve in
figure 4.10 as U-shaped.

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In summary: the traditional theory of costs postulates
that in the short run the cost curves (AVC, ATC and
MC) is U-shaped, reflecting the law of variable
proportions. In the short run with a fixed plant there
is a phase of increasing productivity (falling unit
costs) and a phase of decreasing productivity
(increasing unit costs) of the variable factor(s).

Between these two phases of plant operation there is

a single point at which unit costs are at a minimum.
When this point on the SATC is reached the plant is
utilized optimally, that is, with the optimal
combination (proportions) of fixed and variable
factors.

The relationship between ATC and AVC:

The AVC is a part of the ATC, given ATC = AFC +

AVC. Both AVC and ATC are U-shaped, reflecting the
law of variable proportions. However, the minimum
point of the ATC occurs to the right of the minimum
point of the AVC (figure 4.11). This is due to the fact
that ATC includes AFC, and the latter falls
continuously with increases in output.

After the AVC has reached its lowest point and starts
rising, its rise is over a certain range offset by the fall
in the AFC, so that the ATC continues to fall (over
that range) despite the increase in AVC. However, the
rise in AVC eventually becomes greater than the fall
in the AFC so that the A TC starts increasing. The A Privacy - Terms
VC approaches the A TC asymptotically as X
increases.

In figure 4.11 the minimum AVC is reached at X1

while the ATC is at its minimum at X2. Between X1
and X2 the fall in AFC more than offsets the rise in
AVC so that the ATC continues to fall. Beyond X2 the
increase in AVC is not offset by the fall in AFC, so
that ATC rises.

The relationship between MC and ATC:

The MC cuts the ATC and the AVC at their lowest

points. We will establish this relation only for the
ATC and MC, but the relation between MC and AVC
can be established on the same lines of reasoning.

We said that the MC is the change in the TC for

producing an extra unit of output. Assume that we
start from a level of n units of output. If we increase
the output by one unit the MC is the change in total
cost resulting from the production of the (n + l)th
unit.

The AC at each level of output is found by dividing TC

by X. Thus the AC at the level of Xn is

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Thus:

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(a) If the MC of the (n + 1)th unit is less than ACn (the

AC of the previous n units) the AC n+1 will be smaller
than the ACn.

(b) If the MC of the (n + 1)th unit is higher than ACn

(the AC of the previous n units) the ACn+1 will be
higher than the ACn.

So long as the MC lies below the AC curve, it pulls the

latter downwards; when the MC rises above the AC, it
pulls the latter upwards. In figure 4.11 to the left of a
the MC lies below the AC curve, and hence the latter
falls downwards. To the right of a the MC curve lie
above the AC curve, so that AC rises. It follows that at
point a, where the inter­section of the MC and AC
occurs, the AC has reached its minimum level.

B. Long-Run Costs of the Traditional Theory:

The ‘Envelope’ Curve:

In the long run all factors are assumed to become

variable. We said that 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 output. The long-run average-cost
curve is derived from short-run cost curves. Each
point on the LAC corresponds to a point on a short-
run cost curve, which is tangent to the LAC at that
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point. Let us examine in detail how the LAC is
derived from the SRC curves.

Assume, as a first approximation, 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 small plant operates with costs
denoted by the curve SAC1, the medium-size plant
operates with the costs on SAC2 and the large-size
plant gives rise to the costs shown on SAC3 (figure
4.12). If the firm plans to produce output X3 it will
choose the small plant. If it plans to produce X2 it will
choose the medium plant. If it wishes to produce X1 it
will choose the large- size plant.

If the firm starts with the small plant and its demand
gradually increases, it will produce at lower costs (up
to level X’1). Beyond that point costs start increasing.
If its demand reaches the level X”1 the firm can either
continue to produce with the small plant or it can
install the medium-size plant. The decision at this
point 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 X”1
it will install the medium plant, because with this
plant outputs larger than X’1 are produced with a
lower cost.

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Similar con­siderations hold for the decision of the
firm when it reaches the level X”2. If it expects its
demand to stay constant at this level, the firm will not
install the large plant, given that it involves a larger
investment which is profitable only if demand
expands beyond X”2. For example, the level of output
X3 is produced at a cost c3 with the large plant, while
it costs c’2 if produced with the medium-size plant
(c’2 > c3).

Now if we relax the assumption of the existence of

only three plants and assume that the available
technology includes many plant sizes, each suitable
for a certain level of output, the points of intersection
of consecutive plants (which are the crucial points for
the decision of whether to switch to a larger plant)
are more numerous. In the limit, if we assume that
there is a very large number (infinite number) of
plants, we obtain a continuous curve, which is the
planning LAC curve of the firm.

Each point of this curve shows the minimum

(optimal) cost for producing the corresponding level
of output. The LAC curve is the locus of points
denoting the least cost of producing the
corresponding output. It is a planning curve because
on the basis of this curve the firm decides what plant
to set up in order to produce optimally (at minimum
cost) the expected level of output.

The firm chooses the short-run plant which allows it

to produce the anticipated (in the long run) output at
the least possible cost. In the traditional theory of the
firm the LAC curve is U-shaped and it is often called
the ‘envelope curve’ because it ‘en­velopes’ the SRC
curves (figure 4.13).

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Let us examine the U shape of the LAC. This shape
reflects the laws of returns to scale. According to
these laws the unit costs of production decrease as
plant size increases, due to the economies of scale
which the larger plant sizes make possible. The
traditional theory of the firm assumes that economies
of scale exist only up to a certain size of plant, which
is known as the optimum plant size, because with this
plant size all possible economies of scale are fully
exploited.

If the plant increases further than this optimum size

there are diseconomies of scale, arising from
managerial inefficiencies. It is argued that
management becomes highly complex, managers are
overworked and the decision-making process
becomes less efficient. The turning-up of the LAC
curve is due to managerial diseconomies of scale,
since the technical diseconomies can be avoided by
duplicating the optimum technical plant size.

A serious implicit assumption of the traditional U-

shaped cost curves is that each plant size is designed
to produce optimally a single level of output (e.g.
1000 units of X). Any departure from that X, no
matter how small (e.g. an increase by 1 unit of X)
leads to increased costs. The plant is completely
inflexible. There is no reserve capacity, not even to
meet seasonal variations in demand.
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As a consequence of this assumption the LAC curve
‘envelopes’ the SRAC. Each point of the LAC is a
point of tangency with the corresponding SRAC
curve. The point of tangency occurs to the falling part
of the SRAC curves for points lying to the left of the
minimum point of the LAC since the slope of the LAC
is negative up to M (figure 4.13) the slope of the
SRMC curves must also be negative, since at the point
of their tangency the two curves have the same slope.

The point of tangency for outputs larger than XM

occurs to the rising part of the SRAC curves since the
LAC rises, the SAC must rise at the point of their
tangency with the LAC. Only at the minimum point
M of the LAC is the corresponding SAC also at a
minimum. Thus at the falling part of the LAC the
plants are not worked to full capacity; to the rising
part of the LAC the plants are overworked; only at the
minimum point M is the (short-run) plant optimally
employed.

We stress once more the optimality implied by the

LAC planning curve each point represents the least
unit-cost for producing the corresponding level of
output. Any point above the LAC is inefficient in that
it shows a higher cost for producing the correspon­-
ding level of output. Any point below the LAC is
economically desirable because it implies a lower
unit-cost, but it is not attainable in the current state
of technology and with the prevailing market prices
of factors of production. (Recall that each cost curve
is drawn under a ceteris paribus clause, which
implies given state of technology and given factor
prices.)

The long-run marginal cost is derived from the SRMC

curves, but does not ‘en­velope’ them. The LRMC is
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formed from points of intersection of the SRMC
curves with vertical lines (to the X-axis) drawn from
the points of tangency of the corresponding SAC
curves and the LRA cost curve (figure 4.14). The LMC
must be equal to the SMC for the output at which the
corresponding SAC is tangent to the LAC. For levels
of X to the left of tangency a the SAC > LAC.

At the point of tangency SAC = LAC. As we move

from point a’ to a, we actually move from a position
of inequality of SRAC and LRAC to a position of
equality. Hence the change in total cost (i.e. the MC)
must be smaller for the short-run curve than for the
long-run curve. Thus LMC > SMC to the left of a. For
an increase in output beyond X, (e.g. X’1) the SAC >
LAC. That is, we move from the position a of equality
of the two costs to the position b where SAC is greater
than LAC. Hence the addition to total cost (= MC)
must be larger for the short-run curve than for the
long-run curve. Thus LMC < SMC to the right of a.

Since to the left of a, LMC > SMC, and to the right of

a, LMC < SMC, it follows that at a, LMC – SMC. If we
draw a vertical line from a to the X-axis the point at
which it intersects the SMC (point A for SAC1) is a
point of the LMC.

If we repeat this procedure for all points of tangency

of SRAC and LAC curves to the left of the minimum
point of the LAC, we obtain points of the section of
the LMC which lies below the LAC. At the minimum Privacy - Terms
point M the LMC intersects the LAC. To the right of
M the LMC lies above the LAC curve. At point M we
have

SACM = SMCM = LAC = LMC

There are various mathematical forms which give rise

to U-shaped unit cost curves. The simplest total cost
function which would incorporate the law of variable
pro­portions is the cubic polynomial

The TC curve is roughly S-shaped , while the ATC, the

AVC and the MC are all U-shaped; the MC curve
intersects the other two curves at their minimum
points (figure 4.11).

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