Chapter Four

THEORY OF COSTS OF
PRODUCTION
 Cost
-> Values/payments that made for factors of
production(imputes)
-> Monetary value of inputs used in production of items
 Two types of cost of production
• social cost and private cost.
1. Social cost
cost of producing an item to the society. It resulted
-> due to scarcity of resource
-> due to emit of dangerous chemicals , bad smells etc..
during production process
 Types of cost..
2. Private cost: refers to the cost of producing an item to the
individual producer.
 It can be measured in to two ways:
i) Economic cost & ii) Accounting Cost
I. Economic Cost
-> cost of all inputs used for the production of the item
a. explicit costs :- The actual or out- of- pocket expenditures
that the firm incurs to purchase inputs(raw materials) from
market(outside)(e.g, salary of workers hired, costs of raw
materials bought)
b. implicit costs. Producer’s his/ her own inputs which are not
purchased from the market(his own building, his managerial skill
 Types of cost….

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:
II. Accounting Cost
• Includes cost of purchased inputs only.
• is only explicit cost of production.
• Accountant’s doesn’t consider the cost of
production from the opportunity cost of the
resources point of view
 4.2 Cost functions
• Is an 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
  Short run costs

• In short run some factors of production (usually capital

equipment and management) are fixed.
• Short- run total cost(TC)
• Short –run variable cost(VC)
• Fixed cost(FC)
• Sunk costs( cost that is forever lost after it has been
paid)
 Total and Variable cost
 Total cost(TC):- minimum total cost of producing
alternative levels of out put
• TC = TFC + TVC
 Short run cost…
• Fixed costs(FC)
 Doesn’t vary with the level of out put
 Unavoidable for firms under operation
 Can only be avoidable if firm shuts down the business
(stops operation).
• Variable costs(VC)
• Directly vary with the level of output
– The cost of raw materials
– The cost of direct labor
– The running expenses of fixed capital such as fuel
• their amount depends on the level of out put. if the firm
produces zero output, the variable cost is zero.
 Short run cost…

 short run total cost(TC)

 is given by the sum of total fixed cost and total variable cost.
That is,
TC = TFC + TVC
 Total fixed cost (TFC): Total fixed cost is denoted by a straight
line parallel to the output axis. This is because such costs do not
vary with the level of output.
 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. At
the initial stage of production with a given plant(Fixed), as more of
the variable factor is employed, its productivity increases. Hence,
the TVC increases at a decreasing rate. This continues until the
optimal combination of the fixed and variable factor is reached.
 Cont…
 Beyond optimal point, as increased quantities of
the variable factor are combined with the fixed
factor, the productivity of the variable factor
declines, and the TVC increases at an increasing
rate.
Total Cost (TC) curve is obtained by vertically adding
TFC and 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. It
should be noted that when the level of output is
zero, TVC is also zero which implies that , TC = TFC.
TC & TVC Curves
 Per unit costs (average costs)

a) Average fixed cost (AFC)

AFC =
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.
AFC curve
 Cont…
b) Average variable cost (AVC)
AVC =
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.
 the process of deriving the AVC curve from the
TVC curve.
The slope of the rays decreases until Q3 and starts to
rise beyond Q3.
 Cont….

• Slope of a ray through the origin declines

continuously until the ray becomes tangent to the
TVC curve at C
• To the right of Point c the slope of the rays through
the origin starts increasing.
• Thus, 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
c) Average total cost (ATC) or simply Average cost (AC)
Cont…
 The AC curve is U-shaped because of the law of variable proportions.
Observe the figure that follows.
• From this figure (Panel A), the AC 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. That is, for example, the AC of
producing Q1 level of output is given by the
slope of the line 0a, the AC of producing Q2
level of outputs is given by the slope of the
line Ob and so on.
 Marginal Cost (MC)

• additional cost that the firm incurs to produce

one extra unit of the output
• 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:

 In fact MC is also the rate of change of TVC

with respect to the level of output
 Graphically, the MC is the slope TC curve (or
equivalently the slope of the TVC curve)
 obviously, the slope of curved lines at a given point is
measured by constructing a tangent line to the curve
at each point
 the slope of the TC or TVC curve (i.e. MC) initially
decreases, reaches its minimum and then starts to
rise. due to the law of variable proportions.
Marginal cost curve
 In summary,
 AVC, ATC and MC curves are all U-shaped due to
the law of variable proportions.
 The simplest total cost function which would
incorporate the law of variable proportions is the
cubic polynomial of the following form.
4.4 The relationship between AVC, ATC and MC
• Given ATC or simply AC = AVC + AFC, AVC is part of the ATC
• Both AVC and AC or ATC are u – shaped, reflecting the law of
variable proportions
• However, the minimum of AC or ATC occurs to the right of
the minimum point of the AVC ( see the following figure)
• Q1. Why do you think the AVC reaches its minimum point
before the minimum of AC occurs? Discuss briefly?
• The AVC curve reaches its minimum point at Q1 output and
ATC reaches its minimum point at Q2. The vertical distance
between ATC and AVC decrease continuously as out put
increases.
• The AVC approaches the ATC asymptotically as output
increases.
The MC curve passes through the minimum point of
both ATC and AVC
 Cont….

• when MC<AC, the slope of AC is negative, i.e.

AC curve is decreasing (initial stage of
production)
• When MC >AC, the slope of AC is positive, i.e.
the AC curve is increasing (after optimal
combination of fixed and variable inputs.
• 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.
 4.5 The relationship between short run per unit
production and cost curves
 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(APL).
 When AP variable input(APL) increases, AVC decreases;
when AP variable input(APL) 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(MPL) curve and the MC curve.
short run per unit p & C curves r/s cont…
cont…

•  This can be shown algebraically by using a

linear short run cost function.
 The total cost of production is then,
TC = rK+wL
 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
Cont…
 4.5 Costs in the long run
• 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.
Q2. ‘’it is possible for the firm in the long run to produce zero
units of output at zero costs. That is, it is always possible to
go out of business.’’ Discuss what does it by implies?
 The End

• Thank you