MICROECONOMICS

ECO162
CHAPTER 6
THEORY OF COST
 LEARNING OUTCOMES

At the end of the chapter, you should be able to:

 Describe short-run production.
 Define the law of increasing and diminishing marginal returns.
 Differentiate the stages of production.

Explainthe concept of short-run costs.

Discuss long-run average costs.
Discuss economies and diseconomies of scale.
 COST OF PRODUCTION
 COSTs - refer to the money expenses incurred by a firm in the
production process of a commodity (goods/service).

 Money costs
include wages and salaries of labour; cost of raw materials;
expenditures on machines and equipment; depreciation and
obsolescence charges on machines; buildings and other capital goods;
rent on buildings; interest on capital borrowed; expenses on power,
light, fuel, advertisement and transportation; insurance charges, and
all types of taxes.
ie: payments for the use of factors of production (land, labour,
capital, entreprenuership)
 COST OF PRODUCTION
(Recall..in Production)
SHORT RUN

A production period in which at least one

of the input is fixed*.

LONG RUN

A production period in which all the

inputs are variable**.
* A fixed input is an input which the quantity does not change according to the amount of
output. E.g. machinery
** A variable input is an input which the quantity varies according to the amount of output.
E.g. labour
 SHORT RUN COST

TOTAL COSTS CONCEPT

TOTAL FIXED COST (TFC)
TOTAL VARIABLE COST (TVC)
TOTAL COST (TC)
 SHORT-RUN COSTs
Type of Cost Definition Example (s)
Fixed Cost  Those expenses of production which do not change with the change Rent and interest
in output. (The cost of inputs that are independent of output.) payments,
 Fixed costs have to be incurred by the firm, even if it stops production depreciation
temporarily. Since these costs are over and above the usual expenses charges, wages and
of production, they are described as overhead costs in business salaries of the
parlance. permanent staff,
 Marshall called these fixed costs as supplementary costs of etc.
production.
Variable Cost  Those expenses of production which change with the change in the Labour, raw
firm’s output. materials, power;
 Larger output requires larger inputs (variable inputs) which increase fuel, etc.
the expenses of production. When output is reduced, variable costs
also diminish. They cease when production stops altogether.
 Marshall called these variable costs as prime costs of production.

Total Cost  The sum of cost of all inputs used to produce goods and services.
 ie: Total cost is total fixed cost (TFC) plus total variable cost (TVC).
 SHORT RUN COST

AVERAGE & MARGINAL COSTS CONCEPT

AVERAGE FIXED COST (AFC)
AVERAGE VARIABLE COST (AVC)
AVERAGE TOTAL COST (ATC @ AC)
MARGINAL COST (MC)
 SHORT-RUN COSTs
Concept Definition Formula
AFC  AFC is the fixed cost per unit of output. AFC = TFC ÷ Qty
 AFC is obtained when total fixed cost (TFC)
divided by total output.
AVC  AVC is the variable cost per unit of output. AVC = TVC ÷ Qty
 AVC is obtained when total variable cost (TVC)
divided by total output.
ATC  ATC is the total cost per unit of output. ATC = TC ÷ Qty
(AC)  ATC is obtained when total cost (TC) divided by ATC = AFC + AVC
total output.
MC  MC is the change in total cost that results from MC = ∆ TC ÷ ∆ Qty
a change in output; MC is an addition to the
total cost to produce another unit of output. MC = TC2 – TC1 ÷ Q2 – Q1
 Total costs Average costs

(1) (2) (3) (4) (5) (6) (7) (8)

Quantity Total Total Total Average Average Average Marginal
(Q) fixed variable cost fixed cost variable total cost cost (MC)
cost cost (TC) (AFC) cost (AVC) (ATC)
(TFC) (TVC) TC=TFC AFC = AVC = ATC = MC =
+TVC TFC/Q TVC/Q TC/Q TC/Q

(2)+(3) (2)/(1) (3)/ (1) (4)/(1) or (4) /(1)

(5)+(6)

0 20 0 20 - - - -

1 20 15 35 20 15 35 15

2 20 25 45 10 12.50 22.50 10

3 20 30 50 6.67 10 16.67 5

4 20 35 55 5 8.75 13.75 5

5 20 45 65 4 9 13 10
Exercise 1
 SHORT-RUN COSTs CURVE
Cost Explanation on Behaviour of Curve Shape

TOTAL COSTS TFC TFC remains constant with respect to change in the level of
output, even if the level of output is zero.
A straight line
parallel to the
horizontal axis
(x-axis).
TVC  TVC curve changes with the change in the level of output. An inverted-S
 When production level is zero, TVC is also zero. Thus, the shape.
TVC curve begins from the origin.
 Initially, it increases at a decreasing rate and then
increases at an increasing rate. It is affected by the law of
diminishing returns.

TC  TC also changes with the changes in the level of output. An inverted-S

 Initially, it increases at a decreasing rate and then shaped.
increases at an increasing rate due to the law of
diminishing returns.
 Since TC = TFC + TVC ,
 thus, the TC curve is the same shape as TVC but begins
from the point of TFC rather than the origin (TC will NOT
start from zero as TFC is incurred).
 the difference between the TC and TVC curve is the same
at each level of output and equals TFC.
 SHORT-RUN COST CURVES (cont.)

AVERAGE & MARGINAL COSTS  AFC curve is slopping downward (declining with
increasing output).
 AVC curve is U-shaped.
 AC curve is U-shaped. AC being the sum of
AFC and AVC, AC curve lies above both the
AFC and AVC curves. AVC and AC get closer as
output rises since AFC continuously declines as
output rises.
 MC curve is U-shaped. MC equals both AVC
and AC at their minimum points. Further, MC lies
below both AVC and AC over the range in which
these curves fall; and it lies above them when
they are rising.
•
Source : https://www.kullabs.com/class-12/economics-1/market,-revenue-and-cost-
curves/fixed-variable-cost-and-short-long-run-cost
RELATIONSHIPS BETWEEN MC WITH
AVC & ATC

Source: http://amir-economy.blogspot.com/2012_03_01_archive.html
 COST CURVES IN THE LONG RUN
 Long run is a period where there are only variable factors and no fixed cost
involved.
 In the long run, the factors of production may be utilised in changing
proportions to produce a higher level of output. In such a case, the firm may
not only hire more workers, but also expand its plant size, or set up a new
plant to produce the desired output.

Long Run TOTAL COST (LRTC)

 LRTC curve starts from origin because of the absence of total fixed cost. Source: https://www.geektonight.com/long-run-cost/

 The shape of the LRTC curve is S-shaped. For relatively small quantities of
output, the slope begins to flatten. Then, for larger quantities the slope
makes a turn-around and becomes steeper. That is , LRTC will initially increase
at a decreasing rate and then at an increasing rate.
 Long-run total cost is guided by scale economies and returns to scale.
 The flattening portion of this long-run total cost curve is attributable to
economies of scale or increasing returns to scale. The steepening portion is
then largely due to diseconomies of scale or decreasing returns to scale.
 COST CURVES IN THE LONG RUN

Long Run AVERAGE COST (LRAC)

LRAC refers to per unit cost incurred by a firm in the
production of a desired level of output when all the
inputs are variable. (LRAC = LRTC ÷ Qty)
LRAC curve shows the minimum cost of producing any
given output when all of the inputs are variable. Long run
is a period where firms plan how to minimize average Source: https://www.chegg.com/flashcards/final-study-guide-
review-4f5a9d88-d502-47d0-a043-d59af69cd915/deck
cost
The shape of the LRAC curve is U-shape. The negative Economies of Scale : ATC falls as Qty increases.
slope of the LRAC curve depicts economies of scale and Constant returns to scale : ATC stays constant
as Qty increases.
increasing returns to scale. On the other hand, the Diseconomies of scale : ATC rises as Qty
positive slope of the LRAC curve represents increases.
diseconomies of scale or decreasing returns to scale.
 LONG RUN COST (cont.)

ECONOMIES OF SCALE
Advantages and benefits of a firm as it becomes larger and larger.
Reduce long run average cost (LRAC).
Marketing economies, financial economies, labour economies, technical
economies, managerial economics.

DISECONOMIES OF SCALE
Problems faced by a firm as it becomes larger and larger.
Decrease long run average cost (LRAC).
Mismanagement, competition, labour diseconomies.
 ECONOMIES OF SCALE
Economies of scale are benefits and advantages of a firm
as it expands its production.
• Reduce the average cost.
INTERNAL
Internal economies happen inside an EXTERNAL
organization Advantages of the industry as a whole

Labour Economies

Managerial Economies Economies of Government Action

Marketing Economies
Economies of Concentration
Technical Economies

Financial Economies
Economies of Information

Risk Bearing Economies

Economies of Marketing
Transport and Storage
Economies
 DISECONOMIES OF SCALE
Diseconomies of scale are problems and disadvantages
faced by a firm when it expands production.
• Increase the average cost.

INTERNAL EXTERNAL
Raise the cost of production of a firm as The disadvantages faced by the industry
the firm expands as a whole

Labour Diseconomies Scarcity of Raw Material

Management Problem Wage Differential

Technical Difficulties
Concentration Problem

19
 DERIVATION OF LRATC CURVE

LRAC curve are derived by a series of short run average cost curves

COST
SRAC1
SRAC5

SRAC2 SRAC4 LRAC

SRAC3

Tangential point of the SAC are joined

And made up the LRAC.
QUANTITY