CHAPTER FOUR

Cost of Production
Cost is the monetary value of inputs used in production of an item.

Social cost: is the cost of producing an item to the society. This cost is realized due to the fact
that most resources used for production purpose are scarce and some production process, by
their nature, emit dangerous chemicals, bad smell, etc to surrounding society.

Private cost: refers to the cost of producing an item to the individual producer. It is the cost
that the beer factory incurs to produce the beer.

Private cost of production can be measured in two ways:

Economic cost vs. accounting cost

Economic cost: includes the cost of all inputs used for the production of the item. The producer
may buy part of the inputs from the market which are called explicit costs. The producer can
also use his/her own inputs which are not purchased from the market for the production
purpose which are called implicit costs.

Accounting cost: actual expenses plus depreciation charges for capital equipment. Economic
cost: cost to a firm for utilizing economic resources in production including opportunity cost.

Actual cost and Opportunity cost

Actual costs are expenditures which are actually incurred by the firm. Opportunity cost is the
loss of income due to opportunity forgone. It is also called alternative or economic cost.

Explicit and implicit costs

Explicit costs are those which fall under the actual costs entered in the books of accounts. It
involves cash payment and is clearly reflected by the usual accounting practices. Implicit costs

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are similar to opportunity cost. It does not take the form of cash outlays, nor does it appear in
the accounting system.

Sunk cost

A sunk cost is an expenditure that has been made and cannot be recovered. A sunk cost is
usually visible, but after it has been incurred, it should always be ignored when making future
economic decisions. Expenditure on inputs which have no alternative uses = no opportunity
cost. These costs are excluded because they are not important in decision making. Since they
have no opportunity cost, cannot be regarded as a cost from the point of view of economists.

Fixed cost and variable cost

Fixed cost (FC): a cost that does not vary with the level of output.
Total fixed cost is the same both at zero level of output and all other levels of output.
e.g. building

Variable cost (VC): a cost that varies as output varies.

Fixed cost does not vary with level of output. It must be paid even if there is no output. The
only way that the firm can eliminate its fixed cost is by going out of business.

Normal Profit Vs Economic Profit (Pure Profit)

Suppose you are earning 22,000 birr a year as a sale representative for a T-shirt manufacturing.
At some point you decided to open a retail store to sell T-shirts on your own. You must invest
20,000 birr of your saving that has been earning an interest of 1000 birr per year. And you
decided to pay 18,000 birr for a clerk.
A year after you open the store, you total up your account and find the following.
Total sales revenue -------------------120,000
Cost of T-shirt --------------------- 40,000
Clerk’s salary --------------------- 18,000
Utilities --------------------------- 5,000
Total (explicit) cost ---------------- 63,000
Accounting profit ------------------ 57,000

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Question: Calculate the economic profit assuming that your entrepreneurial talent is worth 5,000
birr.
The 5,000 birr is implicit cost of your entrepreneurial talent in the above example, called a
normal profit. The payment you could otherwise receive for performing entrepreneurial function
is called a normal profit and is an implicit cost. To the accountant, profit is the firm’s total
revenue less its explicit costs.
To the economist, economic profit is total revenue less economic costs including the normal
profit. If a firm’s total revenue exceeds all its economic costs, any residual goes to the
entrepreneur. The residual is called economic profit or pure profit.

Cost functions

Cost function shows the 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

Graphically, cost functions can be illustrated by using a two- dimension diagrams. To do so, first
we observe the relationship between the total cost of production and the level of output (the
most factor determining the cost of production), by assuming that all other factors are
constant. Then, the impact of change in “other factors” such as technology on the cost of
production will be handled by shifting the total cost curves upward or down- ward.

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Short run vs. long run costs

Economics theory distinguishes between short run costs and long run costs. Short run costs are
the costs over a period during which some factors of production (usually capital equipments
and management) are fixed. The long- run costs are the cost over a period long enough to
permit the change of all factor of production.

Short run costs of the traditional theory

In the traditional theory of the firm, total costs are split into two groups: total fixed costs and
total variable costs:

TC = TFC + TVC

Where – TC is short run total cost

TFC is short run total fixed cost

TVC is short run total variable cost

By fixed costs, we mean a cost which doesn’t vary with the level of out put. The fixed costs
include:

a. Salaries of administrative staff

b. Expenses for building depreciation and repairs
c. Expenses for land maintenance
d. The rent of building used for production , etc
All the above costs are regarded as fixed costs because whether the firm produces much output
or zero output, these costs are unavoidable, and the firm can avoid fixed costs only if he / she
shuts down the business stops operation.

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Variable costs, on the other hand, include all costs which directly vary with the level of output.
The variable costs include:

a. The cost of raw materials

b. The cost of direct labor
c. The running expenses of fixed capital such as fuel, electricity power, etc.
All these costs are regarded as variable costs because their amount depends on the level of
output. For example, if the firm produces zero output, the variable cost is zero.

Graphical presentation of short run costs.

Total fixed cost (TFC)

Graphically, TFC is denoted by a straight line parallel to the output axis. It is the sum of all fixed
costs.

$100 TFC

Total variable cost (TVC)

It is the sum of those costs which vary directly with the level of output. The total variable cost
of a firm has an inverse s- shape. The shape indicates the law of variable proportions in
production. According to this law, at the initial stage of production with a given plant, as more
of the variable factor (s) is employed, its productivity increases. Hence, the TVC increases at a
decreasing rate. 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

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the fixed factor (s) the productivity of the variable factor(s) declined, and the TVC increases by
an increasing rate. Thus, the TVC has an inverse s-shape due to the law of diminishing marginal
returns. They are also called direct costs. This cost is zero when output is zero. It increases at a
decreasing rate initially and at an increasing rate later reflecting the law of diminishing return.

Graphically, the TVC looks the following.

TVC

X
Total Cost (TC)

The total cost curve is obtained by vertically adding the TFC and the TVC i.e., by adding the TFC
and the 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. But the TC curve doesn’t start from the origin as
that of the TVC curve. The TC curve starts from the point where the TFC curve intersects the
cost axis.
TC
C

TVC

TFC

Q
Per unit costs (average costs)
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From total costs we can derive per-unit costs. These are even more important in the short run
analysis of the firm. Average fixed cost (AFC) - is found by dividing the TFC by the level of
output.

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

Average variable cost (AVC)

The AVC is similarly obtained by dividing the TVC with the corresponding level of output.

TVC
AVC=
X

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 following graph clearly shows the process of deriving the AVC curve from the TVC curve.

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 C

AVC

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. Had the TVC not been inverse S-shaped, the SAVC would never assume a U-shape.

Generally, at initial stage of production, the productivity of each additional unit a variable input
increases, thus, the variable input requires to produce each successive units of output
decreases at this stage, implying that the AVC (Variable Cost Incurred to produce a unit of
output) decreases. This process continues until the point of optimal combination between the
fixed input and the variable input is reached. Beyond this point, the productivity of each
additional unit of the variable combined with the existing fixed input decreases because the
fixed input is over utilized. As the productivity of such variables decreases, more and more of
the variables are required to produce successive units of the output, implying that the VC
incurred to produce each successive unit (AVC) increases.

Average total cost (ATC) or simply, Average cost (AC)

ATC (or AC, now on) is obtained by dividing the TC by the corresponding level of output. It
shows the amount of cost incurred to produce each unit of successive outputs.

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 TC TVC+TFC
AC= AC=
Q Or equivalently, Q

TVC TFC
= +
Q Q

= AVC + AFC

Thus, AC can also be given as the vertical sum of AVC and AFC.

Graphically, AC curve can be obtained by vertically adding the AVC and AFC for each level of
successive outputs. Alternatively, the AC curve can also be derived in the same way as the SAVC
curve. The AC curve is U-shaped because of the law of variable proportions.

SAC

Q
Marginal Cost (MC)

The marginal cost is defined as the additional cost that the firm incurs to produce one extra unit
of the output. One thing to be noted here is that, the additional cost that the firm incurs to
produce the 10th unit of output is not equal to the additional cost of producing the 1000 th unit.
They would be equal if the TC curve is straight line.

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To sum up, the MC 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:

dTC
MC=
dQ

In fact MC is also the rate of change of TVC with respect to the level of output.

dTFC+dTVC dTVC dTFC

MC= = =0
dQ dQ , since dQ

Graphically, the MC the 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. So, the slope of the curve at a given point is equal to the slope of the tangent line at
that specific point. Given the inverse S-shaped TC (or TVC) curve, the MC curve will be U-
shaped. Thus given inverse S-shaped TC or TVC curve, the slope of the TC or TVC curve (i.e. MC)
initially decreases, reaches its minimum and then starts to rise.

From this, we can logically infer that the reason for the U-shapedness of MC is also the law of
variable proportion. That is, had the TC or TVC curve not been inverse S-shaped, the MC curve
have would never assumed the U-shape, and obviously, the TC or TVC is inverse S-shaped due
to the law of variable proportions.

The relationship between AVC, ATC and MC

Given ATC = AVC + AFC, AVC is part of the ATC. Both AVC and ATC are u – shaped, reflecting the
law of variable proportions however, the minimum of ATC occurs to the right of the minimum
point of the AVC ( see the following figure) this is due to the fact that ATC includes AFC which
continuously decreases as the level of output increases.

After the AVC has reached its lowest point and starts rising, its rise is over a certain range is
more than 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

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in AFC so that the ATC starts increasing. The AVC approaches the ATC asymptotically as output
increases.

AC
MC

AVC

AFC

Q
Q1
Q2

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 (AFC) decrease continuously as output
increases.

The MC curve passes through the minimum point of both ATC and AVC

Finally, the MC curve passes through the minimum point of both ATC and AVC curves.

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

AC curve is decreasing (initial stage of production)

ii) When MC >AC, the slope of AC is positive, i.e. the AC curve is increasing
(after optimal combination of fixed and variable inputs.
iii) 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.

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 The relationship between short run per unit production and cost
curves

The rationale behind u shape of cost curves

This is explained by the laws of diminishing returns, which states that the marginal productivity
of a variable input will eventually declines more of that input is employed. The decreasing AP
and MP eventually increase AVC and MC.

Earlier in this chapter we have said that cost function is derived from production function. Now,
let’s see the important relation that per unit production curves (i.e. AP and MP of the variable
input) and per unit cost curves (i.e. AVC and MC) have. The relationship is that the short run per
unit costs is 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. When AP
variable input increases, AVC decreases; when AP variable input 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 curve
and the MC curve. This can be shown algebraically by using a linear short run cost function.

Suppose the firm uses two inputs, labor L (which is variable) and capital (which is fixed input).
And suppose that the prices of both factors are given and equal to w, and r respectively.

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

1
TVC WL Q Q
AVC = Q = Q = W. L But, L represents APL

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 1
Therefore, AVC = W. APL

Hence, AVC and APL are inversely related. Similarly, MC and MPL ,

dTC dTVC dTC

MC = dQ = dQ (Remember that MC = dQ

d (W . L )
MC = dQ

dL
MC = W. dQ ………………………… (Because w is constant)

dL
MC = W. dQ

1
dQ
MC = W. dL

1 dQ
MC = W. MPL ……………………………………………… (Because
dL = MPL)

Hence, MC and MPL have also an inverse relation.

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Graphically

AP, MP

APL

MPL
L

AVC, MC

MC

AVC

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Costs in the long run

The basic difference between long-run and short run costs is that in the short run, there are
some fixed inputs which results in some amount of fixed costs. However, 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.

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 plant.

Derivation of the long- run average cost curve

The long run average cost curve is derived from the short run average cost curves. Each point
on the long run average cost (LAC, now on) corresponds to a point on the short run cost curve,
which is tangent to the LAC at that point. Now let us examine in detail how the LAC is derived
from the short run average cost (SAC) curves.

Assume 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 operation cost of the small plant is denoted by SAC1, the operating cost of the
medium size plant is denoted by SAC2 and that of the large size plant is denoted by SAC3 in the
following figure.

If the firm plans to produce X1 units of output, it is well advised to choose the small size plant
to minimize its cost. For example, if the firm choose to use the medium size plant to produce X 1
units of output, the per unit costs will be C4 ( a point corresponding to x1 units of output on the
SAC2) but, the firm can produce x1 units of output at a lower unit cost (c1) if it uses the small
size plant. Similarly, if it plans to produce x2 units of output, it will choose the medium size
plant. If the firm wishes to produce x3 units, it will choose the large size plant.

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If the firm starts with the small plant and its demand gradually increases, it will produce at
lower costs (up to X1 level of output). Beyond that level of output costs start increasing. If its
demand reaches the level X1” the firm can either continue to produce with the small plant or it
can install the medium size plant. The decision, at this point, whether to install the medium size
plant or not depends not on the costs but on the firm’s expectation about its future demand. If
the firm expects that the demand will expand further than X1” it will install a medium size plant
because with this plant out puts larger than X1” are produced with a lower cost.

Similar considerations hold for the decision of the firm when it reaches the level X 2”. If the firm
expects its demand to stay constant at X2” level, the firm will not install the large plant, given
that it involves a large investment which is profitable only if demand expands beyond X 2”. If the
firm expects that its demand will expand further, it will install the large size plant to reduce its
cost. For example the level of output X3 is produced at a cost C3 with the large plant, while it
costs C2’ if produced with the medium size plant (C2’ >C3).

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

The LAC curve is then the tangent to these SATC curves of various plant sizes and shows the
minimum cost of producing each level of output.

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 SAC3 LAC

SAC1
SAC2

X1 X2 X3 X4 X5

In summary, the LAC curve shows the minimum per-unit cost of producing any level of
output when the firm can build any desired scale of plant in the sense that the firm chooses the
short –run plant which allows it to produce the anticipated (in the long run)output at the least
possible cost.

Why is the LAC U-shaped?

Similar to the SAC curve, the LAC curve of a firm is also U-shaped, but the reason for the U-
shapedness of LAC curve is different from that of the SAC curve.

The LAC curve is U-shaped due to the laws of returns to scale(i.e. increasing and decreasing
returns to scale). That is, as output expands from a very low levels increasing returns to scale
prevails (i.e., output rises proportionally more than inputs), and so the cost per-unit of output
falls(assuming that input prices remain constant).As output continues expand, the forces of
decreasing returns to scale eventually begin to overtake the forces of increasing returns to scale
and the LAC begins to rise.

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In other words, the per unit costs of production decreases initially as the plant size increases,
due to the economies of scale which larger plant size makes possible.

Economies of scale is the cost dimension of increasing returns to scale and thus, they are like
the two sides of a coin. If a firm has increasing returns to scale in production(i.e., if it requires
the firm less than double inputs to produce double output) the firm will have economies of
scale in costs (it will require the firm less than double cost to produce double output). Thus, the
reason for the decreasing part LAC curve is increasing returns to scale or economies of scale.
Economies of scale may prevail for various reasons such as specialization of skills, lower prices
for bulk-buying of raw materials, decentralization of management system and etc.

The traditional theory of the firm assumes that economies of scale exists only up to a certain
size of plant, which is known as optimal plant size, because with this plant size all possible
economies of scale are fully exploited. If the plant size increases further than this optimal size
diseconomies of scale will start to prevent, arising from managerial in efficiencies, the price
advantage from bulk-buying may also stop beyond a certain limit etc. These diseconomies of
scale will lead to increasing LAC curve. Thus, the increasing portion of the LAC curve shows the
existence of diseconomies of scale or decreasing returns to scale.

In general, the reason for the U-shapedness of the LAC curve are the existence of increasing
returns to scale at initial stage of expansion decreasing returns to scale at a later stage of
expansion.

Increasing returns to scale Decreasing returns to scale

Constant returns to scale

Co

Q
QO

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The long-run marginal cost curve.

The long-run marginal cost curve (LMC) is derived from the short run MC curve but does not
envelope them. The LMC is formed from points of intersection of the SMC curves with the
vertical lines (to the x-axis) drawn from the points of tangency of corresponding SAC curves and
the LAC curve.

C LAC

SMC1 LMC
SAC1 SAC3 SMC3

SMC2
SAC2

Q
Q1 Q2 Q3

Note that, the LMC curve passes through the minimum of the LAC curve.

Dynamic changes in costs: the learning curve

Earlier we have seen that LAC declines because of economies of scale. The LAC may also decline
resulting from learning. This means as output increases, the input especially labor required to
produce a unit of output declines. This arises from experience which workers gain from
producing large output. Their proficiency of doing things can be raised. As a result input
requirement declines.

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Learning curve is a graph that shows the relationship between inputs needed by a firm to
produce each unit of output and cumulative output. As the firm produces more, workers learn a
lot and gain experience, which improves their productivity. Hence, the input requirement
declines.

Number of labor required to produce one unit

Learning
curve

A
Cumulative
out put

In the above graph, the per unit production costs decreases along with the amount of labor
required to produce a unit of the commodity. This happens because labor input per unit of
output directly affects the production costs. The fewer the hours of labor needed to produce a
unit of the commodity, the lower the marginal and average costs of production.

Learning vs. Economies of scale

A firm’s average cost of production can decline overtime because of growth of sales (output)
when increasing returns to scale prevails in the firm (a move from A to B on curve AC,), or it can
decline because there is a learning curve (a move from A to C on curve AC2).Thus, increasing
returns to scale reduces average cost of production with increase in output, where as learning
shifts the average cost curve down ward.

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Cost per unit of out put

Economies of scale

A
B

Learning AC1
C
AC

Out put

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