DR. R.S.

DAUDA
Contents
 Introduction

 The Cost Functions

 Costs
 Costs are incurred on inputs both in the short-run and long-run.
 Cost functions are derived functions because they are derived from the production
function.
 Economic theory distinguishes between short-run costs and long-run costs.
 Short-run costs are the costs over a period during which some production inputs
(usually capital equipment and management) are fixed. They are operating costs .
 The long-run costs are the costs over a period long enough to permit the change of all
inputs into production function. They are planning costs.
 Long run costs are also called ex ante costs because they present the optimal
possibilities for expansion of the output and thus help the entrepreneur plan his
future activities..
 Both in the short run and in the long run, total cost is a multi variable function,
which implies that total cost is determined by many factors.
 Symbolically, cost function could be specified as
 C = f (Q, T, Pj,) (Long run) or C = f (Q, T, Pj, K) (Short run)
 where: C = total cost
 Q = output; T = technology; PJ = prices of factors; K = fixed inputs
 Graphically, costs are shown on two-dimensional diagrams. Such curves imply that
cost is a function of output, C = f(XQ, ceteris paribus.
 ,
 Cost...
 It should be noted that internal economies are built into the shape of the long-run
cost curve, because they accrue to the firm from its own action as it expands the level
of its output.
 External economies arise outside the firm, from improvement (or deterioration) of the
environment in which it operates.
 Such economies external to the firm may be realised from actions of other firms in the
same or in another industry.
 The important characteristic of such economies is that they are independent of the
actions of the firm, they are external to it.
 Their effect is a change in the prices of the factors employed by the firm (or in a
reduction in the amount of inputs per unit of output), and thus cause a shift of the
cost curves (both the short-run and the long-run).

 In summary, while the internal economies of scale relate only to the long-run and are
built into the shape of the long-run cost curve, the external economies affect the
position of the cost curves: both the short-run and the long-run cost curves will shift if
external economies affect the prices of the factors and/or the production function.

 Any point on a cost curve shows the minimum cost at which a certain level of output
may be produced. This optimality is implied by the points of a cost curve.

 Usually the optimality is associated with the long-run cost curve. However, a similar
concept may be applied to the short-run, given the plant of the firm in any one period.
Cost...
 Classification of cost
 In the traditional theory of the firm, total costs are split into two
groups: total fixed costs and total variable costs:
 Total Fixed costs (TFC): These do not change with output level in
the short run. E.g. cost on plants, buildings, etc.
 Total Variable Costs (TVC): They change with the level of
production. E.g. cost incurred on raw materials, etc.
 Thus, Total Cost (TC): Summation of all costs incurred on output
produced.
 TC = TFC + TVC
 So, TFC = TC-TVC; TVC = TC-TFC
 Average Cost (AC): Cost per unit of output
 AC = TC/Q = (TFC + TVC)/Q =AFC + AVC
 AVC = TVC/Q
 AFC = TFC/Q
 Marginal Cost (MC): Cost on one more unit incued for additional
output.
 MC = ΔTC/ ΔQ
Short run cost curves
 The Shape of the Marginal Cost Curve in the Short Run
 Marginal costs ultimately increase with output in the
short run

MPL = ΔTP/ΔL = ΔQ / ΔL
MC= ΔTC/ΔQ = Δ(wL)/ΔQ = w/ MPL
Short run cost curves…
 Total Variable Costs and Marginal Costs

 Total variable costs always

increase with output. The
marginal cost curve shows
how total variable cost
changes with single unit
increases in total output.

• Below 100 units of output,

TVC increases at a decreasing
rate. Beyond 100 units of
output, TVC increases at an
increasing rate.
 Short run cost curves…
 Relationship Between Average Variable Cost and Marginal Cost

 When marginal cost is below

average cost, average cost is
declining.

• When marginal cost is above

average cost, average cost is
increasing.

• Rising marginal cost intersects

average variable cost at the
• At 200 units of output, AVC is
minimum, and MC = AVC. minimum point of AVC.
Short run cost curves…
 Total Costs
 Adding TFC to TVC means
adding the same amount of
total fixed cost to every level
of total variable cost.

• Thus, the total cost curve has

the same shape as the total
variable cost curve; it is
simply higher by an amount
equal to TFC.

TC  TFC  TVC
Short run cost curves…
 Average Total Cost
 Average total cost (ATC) is
total cost divided by the
number of units of output (q).

ATC  AFC  AVC

TC TFC TVC
ATC   
q q q

• Because AFC falls with

output, an ever-declining
amount is added to AVC.
Short run cost curves…
 Relationship Between Average Total Cost and Marginal Cost
 If marginal cost is below
average total cost, average
total cost will decline toward
marginal cost.

 If marginal cost is above

average total cost, average
total cost will increase.

 Marginal cost intersects

average total cost and average
variable cost curves at their
minimum points.
 Short run cost curves…
 The relationship between the MC and AC curves becomes clearer
with the use of simple calculus.
 Given that C = βQ, where β = AC. Clearly β = f(Q). The MC therefore
is
 ∂C/∂Q = ∂(ΒQ)/∂Q
 When we apply the rule of differentiation of 'a function of a function'
(which states that if y = uv, where u = f1(x) and v = f2(x), then dy/dx =
dy/du·du/dx). So,
 MC = ∂C/∂Q = Β(∂Q)/∂Q + Q(∂Β)/∂Q or
 MC = AC + (Q)(slope of AC)
 Given that AC > 0 and Q > 0, the following results emerge:
 (a) if (slope of A C) < 0, then MC < AC
 (b) if(slope of AC) > 0, then MC > AC
 (c) if (slope of A C) = 0, then MC = AC
 The slope of the AC becomes zero at the minimum point of this curve
(given that on theoretical grounds the AC curve is U-shaped). Hence
MC = AC at the minimum point of the average cost curve.
Long run cost curves
 Long Run AC
Long run cost curves…
 A Firm Exhibiting Economies and Diseconomies of Scale
 The long-run average cost curve of a firm that
eventually exhibits diseconomies of scale becomes
upward-sloping.
Long run cost curves…
 Optimal Scale of Plant
 The optimal scale of plant is the scale that minimizes
average cost.
 Practice questions
 1. Given a firm’s total cost function as
 TC = 12 + 60Q- 15Q2 +Q3
 Suppose that the firm produces 10 units of output. Calculate total fixed cost (TFC), total
variable cost (TVC), average total cost (ATC), average fixed cost (AFC), average variable cost
(AVC), and marginal cost (MC).
 2. Suppose that the total cost function of a firm is given as
 TC = 1,000 + 10Q2
 a. Determine the output level that minimizes average total cost (ATC).
 At this output level, what is TC? ATC? MC? Verify that at this output level MC = ATC, and that
ATC intersects MC from below.
 b. Determine the output level that minimizes average variable cost (AVC). At this output level,
what is TC? AVC? MC?
 3. A firm’s long-run total cost (LRTC) equation is given by the
 Expression LRTC = 2,000Q- 5Q2 + 0.005Q3
 a. What is the firm’s long-run average cost equation?
 b. What is the firm’s minimum efficient scale (MES) of production?

 4 . If C = b0 + b1Q- b2Q2 + B3Q3

 Find ATC, AVC and MC

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