ST.

LAWRENCE UNIVERSITY

FACULITY OF BUSINESS AND MANAGEMENT

STUDIES

COURSE UNIT: MICRO ECONOMICS

YEAR: ONE

SEMESTER: ONE

LECTURE: MISS NAMBAZIIRA JULIET

Group 1
Group Members:
1. KABANDA DERICK BABA/24W/U/A0332
2. Kusasira Esther BABA/24W/U/A0505
3. Albert Nuwamanya BABA/24W/U/A0001
4. Mugerwa Edward DBA/24W/U/A0133
5. Kayaga Aisha BABA/21W/U/J0398
6. Nanfuka Michelle Gloria BABA/24W/U/A0602

Topic: theory of costs

COSTS

Cost in production refers to the total expenditure incurred by a company or

business to produce a good or service. Understanding these costs is crucial for
pricing strategies, profitability analysis, and overall business planning. Here are
some key points about costs in production:

1. Opportunity Cost:

 Definition: The cost of forgoing the next best alternative when making a
decision. In microeconomics, it represents the value of the best alternative
use of resources.

 Example: If a company uses its resources to produce Product A instead of

Product B, the opportunity cost is the profit that could have been earned
from producing Product B.

2. Explicit Costs:

 Definition: Costs that involve direct payment of money. These are out-of-
pocket expenses, such as wages, rent, and materials.

 Example: Paying for raw materials, employee salaries, and utility bills.

3. Implicit Costs:

 Definition: The opportunity costs of using resources owned by the firm for
its own production, rather than renting them out or using them in another
way.

 Example: The income a business owner foregoes by investing time in their

own business instead of working for another company.

Short-Run vs. Long-Run Costs

1. Definition of Time Frames:

  Short-Run: A period where at least one factor of production is fixed
(usually capital). Firms can adjust some inputs (like labor), but others (like
machinery or building size) remain constant.
 Long-Run: A period where all inputs are variable, meaning the firm can
change the quantities of all factors of production, including capital and labor.
In the long run, firms can adjust their scale of operations.

Short-Run Costs

a) Fixed Costs (FC):

 Definition: Costs that do not vary with output. These are expenses that a
firm must pay regardless of its level of production (e.g., rent, salaries of
permanent staff, machinery).
 Examples: Rent, insurance, loan payments.

b) Variable Costs (VC):

 Definition: Costs that vary directly with the level of output. These include
costs associated with inputs that change as production increases or decreases
(e.g., wages for workers, raw materials).
 Examples: Wages, raw material costs, utility expenses.

c) Total Cost (TC):



Long-Run Costs

a) No Fixed Costs:

 In the long run, all costs are variable, meaning firms can change the scale of
all inputs, including fixed factors like plant size. As a result, the concept of
fixed costs disappears in the long run.

b) Economies of Scale:

 Definition: Cost advantages that arise when a firm increases its scale of
production. Larger firms may be able to produce at lower per-unit costs due
to factors like bulk purchasing, specialization, and technological efficiencies.
 Example: A factory that doubles in size might experience less than double
the costs, lowering the average cost of production.

c) Diseconomies of Scale:
  Definition: When increasing production leads to higher per-unit costs. This
often happens when a firm becomes too large and faces inefficiencies, such
as management complexity or communication issues.
 Example: A company grows so large that coordinating activities across
divisions becomes inefficient, leading to increased overhead costs.

d) Constant Returns to Scale:

 Definition: A situation where increasing production does not change per-

unit costs. The firm's average costs remain constant as it expands its scale of
operations.

Cost Curves:

 Total Cost Curve (TC Curve)

 The TC curve shows the relationship between the total cost and the level of
output.
 At zero output, total cost equals fixed cost.
 The curve rises as output increases due to variable costs.

 Average Cost Curves (AC, AFC, AVC)

 AFC Curve: Declines as output increases because fixed costs are spread
over a larger number of units.
 AVC Curve: U-shaped, reflecting initially falling variable costs due to
increasing efficiency and then rising costs due to diminishing returns.
 AC Curve: U-shaped due to the influence of both AFC and AVC.
 Marginal Cost Curve (MC Curve)

 U-shaped: Initially, MC falls due to increasing returns to the variable factor,

but eventually rises due to diminishing returns.

Relationship between Short-Run and Long-Run Costs

 In the short run, firms are limited by fixed factors of production, leading to
the distinction between fixed and variable costs. In the long run, these
constraints are relaxed, and firms can adjust all inputs.
 Short -Run Average Cost Curve (SRAC):

Long-Run Average Cost Curve

 Long-Run Average Cost Curve (LRAC): The LRAC is derived from the
short-run average cost curves (SRAC) and shows the lowest possible cost of
production for each output level when all factors are variable. It's typically
U-shaped, reflecting economies and diseconomies of scale.

o At the minimum point of the LRAC, the firm is operating at its

optimal scale (efficient scale).
Cost Structures in Different Market Conditions

1. Perfect Competition
o Firms face a perfectly elastic demand curve, and their marginal cost
determines the optimal level of output.
2. Monopoly
o In monopolistic markets, firms have greater control over prices, and
the cost structure includes inefficiencies due to lack of competition.
3. Oligopoly
o Oligopolistic firms may face price rigidity, leading to strategic pricing
behavior that affects costs.
4. Monopolistic Competition
o Firms differentiate their products, so costs include expenses related to
marketing, product development, and innovation.

Cost-Output Relationship: Law Of Diminishing Returns

 Definition: As more units of a variable input (like labor) are added to fixed
inputs (like capital), the additional output from each new unit of input will
eventually decrease.
 Implication: As firms increase production, the marginal cost initially falls,
but after a point, it begins to rise as diminishing returns set in.

Importance of Cost Analysis in Decision Making

1. Pricing Strategies: Firms use cost information to set prices that cover their
costs and generate profit.
2. Production Decisions: Understanding cost behavior helps firms decide the
optimal output level that minimizes costs.
3. Investment in Capital: In the long run, firms can lower their costs by
investing in technology or scaling up production.
4. Break-even Analysis: Identifying the level of output at which total revenue
equals total cost helps firms plan for profitability.

 Condition: Achieved when the ratio of marginal product to the cost of

inputs is equal for all inputs used in production.
Reference: Richard D. Irwin,