UNIT 4: ANALYSIS OF COST

Contents
4.0 Aims and Objective
4.1 Introduction
4.2 Cost Concepts
4.2.1 Accounting Cost Concepts
4.2.1.1 Opportunity Cost and Actual Cost
4.2.1.2 Explicit and Implicit or Imputed Costs
4.2.2 Some Analytical Cost Concepts
4.2.2.1 Fixed and Variable Cost
4.2.2.2 Total, Average and Marginal Costs
4.2.2.3 Short-Run and Long -Run costs
4.2.2.4 Incremental Costs and Sunk Costs
4.3 Cost –Out Put Relations
4.3.1 Short- Run Cost Output Relations
4.3.2 Long-Run Cost Output Relations
4.4 Economic and Dis-ecomonic of Scale
4.5 Let Us Sum Up
4.6 Key Words
4.7 Answers to Check Your Progress Exercise
4.8 Model Examination Questions

4.0 AIMS AND OBJECTIVES

The aim of this unit is to acquaint students with the basic concepts of cost and its relation to
out put decision. After studying this unit you are able to:
- identify various cost concept used in business decisions
- understand the behavior of cost in relation to change in output
- find an optimal level of output that minimize the cost of a give firm
- explain the behavior of cost in relation to economic and dis economic of scale.

44
4.1 INTRODUCTION

Analysis of cost lays the ground work for major business decisions. Supply decisions of firms
and the price output determination in markets are the basic that can be mentioned. Mangers
seeking to make the most efficient use of the enterprise’s resources and to maximize the value
of the enterprise must be concerned with cost –output relationships. This unit first discusses
the different cost concepts and later on devotes on cost output relationships in the short run
and the long run.

4.2 COST CONCEPTS

The word cost refers to the sacrifice incurred whenever an exchange or transformation of
resources take place however, problem arises when one attempts to measure this sacrifice.
The appropriate manner to measure or define costs is a function of the purpose for which the
information is to be used. Thus the term “Cost” has different meaning under different settings
and is subject to various interpretations.

The cost concepts, which are relevant to business operations and decisions can be grouped
under two categories.
1. Concepts used for accounting purposes
2. Concepts used in economic analysis for business activities

It is important to note here that this classification of cost concepts is only a matter of
analytical convenience. Accountants have been primarily concerned with measuring costs
for financial reporting purpose. As a result, they define and measure cost by the historical
outlay of fund that take place in the exchange or transformation of a resources. However,
economists have been mainly concerned with measuring costs for decision making purposes.

4.2.1 Accounting Cost Concepts

4.2.1.1 Opportunity Cost and Actual cost
Recall our discussion in unit one, resources available to any person, firm or society is scarce.
But these scarce resources have alternative uses with different returns. Owners seek to
maximize their income, can put these scarce resources to their most productive use and thus,
they foregone the income expected from the second best use of the resources. This basic fact

45
introduces the idea of opportunity cost. The opportunity cost may be defined as the expected
returns form the second best use of the resources which are foregone due to the scarcity of
resources. Bear in mind had the resource available to person, a firm or a society been
unlimited there would be no opportunity cost. The opportunity cost is also called alternative
cost.

The following example illustrates how the opportunity cost created. Suppose that Ato Kebede
has 100,000 Birr for which he has only two alternative uses; he can buy either a taxi or
alternatively put the money in the bank. From the taxi he expects an annual income of 20,000
birr and putting it in the bank he can earn 15,000 birr. If he is a profit seeking investor he
would invest in taxi and forgone the expected income from the bank i.e. interest rate. Then the
opportunity cost of the income from the taxi investment is the expected income from the bank
that is 15,000 birr.

Associated with the concept of opportunity cost the concept of Economic rent or Economic
profit is introduced.
introduced. In our example of expected earnings firm taxi economic rent can be
calculated as follow. Economic rent of the taxi is the excess of its earning from the taxi over
the income expected from the bank. That is, economic rent equals to birr 5,000 (20,000 birr-
15,000 birr). The implication of this concept for a business decision is that investing on the
taxi is preferable so long as its economic rent is greater than zero. From this we can conclude
that, if firms know the economic rent of the various alternative uses of their resources, it will
be simple to choice the best investment avenue.

In contrast to the concept of opportunity cost, actual costs are those which are actually
incurred by the firm. It includes payment for labor, material, plant, building, machinery,
equipment, traveling and transport, advertisement, etc. Or actual costs refer the total money
expenses recorded in the books of accounts for all practical purposes. In our example, the
cost of the taxi, i.e., 100,000 birr is the actual cost.

4.2.1.2 Explicit and Implicit or Imputed costs

Explicit costs are those which fall under actual costs entered in the books of accounts. The
payments for wages and salaries, material, license fee, insurance premium, depreciation
charges are the examples of explicit costs. These costs involve cash payment and are

46
recorded in normal accounting practices. In contrast to explicit costs, there are certainly other
costs which do not take the form of cash outlays, nor do they appear in the accounting system.
Such costs are known as implicit or imputed costs.
costs. Opportunity cost is an important example
of implicit cost. For example, suppose an entrepreneur does not utilize his services in his own
business and works as a manager in some other firm on a salary basis. If he sets up his won
business later on he foregoes his salary as manager. This loss of salary is the opportunity cost
of income from his own business. Thus, implicit wages, and rent are the wages, rents which
an owner’s labor and building, respectively, can earn from their second best use.

Implicit costs are not taken into account while calculating the losses or gains of the business,
but they form an important consideration in whether or not a factor would remain its present
occupation. The explicit and implicit costs together make the economic cost.

4.2.2 Some Analytical Cost Concepts

4.2.2.1 Fixed and Variable Costs
Fixed costs are those, which are fixed in volume for a certain given output. In other words,
costs that do not vary for a certain level of output are known as fixed costs. Plant, building,
machinery are the best examples of fixed costs.

Variable costs are those which vary with the variation in the total output. Variable costs
include cost of raw material, running cost of fixed capital, such as fuel, repairs, routine
maintenance expenditure, direct labor charges associated with the level of output, and the
costs of all other inputs that vary with output.

4.2.2.2 Total, Average and Marginal Costs

Total cost (TC) is the total expenditure incurred on the production of goods and services. It
refers to the total outlays of money expenditure, used to produce a given level of output. It
includes both fixed and variable costs. The total cost for a given output is given by the cost
function.

Average cost (AC) is of statistical nature – it is not actual cost. It is obtained by dividing the
total cost (TC) by the total output (Q) i.e., AC = TC/Q. AC simply tells us the cost used to
produce a unit output.

47
Marginal cost (MC) is the addition to the total cost on account of producing one additional
unit of the product. Or, marginal cost is the cost of the marginal unit produced. Marginal cost
is calculated as TC n _TCn-1 where n is the number of units produced. Alternatively, given
the cost function, MC can be defined as MC = TC/ Q which is the first derivate of the
total cost function in respect to Q. These cost concepts are discussed through out the unit.
Total, Average and Marginal cost concepts are used in the economic analysis of firm’s
production activities.

4.2.2.3 Short-Run and long -Run costs

Short run and long-run cost concepts are related to variable and fixed costs, respectively, and
often figure in economic analysis interchangeably.

Short-run costs are the costs, which vary with the variation in output, the size of the firm
remaining the same. In other words, short run costs are the same as variable costs.

Long run costs on the other hand, are the costs, which are incurred of the fixed assets like
plant, building, machinery, etc. It is important to note that the running cost and depreciation
of the capital assets are included in the short-run or variable costs.

Long run costs are by implication the same as fixed costs. In the long-run, however, even the
fixed costs become variable costs as the size of the firm or scale of production increases.
Broadly speaking, the short run costs are those associated with variables in the utilization of
fixed plant or other facilities whereas long-run costs are associated with the changes in the
size and kind of plant.

4.2.2.4 Incremental Costs and Sunk Costs

Conceptually, incremental costs are closely related to the concept of marginal cost but with
a relatively wider connotation. While marginal cost refers to the cost of the marginal unit of
output, incremental cost refers to the total additional cost associated with the decisions to
expand the output or to add a new variety of product, etc. Incremental costs arise also owing
to the change in product lines, addition or introduction of a new product , replacement of
worn out plant and machinery, replacement of old technique of production with a new one,
etc.

48
Sunk costs are those, which cannot be altered, increased or decreased, by varying the rate of
output. For example, once it is decided to make incremental investment expenditure and the
funds are allocated and spent, all the preceding costs are considered to be the sunk costs since
they accord to the prior commitment and cannot be revised or reversed or recovered when
there is a change in market conditions or change in business decisions.

Check Your Progress Exercise 1

1. Explain with illustration the distinction between the following.
A. Fixed cost and variable cost
B. Actual and opportunity cost
C. Marginal and incremental cost
2. Which of the following statements are true?
A. Economic rent is the same as economic profit.
B. Imputed cost is the rent of hired building.
C. Sunk costs should be considered whenever business decisions are made.
D. Running costs and depreciation of the capital assets are included in the long
run cost.
3. How do you define the term 'cost'?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

4.3 THE COST-OUTPUT RELATIONS

The relationship between cost and output serves as an important building block in the theories
of resource allocation and pricing with in the firm. The theory of cost deals with the behavior
of cost in relation to change in output. The basic principle of the cost behavior is that the total
cost increase with increase in output. However what is important from a theoretical and
managerial point of view is not the absolute increase in the total cost but the direction of
change in the average cost (AC) and the marginal cost (MC). The direction of change in AC
and MC – whether AC and MC decrease or increase or remain constant – depends of the
nature of the cost function. The behavior of cost is expressed in terms of cost function. A cost

49
function is a symbolic statement of the technological relationship between the cost and output.
The general form of the cost function is written as
TC = f (Q) TC/
TC/Q>0

The specific form of the cost function depends on whether the time framework chosen for cost
analysis is short-run or long-run. It is important to recall here that some costs remain constant
in the short run while all costs are variable in the long run. Thus, depending on whether cost
analysis pertains to short-run or to long run , there are two kinds of cost functions,
Accordingly, the cost output relations are analyzed is short-run and long-run framework.

4.3.1 Short -Run Cost- Output Relation

Short- run cost output relationship help managers to plan for the most profitable level of
output given the capital resources that are immediately available. Total, Average and
Marginal costs functions are basic analytical cost concepts used in the analysis of cost
behavior in the short run. The short-run TC is composed of two major elements:
i. Total fixed cost (TFC)
ii. Total variable cost (TVC). That is, in the short-run,
TC=TFC+TVC
As mentioned earlier, TFC (i.e., the cost of plant, building, etc.) remains fixed in the short-
run, regardless of whether a small or large quantity of output is produced during the period.
TVC varies with the variation in the output though the variation is not proportional.

Mathematically for a given quantity of output (Q), the average total cost, (AC) average fixed
cost (AFC) and average variable cost (AVC) can be defined as follow
AC = TC/Q = TFC+TVC/Q
AFC = TFC/Q
AVC = TVC/Q
AC = AFC +AVC
As we discuss previously Marginal cost (MC) is defined as the change in the total cost
divided by the change in the total output, i.e.,
MC = TC/
TC/Q
= VC/
VC/Q since FC is zero in the short run
or as first derivative of cost function i.e ., TC/
TC/ Q

50
 Since TC = TFC + TVC and, in the short-run, TFC=0, There fore, TC = TVC.
Furthermore, under the marginality concept, where Q= 1 MC =
=TVC. The concepts AC,
AVC, AFC, and MC give only a static relationship between cost and output. These concepts
do not tell us anything about cost behavior, i.e. how AC, AVC, MC and AFC behave when
output changes. This can be understood better with a cost function of empirical nature.

The following table describes important relationships between costs used in analyzing the
short-run cost behavior and output as follow:

Table 4:1 Short Run Cost Function

Q VC FC TC = FC + VC AFC = FC/Q AVC= VC/Q ATC = TC/Q MC = TC/
TC/Q
0 $0 $150 $150 - - - -
6 50 150 200 $25 $8.33 33.33 $8.33
16 100 150 250 9.38 6.25 15.63 5.00
29 150 150 300 5.17 5.17 10.34 3.85
44 200 150 350 3.14 4.55 7.95 3.33
55 250 150 400 2.73 4.55 7.27 4.55
60 300 150 450 2.5 5.00 7.5 10.00
62 350 150 500 2.42 5.65 8.06 25.00

From the data given in Table 3.1 TC, TVC and TFC are plotted in fig. 1 as follow
Fig. 4.1

As the figure shows TFC remains fixed throughout the whole rang of output and take the form
of horizontal line. TC curve has an identical shape to that of TVC being shifted upward by the

51
FC of $150.TVC first increases at decreasing rate and then increases at increasing rate with
the increases in output. This situation happens because of the law of diminishing returns. The
law states that when more and more units of a variable input are applied, other inputs held
constant, the returns from the marginal units of the variable input may initially increase but it
decreases eventually.
Fig 4.2 Short run Average and Marginal cost function

The AC and MC functions calculated from the table and are plotted in the figure4:2. From the
graph we can observe the following important relationships:
 Over the rage of output AFC and AVC fall, AC also falls because AC=
AFC+AVC. When AFC falls, AVC increases, so change in AC depends on the
rate of change in AFC and AVC.
 When MC falls, AC follows, over a certain rage of initial output. When MC is
falling, the rate of fall in MC is greater than that of AC, because in the case of MC
the decreasing marginal cost is attributed to a single marginal unit while, in case of
AC, the decreasing marginal cost is distributed over the entire output. Therefore,
AC decreases at a lower rate than MC.
 Similarly, when MC increases, AC also increases but at a lower rate for the reason
given above. Compare the behavior of MC and AC over the range of output from
44 to 55from table 3.1 over this range of output, MC begins to increase while AC
continues to decrease.
 MC intersects both AC and AVC cost functions at their minimum point. AC
reaches its minimum when output increases to 55 units. Beyond this level of

52
 output AC stars increasing which shows that the law of diminishing returns comes
into operation. The level of output that minimizes the AC of production 55 in the
above case is an optimum level of output that makes the firm efficient. Bear in
mind this optimum level of output may not result in maximum profit for the firm.
The level of output that introduces the maximum profit will be discussed in unit
six.

Optimum level of output can be calculated using optimization technique. Optimization

technique is a technique of maximizing or minimizing a function. It helps to find the best way
to allocate resources given an objective function, for example to find the level of output that
would minimize the average cost. Mathematically, let the short run cost function is given as
follow. To find the rate of output that result in minimum AC.
T C = 200 + 5Q + 2Q2

We have noted above that an optimum level of output is one that equalizes AC and MC.
Given the cost function
AC = 200+5Q+2Q2
Q
= 200 + 5 + 2Q
Q
and MC = TC = 5 + 4Q
Q
Now you can solve for Q by equating AC an MC equations equal
200 +5 + 2Q = 5 + 4Q
Q
Rearranging terms yields a quadratic equation
2Q2 = 200
Q = 10
The result shows that Q = 10 minimizes the average cost. In other words, the optimum size of
the output is 10 units. Any other output level will increase the average cost of production.

53
4.3.2 The Long -Run Cost Output Relations
Long run cost output relationships are important inputs into the decision to expand or contract
the size of the firm. As we define at the beginning of the unit, long-run is a period in which all
the inputs become variable. Firms are, therefore, in a position to expand the scale of their
production by hiring a larger quantity of all the inputs. Thus the firm can choose the
combination of inputs that minimizes the cost of producing a desired level of output. The
long-run cost-output relations, therefore, imply the relationship between the changing scale of
the firm and the total output, where as in the short-run this relationship is essentially one
between the total output and the variable input basically that of labor.

To understand the long-run-cost-output relations and to derive long-run cost curves it will be
helpful to imagine that (as we observed in fig 4.3) a long-run cost curve is composed of a
series of short-run cost curves. We may now derive the long-run cost curves and study their
relationship with output using the following figure.

Fig 4.3 Long-Run and Short-Run Average and Marginal Cost Curves

Long-run cost curves can be used to show how a firm can decide on the optimum size of the
firm. Conceptually, the optimum size of a firm is one which ensures the most efficient
utilization of resources. Practically, the optimum size of the firm is one, which minimizes the
LAC.

The long-run average cost curve (LAC) is derived by combining the short-run average cost
curves (SACs). In Fig.4.3 there are three corresponding SAC curves as given by SAC1, SAC2,
and SAC3. Thus, the firm has a series of SAC curves, each having a bottom, point showing
the minimum SAC. The LAC curve can be drawn through the SAC 1, SAC2, and SAC3 as

54
shown in Fig. 4.3. The LAC curve is also known as the “Envelope curve” or “Planning
Curve.” as it serves as a guide to the manager in his plans to expand production.

LAC initially decreased until the optimum utilization of the second plant and then it begins to
increase. These cost-output relations follow the “low of return to scale.” When the scale of
the firm expands, unit cost of production initially decreases, but ultimately increases as shown
in Fig 4.4. The decrease in unit cost is attributed to the internal and external economies and
the eventual increase in cost, to the internal and external diseconomies. The economies and
diseconomies of scale are discussed in the following section.

Given the state of technology over time, there is technically a unique size of the firm and level
of output as socialite with the least-cost concept. In Fig 4.3 the optimum size consist of two
plants, which produce 0Q2 units of a product at minimum long run average cost (LAC) of
BQ2. The downtrend in the LAC indicates that until output reaches the level of 0Q 2”, the firm
is of less than optimal size. Similarly, expansion of the firm beyond production capacity 0Q 2,
causes a rise in SMC. The long run marginal cost curve (LMC) is derived from the short-run
marginal cost curves (SMCS). The derivation of LMC considers the points of tangency
between SACs and the LAC, i.e., point A, B and C. In the long-run production planning,
these points determine the output levels at the different level of production. For example, if
we draw perpendiculars from points A, B and C to the X-axis, the corresponding output levels
will be 0Q1, 0Q2 and 0Q3. Another important point to notice is that LMC intersects LAC
when the latter is at its minimum SAC coincides with the minimum LAC. This point is B
where SAC2=SMC2=LAC=LMC

It follows that given technology, a firm aiming to minimize its average cost over time must
choose a plant which gives minimum LAC where SAC=SMC=LAC=LMC: This size of plant
assures the most efficient utilization of the resource. Any change in output level, increase or
decrease, will make the firm enter the area of in optimality.

Check Your Progress Exercise 2

55
1. Which of the following statements are true?
A. When AC = MC, AC is minimum
B. Output is optimum when AC = MC
C. Marginal Cost = VC/
VC/Q
D. LAC intersects LMC when the later is at its minimum
2. When the law of diminishing returns begins to operate, then
A. TVC begins to fall at an increasing rate
B. TVC falls at a decreasing rate
C. TVC rises at a decreasing rate
D. TVC rises at an increasing rate
E. TVC remains constant
3. The Engineering department of a chemical product company has developed the
following TC function for a proposed new plant that produce ammonium sulfate fertilizer.
TC = 1016 – 3.36Q + 0.021Q2
A. Determine the output rate that will minimize AC and the per unit cost at the
rate of output.
B. The current market price of this fertilizer is $5.5 per unit and is expected to
remain at the level for the foreseeable future. Should the plant be built?

4.4 ECONOMIC AND DISECONOMIES OF SCALE

As shown in Fig. 4.4 LAC decreases with the expansion of production scale up to 0Q 2
(relatively lower range of output) and then it begins to rise over higher rang of out put. This
behavior of LAC is caused by the economies and diseconomies of scale. Declining LAC over
the lower part of the range of possible output is usually attributed to economic of scale. Rising
LAC at higher level of output is usually attributed to dis-economic of scale. The sources of
economic or dis-economic of scale may be internal or external factors.

Uses of advanced technology, specialization in production and marketing practice have a

potential to reduce per unit cost of an output. These factors considered as internal factors and
arise from the expansion of the plant-size of the firm and attributed to economic of scale.
Ability of large scale purchase of raw material and acquisition of external finance on the other

56
hand considered as external factors. These factors are available to all the firms of an industry
and they have a contribution to reduce per unit cost of the product. Expansion of the scale of
production leads to managerial inefficiencies as a result close control and supervision
reduced, consequently dis- economic of scale begins to appear

On the other hand increase on the number of labor union encourages labor union activities,
which simply mean the loss of output per unit of time and hence, rise in the cost of
production. Externally when all the firms of the industry are expanding, the discounts and
concessions that are available on bulk purchases of inputs and concessions finances come to
an end. This situation creates higher demand for input market and input prices began to rise
causing a rise in the cost of production.

4.5 LET US SUM UP

 Cost is defined as the sacrifice incurred whenever an exchange or transformation of

resource take place.
 Different approaches are used in measuring costs, depending on the purposes for which
the information is to be used. For financial reporting purposes, the historical outlay of
funds is usually the appropriate measure of cost, where as for decision-making purposes, it
is often appropriate to measure cost in terms of the opportunities forgone or sacrificed.
 The long-run out put relation implies the relation between the total costs and the total
output, where as in the short-run this relation is essentially between the total output and
the variable costs as fixed cost remains constant. Long- run cost curves shows how a firm
can decide on the optimum size of the firm. An optimum size of a plant is one which
leads to the most efficient utilization of resource given the state of technology over time.
 An optimum level of output is one which can be produced at a minimum average cost,
given the technology. It may be noted there that optimum level of output is not necessarily
the maximum profit output profit can not be known unless firm’s revenue is known.
 A down ward trend in the MC shows increasing marginal productivity of the variable
input. Similarly, an upward trend in the MC shows that rate of increase in TVC and the
decreasing marginal production of the variable input.

57
 MC intersects AC at its minimum point. The reason for this is that when MC increase, it
pushes AC up. And when AC is at its minimum, it is neither being pulled down nor being
pushed up, by the MC then MC=AC AC, reaches its minimum. When MC falls AC fall
but MC is greater than that of AC
 The theoretical short-run average variable and marginal cost functions of economic theory
are hypothesized to be U-shaped, first falling and then rising as output is increased.
Falling costs are attributed to the gains available of specialization in the use of capital and
labor.
labor. Rising costs are attributed to diminishing returns in production.
 The theoretical long-run average cost function, like its short-run counterpart, is also
postulated to be U-shaped. This is due to the presence of economies and dis–economies
of scale.
 Economies of scale are attributed primarily to the nature of the production process or the
factor markets, whereas diseconomies of scale are attributed primary to problems of
coordination and control in large-scale organizations.

4.6 KEY WORDS

- Cost function: a schedule, graph, or mathematical relationship showing the minimum

achievable cost (such as total, average, or marginal cost) of producing various quantities
of output
- Opportunity Cost: the valve of a resource in its next best alternative use which are
foregone due to the scarcity of resources.
- Actual costs:
costs: costs, which are actually incurred by the firm.
- Fixed costs: costs that do not vary with variation in the output between zero and a
certain given level of output.
- Variable costs: those which vary with the variation in the total output.
- Total cost: the sum of fixed and variable costs.
- Average cost:
cost: cost incurred per unit it is obtained by dividing the total cost (TC) by
the total output (Q) i.e., AC = TC/Q.
- Marginal cost: the increase in total cost that result from a one-unit increase in output.

58
- Short-run costs: costs, which vary with the variation in output, the size of the firm
remaining the same.
- Long run costs: costs become variable as the size of the firm or scale of production
increases.
- Incremental costs: the total additional cost associated with the decisions to expand
the output or to add a new variety of product.
- Sunk costs: costs which cannot be altered, increased or decreased, by varying the rate
of output.
- Implicit costs:
costs: the earning of owner’s resource like salary employed in their best
alternative uses.
- Explicit costs:
costs: costs which fall under actual costs and entered in the books of
accounting.
- Economic cost:
cost: The sum of explicit and implicit costs
- Economic rent:
rent: expected earnings from the best investment over expected earnings
from the second best investment alternative.

4.7 ANSWERS TO CHECK YOUR PROGRESS EXERCISE

Exercise 1
1. A. Fixed cost and variable cost are analytical cost concepts. Fixed costs are the costs
of inputs to the production process and that are fixed in volume for a certain given
output. These costs will be incurred regardless of whether a small or large quantity of
output is produced during the period. This concept of fixed cost is associated with the
short run. Costs of Managerial and administrative staff, cost of building and
machinery are good example of fixed costs.

Variable costs are the costs of the variable inputs to the production process. They will
increase or decrease in some manner as output is increased. Cost of raw material,
running cost of fixed capital such as fuel and maintenance expenditure are example of
variable costs.

59
 B. Actual cost and opportunity cost
Actual costs are those costs that involve an actual payment to other parties. Actual
cost comes under the accounting cost concept. Payment for labor, material, building
etc. categorized under actual costs.

Opportunity cost refers the expected returns from the second best use of the
resources, which are forgone due to the scarcity of resources. For example the
opportunity cost of using a given quantity of resource to produce a unit of Good A
is the number of units of the next best alternative that must be sacrificed or foregone
as a result of the decision to produce A.

C. Marginal cost and increase costs

Marginal cost is the addition to the total cost on account of producing one addition
unit of the product or it may be the change in total cost associated with a one unit
change in output. This concept basically is integral to short run decisions for
example in an automobile manufacturing plant, the marginal cost of producing one
additional car per production period would be the labor, materials and energy costs
directly associated with that extra car.

Incremental costs refers to the total additional cost associated with the decisions to
expand the output or to add a new variety of product. For example, costs of new
equipment and staff associated with this new equipment can be falled into the
broader class of incremental costs. Marginal cost is the subcategory of incremental
cost.
2. A, B are true whereas C, and D are false
3. Cost refers to the sacrifice incurred whenever an exchange or transformation of
resources take place. The appropriate manner to measure costs as sacrifice is a
function of the purpose for which the information is to be used.

Exercise 2
1. A, B, and C are true whereas D is false.

60
 2. D. When the law of diminishing returns begins to operate TVC rises at an increasing
rate. Please note that TVC first increases at a decreasing rate and then at an increasing
rate with the increase in the output. The pattern of change in the TVC stems directly
from the law of increasing and diminishing returns to the variable inputs.
3. Given the total cost function
TC = 1016 – 3.36Q + 0.021Q2
A. To find the rate of output that minimizes AC
Solution: AC is minimum when it equals to MC
So find AC and MC first
Find AC by dividing TC by output (Q)
That is AC = TC/Q
= 1016 – 3.36Q + 0.021Q2
Q
AC = 1016/Q – 3.36 + 0.021Q

MC is the first derivative of the total cost function

MC = dTC/dQ = - 3.36 + 0.042Q
Because the minimum point of AC occurs at its intersection with MC
MC = AC
-3.36 + 0.042Q
1016 – 3.36 + 0.021Q2
Q
1016 = 0.021Q2
220 = Q
Therefore, the minimum average cost is achieved at an output rate of 220 units.
The per unit cost at the rate of output can be calculated as follows

AC = 1.016 – 3.36 + 0.021(220) = $5.88

220
Per unit cost (cost to produce one output) = $5.88

61
B. The plant should not be constructed because the lowest possible per unit cost is $5.88,
which is $0.38 above the market price (the market price is given as $5.5)

4.8 MODEL EXAMINATION QUESTIONS

1. Three business school graduates decide to open a business, and all three devote their
full time to its management. What cost would you assign to their time? Is this an explicit
or implicit cost?
2. Which of the following statement is true when output is zero?
A. TC = TVC
B. TC > TVE
C. TC < TVC
3. Suppose Z company estimates the following total cost function from cost output data:
TC = $135,000 + $250Q + $1.5Q2
Find the optimum level of output that makes the company efficient and per unit cost (AC)
at the rate of output.
4. A manufacturing firm produces and sells 1,000 units of a product X, where its AC =
MC and makes only normal profit. The firm get an additional order of 250 units at the
ruling price. Should the firm accept or reject the order. Justify your answer on short run
cost output condition and the long run cost output relation.
5. Which of the following statement is false?
A. Declining LACs over the lower part of output are attributed to Economic of
Scale.
B. Rising LACs at higher level of output are attributed to dis economic of scale.
C. Rising costs are attributed to diminishing returns in production.
D. Falling costs are attributed to diminishing returns in production.

62