Theory of Cost

Theory of Cost
Explicit Costs
Explicit costs are actual expenditures of

the firm to hire, rent, or purchase the
inputs it requires in production. These
includes the wages to hire labor, the rental
price of capital, equipment, and buildings,
and the purchase price of raw materials
and semi finished products.
Implicit Costs
Implicit costs refers to the value of the

inputs that are owned and used by the firm
in its own production activity.
These
includes the highest salary that the
entrepreneur could earn in his or her best
alternative employment and the highest
return that the firm could receive from
investing its capital in the most rewarding
alternative use or renting its land and
buildings to the highest bidder.
3
Economic Costs
Economic cost refers the sum of explicit and

implicit costs. These costs must be
distinguished from accounting costs, which
refer only to the firms actual expenditures,
or explicit cost, incurred for purchased or
hired inputs.
Alternative or Opportunity Costs
The cost to the firm of using a purchased or

owned input is equal to what the input could
earn in its best alternative use.
The firm must include the alternative or
opportunity costs because the firm cannot
retain a hired input if it pays a lower price for
the input than another firm.
Short-Run Cost Functions
In short-run period, some of the firms

inputs are fixed and some are variable, and
this leads to fixed and variable costs.
Total costs is the cost of all the productive
resources used by the firm. It can be
divided into two separate costs in the short
run.
Total fixed and variable costs
Total Fixed Costs: The total obligations of

the firm per time period for all the fixed
inputs the firm uses.
Total Variable Costs: The total obligations
of the firm per time period for all the
variable inputs the firm uses.
Total Cost = TC = f(Q)

Total Fixed Cost = TFC
Total Variable Cost = TVC
TC = TFC + TVC
Average Costs
Average total cost (also called average cost)

equals total cost per unit of output produced
ATC = TC/Q
Average fixed cost equals fixed cost divided
by quantity produced
AFC = FC/Q
Average variable cost equals variable cost

divided by quantity produced
AVC = VC/Q
9
Average Costs and Marginal Cost
Average total cost is also the sum of average fixed

cost and average variable cost.
ATC = AFC + AVC
Marginal (incremental) cost is the increase in total

cost resulting from a one-unit increase in output.
Marginal decisions are very important in
determining profit levels.
MC = TC/Q
10
The
marginal cost curve, average variable

cost curve and average total cost curves are
generally U-shaped.
The U-shape in the short run is attributed to

increasing and diminishing returns from a fixedsize plant, because the size of the plant is not
variable in the short run.
11
The marginal cost and average cost curves are

related
When
MC exceeds AC, average cost must

be rising
When
MC is less than AC, average cost

must be falling
This relationship explains why marginal cost

curves always intersect average cost curves at
the minimum of the average cost curve.
12
Graphical Presentation
$
MC will intersect the AVC at the

minimum of the AVC [always].
ATC
ATC*
AVC*
R
TC = ATC* x Q**
TVC = AVC* x Q*
AVC
MC will intersect the ATC
at the minimum of the ATC.
The vertical distance between
ATC and AVC at any output is
the AFC. At Q** AFC is RJ.
Q* Q**
Q
At Q* output, the AVC is at a minimum AVC* [also max of APL].
At Q** the ATC is at a MINIMUM.
13
Relationship Between Marginal and Average

Costs
If MC > ATC, then ATC is rising

If MC = ATC, then ATC is at its minimum
If MC < ATC, then ATC is falling
If MC > AVC, then AVC is rising

If MC = AVC, then AVC is at its minimum
If MC < AVC, then AVC is falling

14
Average Total Cost = ATC = TC/Q

Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = TC/Q = TVC/Q
15
Short-Run Cost Functions-Example
Q
0
1
2
3
4
5
TFC
$60
60
60
60
60
60
TVC
$0
20
30
45
80
135
TC
$60
80
90
105
140
195
AFC
$60
30
20
15
12
AVC
$20
15
15
20
27
Average Total Cost = ATC = TC/Q

Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
16
Marginal Cost = TC/Q = TVC/Q
ATC
$80
45
35
35
39
MC
$20
10
15
35
55
Graphical Presentation
17
Average Cost Curves-Graphical meaning
The
average fixed cost curve slopes

down continuously.
The
average total cost curve is the

vertical summation of the average fixed
cost curve and the average variable cost
curve
The
ATC curve is always higher than

AFC and AVC curves
While output gets big and AFC decline

to zero, the AVC curve approaches the
ATC curve.
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Wage Rate
Average Variable Cost
AVC = TVC/Q = w/APL

Marginal Cost
TC/Q = TVC/Q = w/MPL
19
Long-Run Cost Curves
The long run is the period of time during which:

Technology
All
is constant
inputs and costs are variable
The
firm faces no fixed inputs or costs
The
long run period is a series of short run

periods. [For each short run period there is a
set of TP, AP, MP, MC, AFC, AVC, ATC, TC,
TVC & TFC for each possible scale of plant].
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Long-Run Total Cost = The minimum total

costs of producing various levels of output
when the firm can build any desired scale
of plant: LTC = f(Q)
Long-Run Average Cost = The minimum
per-unit cost of producing any level of
output when the firm can build any desire
scale of plant: LAC = LTC/Q
Long-Run Marginal Cost = The change in
long-run total costs per unit change in
output: LMC = LTC/Q
21
Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = LTC/Q
22

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Theory of Cost

Explicit costs are actual expenditures of

Implicit costs refers to the value of the

Economic cost refers the sum of explicit and

Alternative or Opportunity Costs

The cost to the firm of using a purchased or

Short-Run Cost Functions

In short-run period, some of the firms

Total fixed and variable costs

Total Fixed Costs: The total obligations of

Short-Run Cost Functions

Total Cost = TC = f(Q)

Average total cost (also called average cost)

Average variable cost equals variable cost

Average Costs and Marginal Cost

Average total cost is also the sum of average fixed

Marginal (incremental) cost is the increase in total

Average Costs and Marginal Cost

marginal cost curve, average variable

The U-shape in the short run is attributed to

Average Costs and Marginal Cost

The marginal cost and average cost curves are

MC exceeds AC, average cost must

MC is less than AC, average cost

This relationship explains why marginal cost

MC will intersect the AVC at the

Relationship Between Marginal and Average

If MC > ATC, then ATC is rising

If MC > AVC, then AVC is rising

If MC < AVC, then AVC is falling

Short-Run Cost Functions

Average Total Cost = ATC = TC/Q

Marginal Cost = TC/Q = TVC/Q

Short-Run Cost Functions-Example

Average Total Cost = ATC = TC/Q

Average Cost Curves-Graphical meaning

average fixed cost curve slopes

average total cost curve is the

ATC curve is always higher than

While output gets big and AFC decline

Average Variable Cost

AVC = TVC/Q = w/APL

Long-Run Cost Curves

The long run is the period of time during which:

inputs and costs are variable

firm faces no fixed inputs or costs

long run period is a series of short run

Long-Run Cost Curves

Long-Run Total Cost = The minimum total

Long-Run Cost Curves

Long-Run Total Cost = LTC = f(Q)

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