Chapter 4

CHAPTER FOUR
THEORY COST
Introduction
In this chapter we will discussed about
Short-Run Costs
Long-Run Costs
Derivation of cost function from production function
Dynamic change in cost- the learning curve
Theory of costs
Definition and types of costs
Cost is the monetary value of inputs used in the
production of an item. Explicit
cost
Private
Cost cost
Economic
cost
Accounting
Implicit
Social cost
cost
cost
Explicit
cost
COST FUNCTION
It is algebraically relation between the cost of production and

various factors which determine it.
cost of production depends on
the level of output produced, (X)
technology of production, (t)
prices of factors, (pi) etc.
C = f (x, t, pi)
Short run vs. long run cost
1. Short run costs
In the traditional theory of the firm, total costs are split
into two groups: total fixed costs and total variable costs:
Fixed costs, we mean a cost which doesn’t vary with the
level of out put.
Variable costs, on the other hand, include all costs which
directly vary with the level of output.
TC = TFC + TVC
Total, Average and Marginal costs
1. Total COST TC
(Total Cost)
TC TC; the short run total cost is given by the sum of
total fixed cost and total variable cost. TVC
TVC
(Total Variable
TFC Cost)
TFC
(Total Fixed Cost)
0 Q
Fig. COST CURVES

5
2. Per unit costs
Average fixed cost (AFC) - Average fixed cost is total
fixed cost per unit of output. The curve declines
continuously and approaches both axes asymptotically.
Average variable cost (AVC) - Average variable cost is
total variable cost per unit of output. The short run AVC
falls initially, reaches its minimum, and then starts to
increase. Hence, the AVC curve has U-shape and the
reason behind is the law of variable proportions.
Average total cost (ATC)- is the total cost per unit of
output. AC can also be given by the vertical sum of AVC
and AFC.
3. Marginal Cost (MC)
Marginal cost is defined as the additional cost that a firm
incurs to produce one extra unit of output.
In other words, it is the change in total cost which results
from a unit change in output.
MC is the slope of TC function.
MC is also a change in TVC with respect to a unit change
in the level of output.
AVC, AC and MC curves are all U-shaped due to the law of variable
proportions.
AC
MC
AVC
AFC
Q1
Q2
The relationship between AVC, ATC and MC
Example 1: Suppose the short run cost function of a firm
is given by: TC=2Q3 –2Q2 + Q + 10.
a) Find the expression of TFC & TVC
b) Derive the expressions of AFC, AVC, AC and MC
c) Find the levels of output that minimize MC and AVC
and then find the minimum values of MC and AVC
Example 2:
Find the minimum value of AVC and MC.
The relationship between short run production
and cost curves
i) Marginal Cost and Marginal Product of Labour
MC and MPL are inversely related. When initially MPL
increases, MC decreases; when MPL is at its maximum,
MC must be at a minimum and when finally MPL
declines, MC increases.
ii) AVC and AP of Labour
There is an inverse relation between AVC and APL. When
APL increases, AVC decreases; when APL is at a
maximum, AVC is at a minimum and when finally APL
declines, AVC increases.
maximum MP
Unit maximum AP
product
AP
Labor
MP
Unit cost
MC
AVC
minimum MC minimum AVC

Quantit
y
12
2. COSTS IN THE LONG RUN
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.
It is always possible to produce zero units of output at
zero costs. Derivation of the long- run average cost curve
The long run AVC curve is the lower envelope of the short run average costs of various
plant sizes.
Why is the LAC U-shaped?
the reason for the U-shaped ness 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.
Derivation of long-run marginal cost curve
 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
SAC1
SMC1 SAC3
LMC LAC
SAC2
SMC2 SMC3
Q1 Q2 Q3 Q
 WHY the LMC curve passes through the minimum of the LAC
curve?
DYNAMIC CHANGES IN COSTS:
The Learning Curve
As management and labor gain experience with production, the
firm’s marginal and average costs of producing a given level of out
put fall. Number of labor required to produce one unit
Learning
curve
A
Cumulative
out put
THIS shows that at the firm’s cumulative out put increases(as the
firm gets experienced),the amount of inputs(such as labor)required
to produce one unit of out put decreases.
Learning vs Economies of scale
Increasing returns to scale reduces average cost of production
with increase in out put, where as learning shifts the average
cost curve down ward.
Cost per unit of out put
Economies of scale
Learning AC1
AC2
Out put

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CHAPTER FOUR

It is algebraically relation between the cost of production and

1. Short run costs

Fig. COST CURVES

minimum MC minimum AVC

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