THEORY OF COST

UMULKULTHUM MUSA YEYA

 THEORY OF COST

 Theory of cost helps in understanding the concept of cost. The following are
necessary:
 Opportunity Cost Assuming full resources allocation and employment in
production of good and services increasing the production of any one
product involves the sacrifice of an alternation product. The cost of producing
a certain product is taken to refer to the forgone value of the alternative
product
 Private cost and social cost (negative externalities) private cost refers
to these costs which relates to an individual producer. They include both
explicit and implicit. While social cost refer to these costs which occur to
the third party in the production process.
 Explicit cost refer to the money paid out made by the firm. This includes
payment for resources bought or hired e.g. wages, cost of raw materials, rent
etc.
 Implicit cost includes the resources owned and used by the firm’s
owner. When profit are calculated only on basis of explicit cost we obtain
financial profit.
 When the profits are calculated on the bases of explicit and implicit cost
we obtain economic profit.
Assumptions
 The firms take prices or input as determined by the market forces.
 Firms aim at minimizing the production cost.
 SHORT RUN COST FUNCTION

 In the short run input levels will depend on output level that the firm
wants to achieve.
 In short run not all factors will be varied. At least one must be fixed and
therefore the cost incurred on it will be fixed cost.
 The total fixed cost will be constant regardless of the output level e.g.
rent for factory building, salaries of office staff etc.
 Variable costs are incurred by the firm for its variable input. A firm
wishing to increase its out put will require large variable input thus
higher variable cost.
 The variable costs of a firm will increase as the output levels increase
e.g. cost of raw materials, cost of direct labour and other direct running
expenses.
 VC = f (Q) Where VC - variable costs, f -function, Q- output
 Total cost represents the sum of the fixed cost and the varied cost.
TC = (VC+FC) Where TC - Total costs; VC variable costs, FC – fixed costs
 Average cost is the cost per unit is the total cost of producing any given output
divided by the total number of unit produced. Given by:
 A C= TC Where AC - average cost, Q - total units produced
Q
 Average fixed cost, the total fixed cost divided by the output. Given by: AFC =
TFC Where TFC - total fixed costs
Q
 Average variable cost is given total variable cost divided by the output
AVC = TVC Where TVC - total variable costs
Q
 Marginal costi s the change In the total cost as a result of a unit change in
output
MC = ∆TC
∆Q.
Graphical presentation
Variable cost

Cost T.V.C

Output
Figure Variable costs
Total Cost

Total costs
V. C.

5,000 F. C.
Slope = V.C .e.g. Constant or intercept
$50 per kilo of of $5,000
four

2,000 4000
Output
Unit cost
Unit costs

Unit costs

V. C.

F. C.

2,000 4,000 6,000

Output

Unit fixed reduce as output increases as illustrated below:

Units produced Fixed cost per unit

1 5,000
10 500
100 50
1,000 5
5,000 1
 In the Long run, All costs are variable

Fixed Cost :in practice fixed costs are not constant over the full range of activity, they may
increase in steps

Total Costs
The Relationship between Average Cost
and Marginal Cost

 In most of case the marginal cost the average cost from below. The
average cost must be failing as compared to marginal cost
 Mathematically it can be shown that, if the slope of average cost is less than
zero, then the marginal cost will be less than average cost AC<0;MC<AC
 If the average cost is greater than zero, then marginal cost is greater than
average cost. AC>0;MC>AC
 Since the average cost curve is U- shaped the slope of average cost
becomes zero to its minimum and hence marginal cost is equal to costs
at this point.
The Relationship between Average Total
Costs, Average Fixed Cost, Average variable
cost and marginal cost is shown below.
Output AFC AVC AC MC

1 50 20 10 -

2 25 15 40 10

3 16.7 11.7 28.3 5

4 12.5 11.3 23.8 10

5 10 13 23 20

6 8.3 18.3 26.7 4.5

Table showing Relationship between costs variables

Given that total cost is
TC = Q2+ 3Q + 2
Find a) Marginal cost function
∆TC = 2Q +3
∆Q
b) The average total costfunction
ATC = TC = Q2 + 3Q+ 2 = Q+3+2
Q Q Q
b) Average variable costfunction
AV = VC = Q2 +3Q =Q+3
Q Q

c) At what level of output would the firm minimize its average total cost and its average
variable cost in the shortrun
MC = ATC - 2Q + 3 = Q+3+2/Q
(2Q+3)Q = (Q+3)Q
= 2Q2 + 3Q= Q2+3Q+2
2Q2 - Q2 = 2
Q2 = 2
Q=2
= 1.41
MC = AVC
2Q+3 =Q+3
q=0
Suppose that the total cost function of a firm operating in the short run is
given by TC = Q2 + 5Q+6 Find
i. The ATC function
ii. The marginal cost function
iii. The average variable cost function Calculate the average fixed
cost where Q=3
iv. What will be the value of the following at the output of 100unit
a) Average variable cost
b) AFC
c) Marginal
v. At what level of output will the firm minimize its average total cost by
average variable cost?
sln
i. ATC = TC = QQ2 +5Q+ 6Q= Q+5+6
Q Q Q Q
ii. MC = ∆TC =2Q+5

iii. AVC = AVC =Q+5

iv. Give 3= AFC = 6=2
3

v. Given Q = 104Unit

a. AVC = VC = {(10)2 +5X10} = 150 =15

Q 10 10

b. AFC = TC = 6 =0.6
Q 10

c. MC = ∆TC = 2Q +5 = 2X 10 +5 = 25
∆Q
d. MC = TC
Q (2Q +5) =( Q+5+6 ) Q
Q
2Q2 +5Q = Q2 + 5Q +6
2Q2 +5Q - Q2 - 5Q = 6
Q2 =6
Q= 6
= 2.45 Unit ~ 3 Unit

MC = AVC
2Q+5 = Q+5
Q =0
REVENUE FUNCTION

Revenue is the receipt from the sales of a good or

service Total revenue is given by the price x quantity
sold
TR =PQ Where TR- total revenue, PQ- price x
quantity Average Revenue is given by;
AR =TR refers to revenue per unit sold onaverage
Q
Marginal revenue it is the increase in revenue brought about on extra unit
sold. MR =∆TR
∆Q
 exercise
Given a demand function P =5 -1/ 4 Q. Calculate total revenue marginal revenue
and average revenue.
TR =PQ
=(5 - 1/ 4 Q) Q =5Q - ¼ Q2
MC =∆TR =5 - ½ Q
∆Q
AV=TR =5Q - 1/ 4Q2 =¼
QQ Q

=5 - ¼ Q
OPTIMUM SEIZE OF A FIRM

 This is the level of output at which total profit is at

maximum.
 It is the best or the most efficient size of a firm
when the long run average cost of a firm is at
minimum.
 At this point there will be no motive for further
expansion since at any other size large or smaller
the firm will be less efficient.
 This is also attained when the firm cost of
production is at its minimum level as illustrated in
Figure below
 A
TC BEP TC
BEP
• E
• E

A TR
TR

O L M N Output
Figure showing Optimum seize of a firm
 Explanation of the above graph
 Below OL total cost exceeds total revenue and hence the
firm is making loss.
 At the point EL neither profit nor loss are being made and
hence its break even point (BEP) when total revenue is
equal to the total cost.
 The same case applies to the point EN.

 Maximum profit lies where revenue and total cost difference

total in the greater i.e. the point where the vertical distance
between the total revenue and the total cost is greatest.
 In above the maximum profit is at point M where AA is the
largest vertical distance.
 N/B: For profit maximization the following two conditions must be met

i) The necessary conduction - according to this conduction profit are maximized at the levels of output where
marginal revenues is equal to marginal cost. To maximize profits profit is symbolized by pie ( ∏)

 Maximize profit= ∆ Profit = 0

∆ Quantity

=∆∏ =0
∆Q

 But ∏ = TR - TC

∆∏ = ∆TR - ∆TC =
∆Q ∆Q ∆Q 0 = MR -MC
MR = MC
i) The sufficient condition states that the slope of marginal revenue curve must be less than the slope of marginal
cost curve at the point where they meet. Meaning that the marginal cost curve cuts the marginal revenue curve
from below as shown in Figure below
 N/B: Total profit function is maximized as
follows
 Taking the first derivative and setting it
equal to zero to obtain the critical values.
 Taking the second derivative and evaluating
it at the critical values to ascertain if the
function is at the relative minimum or
maximum.
 Further explanation

1). First-Order Condition:

dY
When a function is at maximum or minimum, the first derivative ( ) equals to zero. This is a
dX
necessary condition for a maximum or minimum, but it is not a sufficient condition to determine
if the function is at a minimum or a maximum.
2). Second-Order Condition:
The test for a maximum or a minimum using the second derivative is called the second-order
condition.

The first-and second-order conditions together are sufficient to test for either a maximum or a
minimum point
Maximum Minimum
First-order Condition dY dY
0 0
dX dX
Second-Order Condition d 2Y d 2Y
0 0
dX 2 dX 2
 e x a m p le

TR = 20Q – Q2
TC = 50 + 4Q

Find the level of output, Q, that maximize profit (Π)

Solution

 TR  TC
20Q  Q 2  50  4Q
 Q 2  16Q  50

Where the profit function is at maximum, first-order-condition

d
0
dQ
Therefore
d
 2Q  16 0
dQ
2Q 16
Q 8
Second-order condition for maximum:
2
d  d d
2
 ( )0
dQ dQ dQ
d
 (  2Q  16)
dQ
 2
Since the second derivative of the profit function is -2, we conclude that the profit is maximized
at Q = 8.
 Numerical example

TR = 45Q – 0.5Q2
TC = Q3 – 8Q2 + 57Q + 2

Find Q that maximizes profit (Π).

Solution

Π = TR – TC
= 45Q – 0.5Q2 – (Q3 - 8Q2 + 57Q + 2)
= - Q3 + 7.5Q2 – 12Q – 2 ……………………………………. (1)

First-Order Condition:

d
0
dQ
d
  3Q 2  15Q  12 0.......... .......... .......... .......... .......... .....( 2)
dQ

Divide equation 2 by (-3)

d
Q 2  5Q  4 0.......... .......... .......... .......... .......... .......... ....( 3)
dQ
Using quadratic formula:

Given 0 = aX2 + bX + C

 b  b 2  4 ac
X 
2a

From equation 3 X = Q, a = 1, b = -5, and c =4

5  52  4(1)( 4)
 Q
2(1)
5  25  16

2
5 3

2
Therefore Q = 4 and 1.
 max

d 2
For maximum, second-order condition 0
dQ 2
d 2 d d d
2
 ( )  (  3Q 2  15Q  12)
dQ dQ dQ dQ

d 2
  6Q  15
dQ 2

d 2
At Q = 1,  6(1)  15 9, and  is min imum
dQ 2

2
At Q = 4, d 2  6( 4)  15  9, and  is max imum.
dQ

Therefore, Π is maximized at Q = 4, and maximum Π = 6.

 Exercise 1
Trusts enterprises is a medium sized firm which specializes in production of water taps
T h e fi n an ce d ep artm en t h as d eterm in ed th e follow ing cost stru ctu re p er u nit
of a tap p rod u ced .
a) Variables cost per unit15/ =
b) The fixed cost period is20/ =
c) Selling price for tap is 25/ =
Required:
i. Deriver the total cost function and re venuefunction
ii. Determine the break winpoint.
iii. The number of taps that would give a profit of 4/ =
If for some reason the price of taps increase to 3 5/ =per tap. What will bethe break
evenoutput
Exercise 2
Q1. The total cost equation in the production of beckon at a certain factory
is
given as follows C= 1000 + 1000-25Q2+ Q3 Where C is the cost is Shs.
and Q
is the quality in Kg.
Required:
I. Compute the total and average cost at the output of 1 0kg and11kg.
II. What is the marginal cost of the 12thkg?
III. Explain the slope and relationship between the average cost, average
variable cost, marginal cost and fixed cost curve using relevant diagrams
Thank you