Chapter Three

Theory of Costs
3.1 Introduction
A firm uses a two-step procedure to determine how to produce a certain amount of output
efficiently. It first determines which production processes are technologically efficient so that it
can produce the desired level of output with the least amount of inputs. The firm’s second step is
to select the technologically efficient production process that is also cost efficient, minimizing the
cost of producing a specified amount of output. To determine which process minimizes its cost of
production, the firm uses information about the production function and the cost of inputs.

All firms, regardless of size, incur costs as they make the goods and services that they sell. Costs
are incurred because a firm uses factor inputs in production, and these must be paid for. Cost refers
to the market value of the inputs a firm uses in production. By reducing its cost of producing a
given level of output, a firm can increase its profit. Any profit-maximizing competitive,
monopolistic, or oligopolistic firm minimizes its cost of production. Economists use a broader
concept of cost.

Types of Costs

Explicit versus Implicit Costs

Because not all costs involve direct monetary outlays, economists distinguish between explicit
costs and implicit costs Explicit costs are out-of-pocket costs, that is, actual payments. Wages that
a firm pays its employees or rent that a firm pays for its office are explicit costs. Implicit costs are
more subtle, but just as important. Besides purchasing resources from other firms, a producer uses
his/her own factor services in the process of production. He/she generally does not take into
account the costs of his/her own factors while calculating the expenses of the firm. The cost of
using such factors is called implicit costs or imputed costs. Thus, implicit costs refer to the imputed
costs of the factors of production owned by the producer himself/herself. They are called implicit
costs because producers do not make payment to others for them. They represent the opportunity
cost of using resources that the firm already owns. Often for small businesses, they are resources
that the owners contribute. For example, working in the business while not earning a formal salary,
or using the ground floor of a home as a retail store are both implicit costs.

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Economic Versus Accounting Costs

Economic costs are synonymous with opportunity costs and, as such, are the sum of a firm’s
explicit and implicit costs. Accounting costs are explicit costs that have been incurred in the past.
As we will see, economists are therefore concerned with economic cost, which is the cost of
utilizing resources in production. What kinds of resources are part of economic cost? The word
economic tells us to distinguish between the costs the firm can control and those it cannot. It also
tells us to consider all costs relevant to production.

Policy Related Cost Concepts: Private and Social Costs

There are certain other costs which arise due to functioning of the firm but do not normally figure
in the business decisions, nor are such costs explicitly paid by the firms. Private cost refers to cost
of production incurred by an individual firm in producing a commodity. Social cost, on the other
hand, refers to the cost that the society has to bear on account of production of a commodity. Social
cost is a wider concept than private cost. It is the sum total of the cost incurred by the producers
of goods and services (private cost) and the cost experienced by those who have to suffer because
of the production of the commodity in terms of external cost. Social cost includes both private cost
and the external cost. External cost includes (i) the cost of ‘resources for which the firm is not
compelled to pay a price’, e.g., atmosphere, rivers, lakes and also for the use of public utility
service like roads, drainage system and so on and (ii) the cost in the form of ‘disutility’ created
through air, water, and noise pollutions and so on.

3.2 Cost of Production

Economic theory distinguishes between short-run costs and long-run costs. Short-run costs are the
costs over a period during which some factors of production are fixed and some inputs are variable.
Accordingly, in short-run production, we have two types of costs - fixed costs and variable costs.
The long-run costs are the costs over a period long enough to permit the change of all factors of
production. In the long run, all factors become variable. Accordingly, in the long run, all costs are
variable costs.

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3.2.1 Short-Run Costs
Some costs vary with output, while others remain unchanged as long as the firm is producing any
output at all. To produce a given level of output in the short run, a firm incurs costs for both its
fixed and variable inputs. A fixed cost is a cost that does not vary with the level of output. Fixed
costs include expenditures on land, office space, production facilities, and other overhead
expenses. The firm cannot avoid fixed costs by reducing output as long as it stays in business. The
only way that a firm can eliminate its fixed costs is by shutting down (going out of business). A
variable cost is a cost that varies as output varies. The variable cost is the cost of the variable
inputs. A firm’s cost (or total cost, C) is the sum of a firm’s variable cost and fixed cost. The main
types of variable cost are expenditures incurred for raw materials, wages and salaries paid to casual
workers, operating expenses like electricity, and taxes such as excise duties, which depend upon
the output produced.

TC = TFC + TVC
Cost

Output
Figure 3.1: TFC, TVC, and TC Curves
To decide how much to produce, a firm uses measures of marginal and average costs. We derive
four such measures using the fixed cost, the variable cost, and the total cost.
i) Average Cost: Firms use three average cost measures.
• The average fixed cost (AFC) is the fixed cost divided by the units of output
produced. The average fixed cost falls as output rises because the fixed cost is
spread over more units.
𝑇𝐹𝐶
𝐴𝐹𝐶 =
𝑄

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 • The average variable cost (AVC) is the variable cost divided by the units of output
Produced. Because the variable cost increases with output, the average variable cost
may either increase or decrease as output rises.
𝑇𝑉𝐶
𝐴𝑉𝐶 =
𝑄
• Average total cost (Average cost): is the total cost divided by the units of output
produced. That is, the average cost is the sum of the average variable cost and the
average fixed cost. A firm uses its average cost to determine if it is making a profit.
𝑇𝐶 𝑇𝐹𝐶 + 𝑇𝑉𝐶
𝐴𝐶 = = = 𝐴𝐹𝐶 + 𝐴𝑉𝐶
𝑄 𝑄
ii) Marginal Cost: is the amount by which a firm’s cost changes if it produces one more unit
of output. It is extra cost that results from producing one extra unit of output.
∆𝑇𝐶 ∆𝑇𝑉𝐶
𝑀𝐶 = =
∆𝑄 ∆𝑄
Costs

Output
Figure 3.2: AFC, AVC, AC and MC Curves

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Table 3.1: Numerical Example

Costs

Output
Costs

Output
Figure 3.3: TFC, TVC, TC, AFC, AVC, ATC and MC Curves

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The Shapes of the Cost Curves
The TFC is graphically denoted by a straight line parallel to the output axis. The TVC in the
traditional theory of the firm has broadly an inverse-S shape which reflects the law of variable
proportions. According to this law, at the initial stages of production with a given plant, as more
of the variable factor(s) is employed, its productivity increases and the average variable cost falls.
The TVC curve is a positively sloping curve, showing that, as output increases, total variable cost
also increases. But the rate of increase of TVC is not the same throughout. TC is the vertical sum
of fixed cost FC and variable cost VC. The shape of the TC curve is the same as that of the TVC
curve.

The AFC curve falls as output increases. It approaches zero as output gets larger because the fixed
cost is spread over many units of output. The AVC curve is U-shaped. The AC curve is the vertical
sum of the AVC curve and the AFC curve. The shape of the ATC is similar to that of the AVC
(both being U-shaped). Initially the ATC declines, it reaches a minimum at the level of optimal
operation of the plant and subsequently rises again. The U shape of both the AVC and the ATC
reflects the law of variable proportions. But, the minimum point of the ATC occurs to the right of
the minimum point of the AVC. That is the AVC cost curve reaches its minimum point at a lower
output than the ATC curve.

The MC curve is U-shaped. As output increases, the MC curve slopes downward, then reaches the
minimum and then starts sloping upward. The U-shape of the MC curve is because of the law of
variable proportions. The MC cuts the ATC and the A VC at their lowest points.

Relation Between Average and Marginal Cost

• Whenever MC lies below AC, the AC curve falls.

• Whenever MC lies above AC, the AC curve rises.
• When MC equals AC, AC is at a minimum

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3.2.2 Long-Run Costs
In the long run, all factors are assumed to become variable. In the long run, a firm adjusts all its
inputs to keep its cost of production as low as possible. The firm can change its plant size, design
and build new equipment, and otherwise adjust inputs that were fixed in the short run. Thus, there
are no fixed costs in the long-run and thereby the long-run total cost equals the long-run variable
cost.

Suppose a firm uses two inputs, labour and capital, to produce efficient level of output. A firm can
produce a given level of output using many different technologically efficient combinations of
inputs, as summarized by an isoquant. From among the technologically efficient combinations of
inputs, a firm wants to choose the particular bundle with the lowest cost of production, which is
the cost-efficient combination of inputs. To do so, the firm combines information about technology
from the isoquant with information about the cost of labor and capital.

We will the concept of an isocost line in long-run costs. Then we show how a firm can combine
the information in isoquant and isocost lines to determine the cost-efficient combination of inputs.

Isocost Line:

The cost of producing a given level of output depends on the price of labor and capital. The firm
hires L hours of labor services at a wage of w per hour, so its labor cost is wL. The firm rents K
hours of machine services at a rental rate of r per hour, so its capital cost is rK. The price of labor
could be either an explicit cost or an implicit cost. It would be an explicit cost if the firm (as most
firms do) hires workers in the open market. It would be an implicit cost if the firm’s owner provides
his/her own labor to run the firm and, in so doing, sacrifices outside employment opportunities.
Similarly, the price of capital could either be an explicit cost or an implicit cost. It would be an
explicit cost if the firm leased capital services from another firm (e.g., a firm that leases computer
time on a server to host its website). It would be an implicit cost if the firm owned the physical
capital and, by using it in its own business, sacrificed the opportunity to sell capital services to
other firms.

The firm’s total cost is the sum of its labor and capital costs:
C = wL + rK.

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The firm can hire as much labor and capital as it wants at these constant input prices. The firm can
use many combinations of labor and capital that cost the same amount. These combinations of
labor and capital are plotted on an isocost line, which indicates all the combinations of inputs that
require the same (iso) total expenditure (cost). An isocost line represents a set of combinations of
labor and capital that have the same total cost (TC) for the firm. Along an isocost line, cost is fixed
at a particular level, C, so by setting cost at C in we can write the equation for the C isocost line
as
𝐶̅ = wL + rK
Using algebra, we can show how much capital the firm can buy if it spends a total of C and
purchases L units of labor:
𝐶̅ 𝑤
𝐾= − 𝐿
𝑟 𝑟
Capital

Labour
Figure 3.3: Isocost Lines
The slope of an isocost line is the ratio of the wage rate to the rental cost of capital. Note that this
slope is similar to the slope of the budget line that the consumer faces.
∆𝐾 𝑤
=−
∆𝐿 𝑟

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The role of the isocost line in the firm’s decision making is similar to the role of the budget line in
a consumer’s decision making. Both an isocost line and a budget line are straight lines with slopes
that depend on relative prices. The firm faces many isocost lines, each of which corresponds to a
different level of expenditures the firm might make. A firm may incur a relatively low cost by
producing relatively little output with few inputs, or it may incur a relatively high cost by
producing a relatively large quantity.

A firm determines how to produce a given level of output at the lowest cost. Thus, to minimize its
cost of producing a given level of output, a firm chooses its inputs. The cost-minimizing input
combination occurs when marginal rate of technical substitution equals the negative of the relative
input prices. The cost-minimizing input combination occurs at a point where an attainable isoquant
is tangent to the lowest attainable isocost line. That is

Capital

Labour
Figure 3.4: Cost-Minimizing Input Combination

In Figure 3.4, the cost-minimizing input combination occurs at point A. Point G is technically
inefficient. Points E and F are technically efficient, but they do not minimize cost (the firm can
lower cost from TC1 to TC0 by moving to input combination A).

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Using Calculus to Minimize Cost

A firm minimizes its cost subject to the information about the production function that is contained
in the isoquant formula, 𝑞̅ = f(L, K).

Objective function: Minimize wL + rK

Constraint function: Subject to 𝑞̅ = f(L, K)

The corresponding Lagrangian problem is

ℒ = wL + rK + 𝝀[𝑞
̅ − 𝑓(𝐿, 𝐾)]

Assuming that we have an interior solution where both L and K are positive, the first-order
conditions are
𝜕ℒ 𝜕𝑓(𝐿, 𝐾)
𝑖) =𝑤−𝜆 =0
𝜕𝐿 𝜕𝐿
𝜕𝑓(𝐿, 𝐾)
𝑤=𝜆
𝜕𝐿
𝑤
𝜆= … … … … … … … … … . . (1)
𝑀𝑃𝐿

𝜕ℒ 𝜕𝑓(𝐿, 𝐾)
𝑖𝑖) =𝑟−𝜆 =0
𝜕𝐾 𝜕𝐾

𝜕𝑓(𝐿, 𝐾)
𝑤=𝜆
𝜕𝐾
𝑤
𝜆= … … … … … … … … … . . (2)
𝑀𝑃𝐾

𝜕ℒ
𝑖𝑖𝑖) = 𝑞̅ − 𝑓(𝐿, 𝐾) = 0
𝜕𝜆

𝑞̅ = 𝑓(𝐿, 𝐾) … … … … … … … … . . (3)

From equation 1 and 2, we have

𝑀𝑃𝐿 𝑤
=
𝑀𝑃𝐾 𝑟

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That is, the firm minimizes cost where the factor-price ratio equals the ratio of the marginal
products.
Maximizing Output: An equivalent or dual problem to minimizing the cost of producing a given
quantity of output is maximizing output for a given level of cost. I.e.
Maximize q = f(L, K)
Subject to 𝐶̅ = wL + rK
We can follow the same procedure like the above lagrangian multipliers method. We obtain the
same condition as when we minimized cost by holding output constant. That is, at the output
maximum, the slope of the isoquant equals the slope of the isocost line.

Example: Suppose that a firm’s production function is 𝑄 = 50√𝐿𝐾. Suppose that the price of labor
w is 5 birr per unit and the price of capital r is birr 20 per unit.
A) What is the cost-minimizing input combination if the firm wants to produce 1,000 units per
year? What is the firm’s total cost at this input combination?
B) Find λ, which measures the firm’s marginal cost when Q = 1,000 units. Interpret λ

Solution:
A) Minimize 5L + 20K
Subject to 50√𝐿𝐾 = 1000
For this problem the Lagrangian function is
ℒ = 5L + 20K + 𝝀[1000 − 50√𝐿𝐾 ]
The first-order conditions are

𝜕ℒ 𝐾
𝑖) = 5 − 25𝜆√ = 0
𝜕𝐿 𝐿

𝐾 1 𝐿
5 = 25𝜆√ , 𝜆 = [√ ] … … … … … … … … … … (1)
𝐿 5 𝐾

𝜕ℒ 𝐿
𝑖𝑖) = 20 − 25𝜆 √ = 0
𝜕𝐾 𝐾

𝐿 4 𝐾
20 = 25𝜆√ , 𝜆= [√ ] … … … … … … … … … (2)
𝐾 5 𝐿

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 𝜕ℒ
𝑖𝑖𝑖) = 1000 − 50√𝐿𝐾 = 0
𝜕𝜆
1000 = 50√𝐿𝐾 … … … … … … … . . … … … … … … … (3)

From equation 1 and 2, we have

1 𝐿 4 𝐾
[√ ] = [√ ] , 𝐿 = 4𝐾
5 𝐾 5 𝐿

Substitute L = 4K into equation 3

1
1000 = 50(4𝐾 2 )2
1000 = 100𝐾, 𝐾 = 10, 𝐿 = 4 ∗ 10 = 40
B)
1 𝐿 4 𝐾
𝜆 = 5 [√𝐾 ] = 5 [√ 𝐿 ] = 0.4.

This is the rate of change ∆TC/∆Q in total cost when the quantity is 1,000 units. If the firm’s output
rate were to increase by 1 unit, we would expect to see total cost increase by about birr 0.4.

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