Cost function

The term cost function refers to the relationship between a firm's output of goods and services
and the cost of production. Since the cost of production is the sum of the inputs multiplied by
their prices, one can easily move from the production function to the cost function
The term cost function, therefore, refers to the total payment that the firm makes for its factors of
production, inputs or resources. In economics, the term cost is not merely the firm's historical
cost, but more so its opportunity cost. This is because the owner of the resources must be paid
the minimum of what their resources could have earned in their next best alternative uses.
Types of cost based on who owns the factors of production
Based on the classification, cost can be divided into two categories:
1. Explicit cost
2. Implicit cost
Explicit cost – the total explicit cost refers to the payment that the firm makes to non-owners for
the resources that it employs. They include the salaries paid to employees, the payment for raw
materials, the payment for insurance services, etc.
Implicit cost – the implicit cost, on the other hand, refers to the opportunity cost of the resources
that the firm employs but owns. If a firm uses the resources that it owns, it must be paid at least
what those resources could have earned in their next best alternative uses. For example, the
entrepreneur could manage another firm and earn a salary of $200,000 monthly. The building
that the firm operates could have been rented for $50,000 monthly, and the money that was used
to start the business could have been placed in the bank, earning a monthly interest of $50,000.
The total implicit cost is $300,000. If the firm is to operate its own business, it must make a
minimum profit of $300,000.
Types of costs based on how they vary with production
They include:
1. Total fixed cost
2. Total variable cost
Total fixed cost refers to the payment that the firm makes for fixed resources such as buildings,
machinery, insurance, etc. The total fixed cost remains the same regardless of the level of output.
If the firm produces zero units or thousands of units of output, the total fixed cost remains the
same. Therefore, when the level of output is zero, the total cost is the fixed cost.
The total variable cost, on the other hand, varies directly with the level of output. When the
output is zero, the total variable cost is zero and as the output increases, variable cost also
increases and vice versa. Examples of variable costs are labour, utility and raw materials.

TC
TVC

Cost
FC

0
Units of output
The graph shows the total cost can be attained by adding the total fixed cost and the total variable
cost.
Units of TFC TVC TC
output

0 100 0 100
1 100 30 130
2 100 90 190
3 100 100 200
4 100 110 210
5 100 130 230
6 100 160 260
7 100 200 300
8 100 300 400
9 100 350 450
10 100 410 510

Unit cost

The total cost can be further subdivided into unit cost. These costs are really costs in the short
run since they are based on the premise that there is a total fixed cost. The total variable cost can
be divided into the average fixed cost. TC = TFC + TVC. By dividing both sides by Q, one
obtains TC/Q = ATC; TFC/Q = AFC and TVC/Q = AVC. This shows the average total cost is
obtained by dividing the total cost by the number of units (Q). The average fixed cost can be
obtained by dividing the total fixed cost by the number of units of output (Q). The same thing is
done for TVC.

TC/Q = TFC/Q + TVC/Q

.
TC/Q = ATC, TFC/Q = AFC

TVC/Q = AVC

The average total cost can be obtained in two ways:

1. By dividing the total cost by the quantity of output = TC/Q
2. By adding the AFC and the AVC

The unit costs are the average total cost and the marginal cost. The marginal cost is the cost of
providing one more or one less unit, while the average cost is the cost of producing one unit

Units TC ATC MC
of output
0 100 ∞
1 190 190 90
2 270 135 80
3 330 110 60
4 380 95 50
5 450 90 70
6 540 90 90
7 630 90 90
8 800 100 170
Unit TFC AFC TVC AVC
of output
0 100 ∞ 0 ∞
1 100 100 90 90
2 100 50 170 85
3 100 33 230 77
4 100 25 286 72
5 100 20 350 70
6 100 17 440 73
7 100 14 530 76
8 100 13 700 88

All the unit costs except the average fixed cost are U-shaped. This means they fall, reach a
minimum, and then begin to rise. This shape arises in the short run due to the law of diminishing
marginal product. If additional units of variable inputs lead to a decrease in output, the average
cost and the marginal cost must be increasing.

MC
ATC

MP AP

The graph shows that there is a close relationship between the average and marginal product, and
the average and marginal cost. When the average and marginal products are rising and the firm is
adding more output per unit of input or more output per additional unit of input, the average and
the marginal cost must be falling. Note that the average fixed cost is not fixed but variable. It
actually decreases as output increases. This is because a fixed number is being divided by a
larger quantity of output. The fixed cost is spread over a wide range of output, each unit bearing
a smaller percentage of the cost. On a graph, it is a downward-sloping curve that approaches the
x-axis but never touches it.

Unit cost

0
Units of output
When both the average and the marginal cost are decreasing, economists refer to this as increase
in returns to the variable inputs.
Where the firm is experiencing decreasing returns to the variable inputs, the average and
marginal costs are increasing.

b
Unit cost ($) c a » AFC
d b » AVC
c » ATC
d » MC

a
Units of out put
Relationship between average cost and marginal cost
When marginal cost is below average cost, it pulls the average cost downwards, and so, the
average cost must be decreasing. When the marginal cost rises above the average cost, it pulls
the average upwards, and so, the average cost must be increasing. When average cost and
marginal cost are equal, average cost is at its minimum.
Marginal cost is defined as the change in the total cost arising from the change in the number of
units of output by one. When the total cost is increasing, the marginal cost can be defined as the
addition to the total cost arising from increasing output by one unit.
Long-run average cost function
The term long-run function shows the relationship between a firm’s output of goods and services
and the cost of production when the firm has sufficient time to vary all factors. In the long-run,
all factors are variable. There is no long-run average nor total fixed cost. There is a long-run
average cost curve and a long-run marginal cost curve.
Long-run average cost curve
This curve shows the lowest cost of producing a unit of output when the firm has sufficient time
to vary all factors. It is sometimes called the envelope curve since it encloses a number of short-
run average cost curves.
The LRAC curve is formulated by joining the lowest points on its SRAC curve. It represents the
points of tangency between the two curves. Only the segment where the SRAC curve is falling is
taken into consideration. The segment where the SRAC curve is rising is excluded.
The objective of the firm is to maximize profits and it can do so in two ways:
1. by increasing its total revenue by increasing pricing price or quantity which is
represented by TR = P x Q

2. it can also increase its profit by minimizing its cost.

The LRAC curve is intended to increase the firms profit by minimizing its long run average cost.
The objective is to achieve the least cost combination of resources to achieve the optimum level
of output. In the long run a firm can build different size plants for example, a small, medium
large etc. In the diagram above, a small plant SRAC1, a medium size SRAC2 and a large plant
SRAC3. The type of plant size that the firm will choose will depend on the output that it plans to
produce.
If the firm wants to produce up to 200 units of output, it will choose the small plant SRAC1. This
is because it will produce that amount of output at the lowest cost which is $1000. If the firm
were to select the medium size plant SRAC2 to produce the 200 units of output, it would cost
them far more than $1000, and if they were to use the large firm SRAC3 to produce the same
amount (200 units), it would cost the firm even more.
If the firm wants to produce 400 units of output, it will choose the medium-sized plant SRAC2.
This is because it will produce that amount of output at the lowest cost, which is $600. If the firm
were to select the large plant SRAC3 to produce the 400 units of output, it would cost the firm far
more. If the firm were to select the small plant SRAC1 to produce the 400 units of output, it
would cost even more.
If the firm wants to produce 500 units of output. It will choose the large plant SRAC3. This is
because it will produce that amount of output at the lowest cost, which is $500. If they were to
use the small plant SRAC1 to produce the 500 units, it would cost the firm a great deal more. The
same can be said if they use the medium-sized plant SRAC2 to produce the 500 units.
The optimum plant size
The optimum plan size is the most efficient plant that the firm can build. It is found where the
SRAC curve is just tangent to the LRAC curve and forms the lowest point of the LRAC curve
Economies of scale
In the long run, the firm can achieve the following:
1. Economies of scale - is a condition in which a firm expands its scale of production and its
long-run average cost (LRAC) curve decreases.

2. Constant economies of scale – a condition in which the firm expands its scale of
production and its LRAC curve remains constant.

3. Diseconomies of scale – is a condition in which a firm expands it scale of production and

its LRAC curve increases. When a firm experiences diseconomies of scale, it becomes
less efficient. The major diseconomies of scale are a management problem. The firm has
become so large that it is very difficult to manage.

Causes of diseconomies of scale

• Communication problem – as an organisation gets too large, difficulties may be
encountered in transmitting information to the various departments and
organisational groups. In some cases, the information could be distorted when it
gets to the end user.
 • Coordination problem – as the firm gets bigger and is divided into more
specialised departments, it becomes more difficult to ensure that these
departments all meet the objectives of the firm.

• Worker alienation - as the organisation gets larger, workers feel less important or
special. The relationship becomes more impersonal and may lead to workers
becoming less motivated.

• Difficulties encountered in making decisions – as the organisation gets larger, the

management team gets larger, and delays occur when making decisions

• Boredom due to overspecialisation – as the organisation gets too large, personnel

and departments get overspecialised. Persons carrying out the same activities over
and over may become bored due to a lack of interest as a result of the absence of
job enrichment.

Cost of production

Economies of scale

Diseconomies of scale

Constant Average cost

or
Constant returns to scale

0 Units of output as a proxy of the scale of production

Minimum efficiency scale

This represents the lowest level of output at which the firm experiences economies of scale, on a
graph, it is represented after the firm has fully exhausted its economies of scale and begins to
experience constant average cost before it experiences diseconomies of scale.

There are two types of economies of scale:

1. Internal – this is a decrease in the average cost of a single firm arising from an expansion
in the firm’s scale of production.

2. External – This is a condition in which the average cost of one or more firms decreases,
arising from an increase in the scale of production of the entire industry. For example,
arising from an increase in livestock production in Clarendon, a firm sets up a processing
plant in that area. Another example is that, arising from the expansion of alumina
production in Jamaica, an American company has introduced a factory that produces
caustic soda in the same alumina-producing belt. Therefore, they will achieve a lower
cost of production due to the proximity between the caustic soda producing plant and the
different alumina producing plants

Types of internal economies of scale

1. Technical – occurs when a firm increases all its inputs by a given percentage and its
output increases by a larger percentage. Therefore, technical economies of scale is the
same as increasing returns to scale.

2. Commercial – this occurs when a firm produces a large quantity of goods, purchasing a
large amount of raw materials and other inputs and can obtain discounts as a result of
buying in bulk
3. Managerial – As a firm expands its scale of production, it can employ specialists and
managers of specific departments. The expertise of each manager or specialist would
increase factor productivity, leading to lower cost production.

4. Marketing – As the firm expands its scale of production, it not only produces more goods
and services but tends to enjoy a more diversified operation. When the company markets
a large quantity of goods, it realises savings from advertising under the company’s brand.
This will lead to lower cost production due to economies of scale

5. Financial – When a company is well established, such as blue-chip companies like Grace
Kennedy and Lasco, they are perceived by financial institutions as less risky and can
borrow money at a lower interest rate. The lower cost of money will benefit the company
by decreasing the cost of production.

6. Risk-bearing – Many large, well-established companies tend to diversify their businesses

by branching off into different areas. The company’s risk is reduced if one line of
production fails, the company can rely on other lines of production. This is more
economies of scope than economies of scale.