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ACC 815: ECONOMIC THEORY

THE THEORY OF COST a
The theory of cost examines how production costs vary with changes in output levels and
the factors that influence the costs. This knowledge is vital for business decision making. The
theory of cost definition states that the costs of a business highly determine its supply and
spendings. The modern theory of cost in Economics looks into the concepts of cost, short-run
total and average cost, long-run cost along with economy of scales. The theory of cost of
production needs to be understood in detail by managers to be able to run their enterprise and
increase its profit and productivity. The cost function varies concerning factors such as operation
scale, output size, price of production, and more.

Why is the theory of cost important?

The theory of cost is important because it helps policy makers and business organisations
understand how production costs change as output changes. This understanding is necessary for
setting pricing strategies, production levels and guaranteeing profitability. It also provides the
basis for business performance optimisation and growth.

The concepts of cost

In accounting, cost is referred to as the monetary value that has been spent by a company
in order to produce something. In a business, cost expresses the amount of money that is spent on
the production or creation of a good or service.
Economist emphasise that for efficient decision making by the firm, it is the opportunity
cost rather than explicit and historical cost; while the Accountant tend to focus on the explicit
and historical costs. The opportunity cost concept includes both the explicit and implicit costs.
The emphasis here is on the meaning of cost as used by the economists which is relevant for
decision making.
Opportunity cost
Opportunity cost is a basic concept of cost in economics. Scarcity of resources has made
it impossible to produce all the goods that the people may desire. This means that if more
resources are allocated to one product, some other product has to be sacrificed that is, forgone.
The opportunity cost of a product is therefore, the value of the next best alternative
product that is forgone so as to release resources for the production of the former. The problem
of constrained optimisation also necessitates the knowledge of opportunity cost for decision
making by a firm. Our concern in the theory of cost is more on the opportunity cost of the factor
of production of a commodity. In this sense, the opportunity cost of an input or factor of
production is its value (that is, earnings) the next best alternative use or employment.
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The firm must consider the opportunity cost of all inputs and factors of production. If a
firm pays lower price for a factor that it can get in any other firm or use, it will not be able to
retain it. The actual payment for an input or factor of production which is called explicit cost
must not be less than the opportunity cost, otherwise it will not be able to retain it.
Cost functions
The short-run is a period of time in which output can be increased or decreased by
changing only the number of variable factors such as labour and raw materials. The short-run
costs are those cost which are incurred by the firm during a period in which some factors,
especially capital equipment, land and management are held constant. They are incurred on the
purchases of labour, raw materials, chemical, fuel etc, which varies with the changes in the level
of output. The short-run cost function relates the cost of production with level of outputs where
capital (and other fixed) factors are held constant along with the given technology and given
prices
The long-run is defined as the period of time in which the quantities of all factors may be
varied. Long-run costs are the costs incurred during a period which is sufficiently long to allow
variation in all factors of production including capital equipment, land and managerial staff to
produce output. The long-run cost function relates to the change in cost when output is varied by
changing the quantities of all factors used for the production of a commodity.
Total fixed costs
Fixed costs are those which are independent of output, that is they do not change with
changes in output. These costs are a fixed amount which must be incurred by a firm in the short-
run, whether the output is small or large. Fixed costs are also known as overheads and include
costs such as contractual rents insurance fee, maintenance cost, property tax, managers
administrative expenses, watch man wages etc.
Total variable costs
These are those incurred in the employment of variable factors of production whose
amount can be altered in the short-run. This means, the total variable costs changes with the
output in the short-run. They also referred to as prime costs or direct costs. Total costs of a firm
are the sum of its total variable costs and fixed costs. Thus:

TC=TFC +TVC

Note that total cost increases as thelevel of output increases .

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Table 1
Fixed, variable and total costs in the short-run
Numbers Output Daily Total Total Short-run
of Meters of wages variable Fixed total cost
workers cloth per costs W.L cost (TVC+TFC)
(L) produces worker (TVC) (TFC) N
per day (W) N N
(Q) N

i. ii. iii. iv. v. vi.

0 0 60 0 120 120
1 10 60 60 120 180
2 22 60 120 120 240
3 36 60 180 120 300
4 52 60 240 120 360
5 70 60 300 120 420
6 86 60 360 120 480
7 100 60 420 120 540
8 112 60 480 120 600
9 122 60 540 120 660
10 130 60 600 120 720
11 137 60 660 120 780
12 143 60 720 120 840
13 148 60 780 120 900
14 152 60 840 120 960
15 155 60 900 120 1,020

Total costs of a business are the sum of its total variable costs and total fixed costs:
TC=TFC +TVC

Cost (TC) is a function of output f(Q)

Average fixed cost is the total fixed costs divided by the number of units of output
TFC
produced. Therefore, AFC= Where Q represent the number of units of output produced.
Q
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Table 2
Average variable cost, average fixed cost, average total cost, and marginal cost
Numbers Output of TVC AVC TFC AFC ATC MC

( )
of rods (W= N70) TVC

( TFC
Q ) ( ) ( ∆∆TVC
Q )
workers (Q) w. L Q N TVC +TFC
(L) Q
I II III IV V VI VII VIII
0 0 0 0 140 0 0 -

1 10 70 7.00 140 14.00 21.00 7.00

2 22 140 6.36 140 6.36 12.72 5.83
3 36 210 5.83 140 3.89 9.72 5.00
4 52 280 5.38 140 2.69 8.08 4.37
5 70 350 5.00 140 2.00 7.00 3.89
6 86 420 4.88 140 1.63 6.51 4.37
7 100 490 4.90 140 1.00 6.30 5.00
8 112 560 5.00 140 1.25 6.25 5.83
9 122 630 5.16 140 1.15 6.31 7.00
10 130 700 5.38 140 1.08 6.46 8.75
11 137 770 5.62 140 1.02 6.64 10.00
12 143 840 5.87 140 0.98 6.85 11.67
13 148 910 6.15 140 0.95 7.09 14.00
14 152 980 6.45 140 0.92 7.37 17.05
15 155 1050 6.77 140 0.90 7.68 23.33

TVC
AVC= Where Q represent total output produced.
Q
Algebraic forms of cost functions
Cubic cost function
Economists generally use polynomial (a mathematical expression with variables and coefficients,
using only non-negative integer components.) functions to represent the relationship between
cost and output. The algebraic form of the total cost function used in standard economic theory
represents a cubic relationship between costs and output which can be written as:
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TC=a+ bQ+ cQ +dQ …(i)
Where:
TC= Total cost
Q= level of output
a, b, c, d = constants of the function
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Note: Cost function (i) is a short-run cost function because the term ‘a’ does not contain Q
element which means that ‘a’ represent fixed cost which has to be borne even if output produced
is zero. Therefore, cubic total variable cost (TVC) function is:
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TVC =bQ+cQ +dQ …(ii)
From the above total cost function marginal cost function can be derived by taking the first
derivative of the total cost function in equation (i) with respect to output (Q).
d ( TC )
Marginal cost function is therefore: MC= =b +2 cQ+3 dQ2 …(iii)
dQ
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TC a+ bQ+c Q + d Q
AC= =
Q Q

a 2
¿ +b +cQ+d Q
Q

Quadratic cost function

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TC=a+ bQ+ c Q
In the Quadratic cost function total cost increases at an increasing rate throughout as output is
expanded. The marginal and average cost functions corresponding to the above quadratic total
d ( TC )
cost functions are: MC= =b +2 cQ …(iv)
dQ

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TC a+bQ+ cQ a
AC = = = +b+ cQ
Q Q Q
From equation (iv) the marginal cost increases linearly i.e., at a constant rate as output is
expanded.
Linear cost function
TC=a+ bQ

By taking the first derivative of the linear cost function, we have the following
marginal cost function.
d ( TC )
MC= =b …(v)
dQ
To get average cost function we divide the linear cost output function thus:
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TC a+bQ
AC ¿ Q = Q

a
¿ +b
Q
d ( TC )
MC= =b +2 cQ+3 dQ2
dQ
Exercises on cost functions
1. Suppose a company faces a cost function of C=8+ 4 q +q2
i. What is the company’s fixed cost;
ii. Derive an expression of the company’s average cost and marginal costs.
Solution
i. Since the fixed cost of a company does not vary with the output, the term in the given cost
function which has no output (q)term will be the fixed cost. This means that the fixed cost is
8, from the given cost function.

ii. Total variable cost (TVC) = TC- TFC

TVC =( 8+ 4 q+ q2 ) −8=4 q +q2

2
TVC 4 q+q
AVC= = =4 +q
Q q

∆ TVC
MC= =4+ 2q
∆q