THEORY OF COST
INTRODUCTION
The total cost is a multivariable function, that is, it is determined by many factor.
Symbolization we may write the cost function as
C f X , T , Pf
Where:
C is total cost
X is output
T is technology
Pf is price of factors.
For simplicity purpose, cost are graphically shown as a function of output, C f X , ceteris
paribus. If other factors do change their effect on costs is shown graphically by a shift of cost
curve.
TRADITIONAL THEORY OF COST
Traditional theory distinguishes between the short run and the long run.
The short run is the period during which some factor(s) is fixed, for example capital equipments
and entrepreneurship. During such a period the usage of the fixed factors cannot be varied
regardless of the level of output. Similarly, there are other inputs, variable inputs, whose usage
can be changed, e.g. unskilled workers and raw materials.
In the long run, on the other hand, all inputs are variable. The quantity of all inputs can be
varied so as to obtain the most efficient input combination.
SHORT RUN COST
In the short run, the firm incurs cost on fixed factors and variable factors are known as fixed
cost while cost on variable factors are known as variable cost.
This implies that
TC TFC TVC
TFC - total fixed cost
TVC - total variable cost
TFC does not vary with variation in the output between zero and a certain level of output.
100 FC
0 Q
TFC is graphically denoted by a straight line parallel to the output axis.
TVC vary with variations of output. When output is zero, TVC 0 . It starts from the origin
and has an inverse S- shape.
C
TVC
100 TFC
Q
0
Total cost curve shape
TC
TVC
100 TFC
0 Q
Total cost have same shape as a total variable cost but doesn’t start from the origin. Where it
intersect the vertical axis depends on the value of the fixed cost.
The TVC has an inverse S-shape it shows that the TVC first increases at a decreasing rate and
then at an increasing rate with the increase in the total output. The pattern of change in the
TVC stems directly from the law of increasing and diminishing returns to the variable inputs.
According to this law, at the initial stage of production worth a given fixed input, additional
variables factor is productive so that output increases at an increasing rate. Taking total variable
cost and dividing it by output would mean that average variable cost declines.
At optimal combination of the fixed and variable factor, marginal productivity of additional
variable factor reaches its maximum implying that average variable cost reaches its minimum.
Beyond an optimal combination of the fixed and variable factor(s) increased employment of
the variable factors causes productivity of the variable factor(s) to decline and thus average
variable costs to rise. TVC increases at an increasing rate.
Concept of average and marginal costs
ATC = AFC + AVC
TFC
AFC (fixed cost per unit of output)
Q
TVC
AVC (average cost per unit of output
Q
AFC
0 Q
AFC is a rectangular hyperbola
It never intersects the axis.
SHAPE OF AVC
C
TVC
D
A B C
Q
0
A
Cost AVC
B D
Q
0
To derive the AVC graphically, we get the slope of a line joining the origin and a point on
TVC curve.
Line OC has the lowest slope compared to all the other lines from origin.
At point C, AVC is at its minimum
To the left at point C, AVC is declining
To the right of point C, AVC is increasing at increasing rate.
ATC can be derived in the same way as the AVC curve from TC curve.
SHAPE OF MARGINAL COST CURVE
Cost
TC
e
c d
b
MC 0
a
Q
0
f MC
Cost
a e
b
d
The MC curve is derived by getting the slope of the TC curve (which is the same at any point
as the slope of the TVC). The slope of TC is found by drawing tangent lines at different points
along the TC curve.
At point C, MC curve is at its minimum since the slope of TC = 0.
To the left at point C, slope of TC is declining. Thus we expect MC to be declining.
To the right of point C, the TC curve starts rising at increasing rate. Thus MC start rising.
RELATIONSHIP BETWEEN ATC, AVC & MC
Cost
SMC
STVC
e
SAVC
AFC
0 Output
MC curve cuts both AVC and ATC at their minimum
(i) So long as the MC lies below the AC curve, AC must decline as output expands
(ii) When MC is above AC, the AC will be rising
(iii) The MC cuts the AC when AC is at its minimum.
Same relationship can be observed between MC and AVC
ATV and AVC do not reach their minimum at the same level of output. ATC reaches its
minimum after the AVC.
Minimum point of the ATC occurs to the right of the minimum point of the AVC.
This is due to the fact that ATC includes AFC and the latter falls continuously with
increases in output.
After AVC has reached its lowest point and starts rising, its rise is over a certain range off
set by the fall in AFC so that the ATC continues to fall.
However the rise in AVC eventually becomes greater than the fall in the AFC so that the
ATC starts increasing.
LONG RUN COST
LONG RUN AVERAGE COST CURVE.
SAC K 0
Cost
SAC K1
SAC K 3
SAC K 2
C3
C2
C1
0 Output
Q0 Q1 Q2 Q3
In the long run planning period is long enough for a firm to be able to vary all factors of
production it uses.
A long run is composed of a series of short run alternative situations.
Each situation comprises of a certain quantity of a fixed input (e.g. capital) which various units
of variable inputs.
SAC K 1 is a short run average cost curve associated with K1 units of capital input. SAC K 0
is a short run average cost curve associated with a lower amount of capital.
If we join the minimum point of the SAC curve, LAC curve is obtained.
The LAC curve is also known as envelope curve or planning curve. because it covers various
short-run average cost curves.
It shows the least possible cost per unit of producing various output using different sizes of
plants (capital).
For instance, for the firm to produce Q2 units of output, it would be appropriate to employ K 2
units of capital because it maximizes cost (SAC K 1 is at its maximum). The firm would pay
a higher cost if it tried to produce Q2 with K1 units of capital.