3.

6 THEORY OF COST

3.6.1 Concepts and Types of Costs

The theory of production shows the relationship between inputs and outputs in physical terms
while the theory of cost deals the money value of inputs (i.e., costs of production) and the
money value of outputs (i.e., revenue). The excess of revenue over cost yields profit which is
the primary objective of firms. To achieve the profit goal of the firm a manager would make a
decision on costs and outputs. Since managerial decisions are affected by the types of costs
the manager should understand the different types of costs so as to focus on a relevant cost
for a particular decision making. And also understand the relationship between cost and
output both in the short run and long run.

3.6.1.1 Types of Costs

Actual and Opportunity Cost
Costs that are actually incurred in acquiring or producing a good or service is known as actual
cost. The opportunity cost, on the other hand, refers to the foregoing of opportunities to
produce an alternative good or service. Because of the fundamental economic problem of
scarce resources the manager forced to choose the best out of the available alternative. Thus,
the value that must be forgone in the second/next best alternative as a result of putting
resources on the first best alternative. For example, a firm with Birr 100 can either make a
fixed deposit with a bank and earn an interest of 10% per annum or can purchase a factors of
production for producing t-shirts. Let the costs of land, labor, capital and management be Birr
20, 35, 30 and 10 respectively. Thus, the actual cost is Birr 95 while the opportunity cost is
Birr 10.

Explicit and Implicit Costs

Explicit costs are monetary payments, that is out of pocket or cash expenditures, which a firm
make to those “out-sider” who supply labor and other raw materials. The costs related to the
firm use of certain resources which they own are called explicit or imputed costs. While the
wages and other costs of raw materials constitute explicit costs, depreciation, salary of owner
manager and other costs of self owned/self sponsored resources are implicit costs.
Incremental and Sunk Costs
Costs which depend on decision and relevant for decision making are incremental costs while
costs which do not depend on decision and irrelevant on decision making are sunk costs. For
illustration, consider a university as a firm which going to start an evening program on
commercial basis beyond its regular program which runs in the day time.

The evening program is intended to use the time of academic as well as administrative staff
for whom extra payments would have to be made for their services. In addition, there will be
some costs on electricity, chalk etc. Besides, the classroom and blackboard of the university
would be utilized for the purpose. With this regard, the costs of the time of the staff and the
amount spent on electricity bill and chalk etc are incremental costs while the cost of the use
of classroom and blackboard are the sunk cost. Other types of costs, but not part of this
chapter, includes: economic and accounting costs, private and social costs, separable and
common cost, historical and replacement cost.

3.6.1.2 Short Run and Long Run Costs

Short-run and long-run cost concepts are related to variable and fixed costs, respectively, and
often figure in economic analysis interchangeably.

Short-run costs are the costs which vary with the variation in output, the size of the firm
remaining the same. In other words, short-run costs are the same as variable costs. Long-run
costs, on the other hand, are the costs which are incurred on the fixed assets like plant,
building, machinery, etc. Such costs have long-run implication in the sense that these are not
used up in the single 'batch of production'.

Long-run costs are, by implication, the same as fixed costs. In the long-run, however, even
the fixed costs become variable costs as the size of the firm or sale of production increases.
Broadly speaking, 'the short-run costs are those associated with variables in the utilization of
fixed plant or other facilities whereas long-run costs are associated with the changes in the
size and kind of plant.

Production Cost in the Short-Run

In the short run, the relationship between the TC and per unit costs (average & marginal
costs) can be displayed using tabular and graphical illustration.

Fixed and Variable Costs

Total Fixed Costs (TFC) are costs of a firm that do not vary with the change in output so
that firm’s might incur costs even if no output is produced. Example, cost of firm’s plant and
machinery, rent of building and factory etc. Total Variable Cost (TVC) is the sum of the
amounts spent for each of the variable inputs used. Total variable cost increases as output
increases. Example, costs of raw materials and wages. Total Cost (TC) is the sum of total
fixed cost and total variable cost. Total cost increases with increases in output (TC = TVC +
TFC).

Table 3.3 Short-Run Total Cost Schedules

(1) (2) (3) (4)
Output Total fixed cost Total variable cost Total cost (TC)
(Q) (TFC) (TVC) TC = TFC + TVC
0 $6,000 $ 0 $6,000
100 6,000 4,000 10,000
200 6,000 6,000 12,000
300 6,000 9,000 15,000
400 6,000 14,000 20,000
500 6,000 22,000 28,000
600 6,000 34,000 40,000

Figure 3.4 Total Cost Curves

Average and Marginal Costs

Average Fixed Cost (AFC): is total fixed cost divided by output:
AFC = TFC/Q
Average fixed cost is obtained by dividing the fixed cost (in this case $6,000) by output.
Thus, AFC is high at relatively low levels of output; since the denominator increases as
output increases, AFC decreases over the entire range of output. If output were to continue
increasing, AFC would approach 0 as output became extremely large.

Average Variable Cost (AVC): is total variable cost divided by output:

AVC = TVC/Q
The average variable cost first falls to $30, then increases thereafter.
Average Total Cost (ATC): it is the per unit cost of the total cost and computed as the sum
of average variable cost (AVC) and average fixed cost (AFC).
ATC = TC/Q = (TVC + TFC)/Q = AVC + AFC
Marginal Cost (MC): it is the change in TC due to the production of one additional unit of
output. In other words, the change in either total variable cost or total cost per unit change in
output.
MC = TC/Q

Table 3.4 Average and Marginal Cost Schedules

(1) (2) (3) (4) (5)
Output Average fixed cost Average variable cost Average total cost Marginal cost (MC)
(Q) (AFC) (AVC) (ATC) MC = TC/Q
AFC = TFC/Q AVC = TVC/Q ATC = TC/Q
0 - - - $40
100 $60 $40 $100 20
200 30 30 60 30
300 20 30 50 50
400 15 35 50 80
500 12 44 56 120
600 10 56.7 66.7

Figure 3.5 Average and Marginal Cost Curves

The average total cost first declines, reaches a minimum at $50, then increases thereafter. The
minimum AFC is attained at a larger output (between 300 and 400) than that at which AVC
attains its minimum (between 200 and 300). This result is not peculiar to the cost schedules
given above.

It can be seen that MC first declines, reaches a minimum of $20, then rises. Note that
minimum marginal cost is attained at an output (between 100 and 200) below that at which
either AVC or ATC attains its minimum. Marginal cost equals AVC and ATC at their
respective minimum levels.

The average and marginal cost schedules in columns 3, 4, and 5 are shown graphically in
Figure 3.5. Average fixed cost is not graphed because it is a curve that simply declines over
the entire range of output and because, as you will see, it is irrelevant for decision making.
All three curves decline at first and then rise. Marginal cost equals AVC and ATC when they
are declining and above them when they are increasing. Since AFC decreases over the entire
range of output and since ATC = AVC + AFC, ATC becomes increasingly close to AVC as
output increases. These are the general properties of typically assumed average and marginal
cost curves.

 Relations: (1) AFC declines continuously, approaching both axes asymptotically (as
shown by the decreasing distance between ATC and AVC). (2) AVC first declines,
reaches a minimum at Q2, and then rises thereafter. When AVC is at its minimum, short-
run marginal cost equals AVC. (3) ATC first declines, reaches a minimum at Q 3, and
then rises thereafter. When ATC is at its minimum, short-run marginal cost equals ATC.
(4) Short-run marginal cost first declines, reaches a minimum at Q 1, and rises
thereafter. Short-run marginal cost equals both AVC and ATC when these curves are at
their minimum values. Furthermore, short-run marginal cost lies below both AVC and
ATC over the range for which these curves declines; Short-run marginal cost lies above
them when they are rising.

In general, the reason marginal cost crosses AVC and ATC at their respective minimum points
follows from the definitions of the cost curves. If marginal cost is below average variable
cost, each additional unit of output adds less to cost than the average variable cost of that
unit. Thus, average variable cost must decline over this range. When short-run marginal cost
is above AVC, each additional unit f output adds more to cost than AVC. In this case AVC
must rise.

Mathematical relationships between AC and MC

AC= TC/Q =VC/Q + FC/Q (by using derivative of a quotient)

= +

= +

= +

= - +

= (

= (MC-AVC-AFC)

1. If = 0 when AC is minimum, then

(MC-AVC-AFC) = 0

MC = AVC+AFC, MC= AC
 2. If = + ve (when AC is rising)

(MC-AVC-AFC) = + ve

(MC-AVC-AFC) = + ve(Q)

MC = AVC+AFC (+ ve)(Q)

MC = AC(+ ve)(Q), So MC > AC

3. If = (- ve )(when AC is decling)

(MC-AVC-AFC) = (- ve)

(MC-AVC-AFC) = (- ve)Q

MC = AVC+AFC +(- ve)Q

MC = AC+(- ve)Q, So MC < AC

Figure 3.6 Graph – Optimum Cost And Output

Production Cost in the Long-Run
To analyze the production costs in the long run it is good to deal above the long run cost
curves which are a guide for an entrepreneur in his/her decision to plan future expansion of
the firm’s output. Due to this circumstance, the long run curves are known as a ‘planning
curve’ or sometimes called the ‘planning horizon’. The most important long run costs are the
long run average cost (LAC) and long run marginal cost (LMC) and these curves are derived
from their respective short run cost curves as depicted in the following graphs.

The LAC is derived from the short run average costs SAC 1, SAC2& SAC3 which are
associated with the three different plant sizes as small, medium and large plants respectively.
The firm produces OX1 at the minimum point of its short run average cost, SAC 1. By
installing a medium size plant, the firm can increase its output to OX 2 at a reduced cost of
BX2 at the minimum level of its short run average cost, SAC 2, as well as the minimum of
LAC. This production of more output at lower cost is due to economics of scale which could
be achieved through specialization and factor productivity. If the firm wishes to increase its
size by installing a large plant the output might increase to OX 3 but the cost, CX3, rising
compared to that of small plant size. This production of more output at higher cost resulted
from diseconomies of scale in this situation the firm becomes less efficient as its size gets
large and large. Because the system of management becomes complex so that the managers
are overworked and thus less efficient.
 Figure 3.7 The LAC Curve

The LAC is, therefore, derived by joining then points on falling part of SAC 1 (which is on the
left of its minimum indicating underutilization of the firm), the minimum of SAC 2, and the
rising part of SAC3 ( which is on the right of its minimum indicating overutilization of the
firm). In traditional theory of firms the LAC is U-shaped and it is often called the envelope
Curve because it envelops the SAC curves.

Note: The SAC curve of the medium plant size is an optimal plant size. This is because all
possible economies of scale are fully exploited. At this point more output is produced at
lower cost in which both the SAC and LAC are at their minimum levels. An optimal scale of
the firm (or the firm’s long run equilibrium) is achieved at the point where SAC 2 = LAC =
LMC = SMC2 and the equilibrium level of output is X2.
3.2 Scale and Scope Economies
Economies and diseconomies of scale are a phenomenon relating to the long run cost-output
relationship while economies of scope is a phenomenon relating to the comparison of the
long run costs between the joint and separate production process.
Economies of scale: it refers to range of output over which LAC falls as output increases by
increasing the plant size. It is represented by the range of output between point 0 and M 2 on
the LAC curve in Figure 6.7. In other words, economies of scale are referred to the
production ofmore outputs at lower costs by increasing the size of the plant. Better facilities
operative system, training and R & D are main factors causing the economies of scale.

Diseconomies of scale: it refers to a range of output over which LAC rises as output rises by
further increasing the plant size. It is represented by the range of output on the right of M 2 on
the LAC curve in figure 6.7. In other words, diseconomies of scale are referred to the
production of more output at higher costs by further increasing the size of the plant.
Difficulties in rising funds and difficulties in team-work and coordination are main factor
causing diseconomies of scale.

Figure 3.8 – Economies of Scale and Diseconomies of scale

Economies of scope: it is a situation in which the joint cost of producing two or more goods
by a single firm is less than the sum of a separate costs of producing the same level of output
for each goods by a separate firms.
3.6.3 Cost Function
The cost of production (C) is a function of three main factors the total output produced (q),
the price of inputs (p) and the efficiency of inputs (e). I.e., C = f (q, p, e).
There are various functional forms of cost function. The most important function forms are
linear, quadratic and cubic forms of cost functions.
Linear:
Quadratic:
Cubic:

Exercise
1. The short run total cost function of Siket enterprise has been estimated as:
TC = 100 + 6Q + 0.25Q2,where TC is total cost; Q is output.
A. Determine the AFC, AVC, ATC & MC of the enterprise.
B. If you were a business advisor of the enterprise which aims to minimize its cost, how
much would you recommend it to produce?
C. Determine the output level at which the ATC is at its minimum.

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