THEORY OF COSTS

Short Run
 Theory of costs
• Costs of a firm is incurred to establish the
production unit and to purchase different
factors of production.
• Cost of a firm (TC) is classified into two
broad categories - Fixed cost (TFC) and
Variable cost (TVC).
i.e. TC = TFC + TVC
• However, nothing is fixed in the long run.
 Theory of costs
Fixed costs
Fixed costs are expenses that does not
change in proportion to the activity of a
business.
Fixed costs include overheads (rent,
insurance-premium, interests), and also
direct costs such as payroll (particularly
salaries).
 Theory of costs
Fixed cost does not change with the
volume of production.
costs

100 TFC

O Q
 Theory of costs

Variable costs
Variable costs change in direct
proportion to the activity of a business
such as sales or production volume. In
retail, the cost of goods is almost entirely
variable. In manufacturing, direct material
costs, wages, fuel costs are examples of
variable costs.
 Theory of costs
For example, a manufacturing firm pays for
raw materials. When activity is decreased,
less raw material is used, and so the
spending for raw materials falls. When
activity is increased, more raw material is
used and spending therefore rises.
Although tax usually varies with profit, which
in turn varies with sales volume, it is not
normally considered a variable cost.
 Output TFC Total costs for firm X
100
(Q) (£)

0 12
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40

20
TFC
0
0 1 2 3 4
fig
5 6 7 8
 Output TFC TVC Total costs for firm X
100
(Q) (£) (£)

0 12 0
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20
TFC
0
0 1 2 3 4
fig
5 6 7 8
 Output TFC TVC Total costs for firm X
100
(Q) (£) (£)

0 12 0 TVC
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20
TFC
0
0 1 2 3 4
fig
5 6 7 8
 Total costs for firm X
100

TVC
80

Diminishing marginal
60
returns set in here

40

20
TFC
0
0 1 2 3 4
fig
5 6 7 8
 Output TFC TVC Total costs for firm X
100
(Q) (£) (£)

0 12 0 TVC
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20
TFC
0
0 1 2 3 4
fig
5 6 7 8
 Output TFC TVC TC Total costs for firm X
100
(Q) (£) (£) (£)

0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20
TFC
0
0 1 2 3 4
fig
5 6 7 8
 Output TFC TVC TC Total costs for firm X
100 (Q) (£) (£) (£) TC
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20

TFC
0
0 1 2 3 4
fig
5 6 7 8
 Total costs for firm X
100 TC
TVC
80

Diminishing marginal
60
returns set in here

40

20

TFC
0
0 1 2 3 4
fig
5 6 7 8
 Average fixed cost
Average fixed cost (AFC) = TFC/Q
where TFC = fixed cost, Q = total number of
units produced.
Unit fixed costs decline along with volume,
following a rectangular hyperbola. As a
result, the total unit cost of a product will
decline as volume increases.
 Average Fixed costs

Costs

AFC

O Q
 Average variable cost
Average variable cost (AVC) is the TVC of a firm
divided by the total units of output (Q).
AVC = TVC/Q
costs AVC

O Q
 Average cost
Average cost (AC) is the TC of a firm divided by
the total units of output (Q).
AC = TC/Q = AFC + AVC
costs AC

O Q
 Marginal Cost

The additional cost incurred to produce one

additional unit of output is called the
Marginal Cost (MC).

MC = dC/dQ
 MC
The marginal cost curve is U-shaped.
Marginal cost is relatively high at small
quantities of output - then as production
increases, it declines - then reaches a
minimum value - then rises.
This shape of the marginal cost curve is
directly attributable to increasing, then
decreasing marginal returns (the law of
diminishing marginal returns).
 Marginal costs
MC

Diminishing marginal
returns set in here
Costs (£)

Outputfig(Q)
 Numerical Example

Q TFC TVC TC AFC AVC AC MC

0 100 0 100
1 100 20 120 100 20 120 20

2 100 37 137 50 18.5 68.5 17

3 100 52 152 33.33 17.33 50.67 15

4 100 80 180 25 20 45 28

5 100 120 220 20 24 44 40

6 100 165 265 16.67 27.5 44.17 45

 Average and marginal costs
MC
AC

AVC
Costs (£)

x
AFC

Outputfig(Q)
LONG RUN
 Long run cost curves

The Long run average cost (LRAC or LAC)

curve illustrates - for a given quantity of
production - the average cost per unit
which a firm faces in the long run (i.e.
when no factors of production is fixed).
 LRAC

LRAC curve is derived from a series of short

run average cost curves.
It is also called the ‘Envelope curve' since it
envelops all the short run average cost
curve.
The curve is created as an envelope of an
infinite number of short-run average total
cost curves.
 LAC

The LRAC curve is U-shaped, reflecting

economies of scale when it is negatively-
sloped and diseconomies of scale when it
is positively sloped.
In perfect competition, the LRAC curve is flat
at the point of equilibrium – in this stage
the firm is enjoying constant returns to
scale.
 LAC
In some industries, the LRAC is L-shaped,
and economies of scale increase
indefinitely. This means that the largest
firm tends to have a cost advantage, and
the industry tends naturally to become a
monopoly, and hence is called a natural
monopoly. Natural monopolies tend to
exist in industries with high capital costs in
relation to variable costs, such as water
supply and electricity supply.
 Long-run average cost curves

Economies of Scale
Costs

LRAC

O Output
fig
 long-run average cost curves

LRAC
Diseconomies of Scale
Costs

O Output
fig
 long-run average cost curves

Constant costs
Costs

LRAC

O Output
fig
 Long-run Costs
• Long-run average costs
– assumptions behind the curve
• factor prices are give
• state of technology and factor quality are given
• firms choose least-cost combination of factors
 A typical long-run average cost curve

LRAC
Costs

O Output
fig
 A typical long-run average cost curve

Economies Constant Diseconomies LRAC

of scale costs of scale
Costs

O Output
fig
 Long-run Costs
• Long-run average costs
– assumptions behind the curve
• factor prices are give
• state of technology and factor quality are given
• firms choose least-cost combination of factors
– shape of the LRAC curve
– a typical LRAC curve
– long-run average and marginal cost curves
 Long-run average and marginal costs

Economies of Scale
Costs

LRAC
LRMC

O Output
fig
 Long-run average and marginal costs

LRMC

LRAC
Diseconomies of Scale
Costs

O Output
fig
 Long-run average and marginal costs

Constant costs
Costs

LRAC = LRMC

O Output
fig
 Long-run average and marginal costs

LRMC
Initial economies of scale,
then diseconomies of scale
LRAC
Costs

O Output
fig
 Long-run Costs
• Long-run average costs
– assumptions behind the curve
• factor prices are given.
• state of technology and factor quality are
given.
• firms choose least-cost combination of
factors.
 Envelope Curve

The envelope curve is based on the point of

each short-run ATC curve that provides
the lowest possible average cost for each
quantity of output.
 Deriving long-run average cost curves: plants of fixed size

SRAC1 SRAC SRAC5

2
SRAC4
SRAC3

1 factory 5 factories
Costs

2 factories 4 factories
3 factories

O
Output
fig
Deriving long-run average cost curves: factories of fixed size

SRAC1 SRAC SRAC5

2
SRAC4
SRAC3

LRAC
Costs

O
Output
fig
Deriving a long-run average cost curve: choice of factory size
Costs

Examples of short-run
average cost curves

O
Output
fig
Deriving a long-run average cost curve: choice of factory size

LRAC
Costs

O
Output
fig