Prepared by: Prof.

Said Ossman
 To produce any quantity of goods and
services, the firm will bear a cost, it will
pay for raw materials and workers
………………… etc.
 The cost paid depends on the produced
quantity of goods and services, the
behavior of the relation-ship between the
cost and the amount of goods and services
are produced controlled by increasing and
diminishing returns law (short run) or
returns to scale (Long run).
Table (2)
Cost function: describe the relationship between
the cost of production and the quantity produced
with certain period of time.

CX = F (QX )

The behavior of the total cost function in the short

run based on or controlled by increasing and
diminishing return law. Based on this law of return,
the behavior of cost function will be as follow:
 First stage: the total cost of production will
increase with increasing of the total output,
by decreasing rate to certain point of
production, the increasing with decreasing
rate of the total cost because of, in the same
stage of production the total product
increases with increasing rate for many
reasons. One of them is the firm will benefit
from specialization and division of the
work.
 Second stage: the total cost of production
will increase with decreasing rate with the
increasing of production because the total
product of this stage of production increases
with decreasing rate as a result of many
reasons.

The following curve represents the behavior

of the total cost in two stages:
TC TC

Q* Q

(2-A)
 From figure (2-A):
- Any increasing of Q to reach Q*, the TC increases
by decreasing rate, the slope of the TC curve
reflects the rate of increasing and the marginal
cost of production.
- After Q* any increasing of Q leads to increasing of
TC by increasing rate, the slope of the TC in this
stage reflects the rate of increasing of the TC and
marginal cost.
Fixed cost (FC):
 It is the total costs
paid to fixed factors of
production such as: capital,
this type of cost will be
fixed at any level of
production in short run as
represented in figure (2-b).
 FC
FC

FC = K * R
K: Amount of capital
R: the price of capital
suppose the amount of K equals 100 units, and the price is
$10, (K is purchased from perfect competition market).
FC = 100 * 10 = $1000
Average fixed cost: reflects the share of each unit of

production from the fixed cost.

AFC = FC / Q
AFC always is decreasing with any increasing of
production, it doesn`t equal zero in the short run as
represented in figure (2-C)

(2-C)
Variable cost:
This type of cost reflects the amount of money paid to
variable factors of production.

VC =L*W
L: Is the amount of labor which changes with
increasing of production.
W: price of each unit of labor
and is purchased from perfect
market.
 Note: price of both capital (r) and labor (w) are
fixed, because both are purchased from perfect
competition market.
Behavior of variable cost: the behavior of the VC with
the amount of production controlled by increasing and
diminishing return law in the short run.
Based on the increasing and diminishing return law,
the behavior of the variable cost will be as follows:
Variable Cost increases by increasing rate with any
increases of the output to reach certain point of
production Q* ( the end of the first stage), after this point,
any increasing of production leads to increasing of variable
cost by increasing rate (second stage), as represented in
figure (2-c).
Note: TC starts from positive value on the vertical
axis, why ???
This positive value reflects the fixed costs.
From figure (2-c):
-VC starts from zero point, where the output equals zero, the
variable cost will be zero.
-The VC curve is parallel with the TC curve, because the vertical
distance between them reflects the fixed cost, which is fixed at
any level of production.
-Fixed cost curve is straight line, reflects that the value of the
fixed cost is constant.
-Figure (2-c) reflects the relationship between the total and the
variable cost.
Algebra formula of the total cost:
TC = a + b1 Q1 + b2 Q12 + b3 Q1 Q3
= 100 + 3Q1 + 1.2Q12 + 1.3Q13
Where:
a, b1,b2 and b3 are constant (parameters).
a: is a fixed cost and Q1 is the amount of production of X1
Average variable cost:
Reflects the share of each unit of the production of the
variable cost.
The AVC behavior is controlled by the behavior
of the average product of labor as is
represented before. It means the AVC will
decrease at the first stage with increasing
output because the average product of labor
increases, when the average product reaches
to maximum value, the AVC will reach to
minimum value, when the APL at the
maximum value and starts to
decrease, AVC starts
to increase.
From figure (2-d):
* When APL reaches its
maximum value at L*, the
AVC will be at the minimum
value at Q*.

When the APL starts to decrease, the AVC starts to

increase.
Marginal cost:
Reflects the cost of the last unit of production, also
reflects the changes of variable cost or changes of
the total cost as result of changes of output by one
unit.

MC =  VC /  Q =  TC /  Q
You can use this formula
if the data are
available in a table
MC: reflects the first derivative of the total cost
function.

MC = d TC / d Q
Use this formula if the total function is equation and
includes one independent variable.
MC =  TC /  Q
Reflects the first derivatives of the total cost
function, if the function includes more than one
independent variable.
 Relation among costs

What is the relation among ATC, AVC, AFC and MC

graphically under the assumption that output is
infinitely divisible?

The figure (2-d) represents these relations.

The shapes of the curves indicate the relation

between the marginal and average costs.
Multiple Choice Questions:

1) When referencing the relationship between cost

curves, the marginal cost curve will intersect the
Average Variable Cost curve..

a) where the AVC curve is declining

b) where the AVC curve is inclining
c) at its minimum point
d) at its origin
Notes

1.AFC always decreases with increasing of the

output level.
2.The marginal cost curve intersects both the
ATC and AVC curves at their minimum points.
3.When the MC curve is below on the average
cost curve, average cost is declining and when
the marginal cost is above the average cost, the
average cost is rising.
  If your grade on an exam is below your average grade, the
new grade lowers your average grade, if the new grade is above
average, the new grade increases your average. The new grade is
the marginal contribution to your total grade.
 In general when the marginal is above the average, the
average increases, when the marginal is below the average the
average decreases.
4- The ATC and AVC curves get closer together as output
increases. Why????
because the difference between them is AFC, which always
decreases.
Fixed & sunk cost:
Fixed cost: is a cost does not change with any changes of output
and the end of the project life there is a salvage value( value of
building ,machine ,equipment, value of any tangible or
intangible assets)
Sunk cost: A related concept to fixed cost but is a cost that is
lost forever once it has been paid (there is no salvage value).
Suppose: you are a manager of a coal company and you paid $
1000 to lease a railcar for one month. This expense reflects a
fixed cost, the $ 1000 cost may be totally or partially sunk cost,
depends on the terms of lease.
- If the terms of lease, requires to pay $ 1000 regardless the
amount of coal, that is transported, the total $1000 will be sunk
cost.
- If the terms of lease states that you will be refund $ 600 if you
don`t need the railcar, then only $400 of the $1000 will consider
sunk cost. Sunk costs are the amount of fixed costs that can not be
refunded. ( nonrefundable amount of fixed cost ).
- If the terms of lease permit you to sublease the railcar to the
farmers, it will be good to the firm especially if the demand of the
coal lower than expected, the manger could reduce the sunk cost
in these conditions by leasing the railcar to the farmers.
 Multiple output cost function
In the previous, we supposed the firm is used its
inputs to produce a single product. In the other hand
there are many examples that the firm produce
multiple products by using the partially the .same
facilities. Toyota produces cars and trucks and many
varieties of each. Also, Dell produces many types of
computers and printers. Based on the same analysis is
used in case single product the multiple product cost
function will be as the follow:
Multiple product cost function:
C = F (Qx1, QX2, ………, QXn)
 Where:
C: refers to the total cost of producing x1, x2, ….. Xn
Qx1, Qx2, .. QXn refer to the quantity produced from the
multiple products ,X1, X2, …………. and Xn.

The total cost behavior in the multi-product cost

function depends on how much the output is
produced from each type of products.
This behavior could be explained by economies of
scope and cost complementary.
Economies of Scope:
This type of economies will be existed when
the total cost of producing Q1, and Q2
(multiple product) together is less than the
total cost of producing Q1 and Q2 separately.

C (Q1, Q2) < C (Q1,0) + (Q2,0)

C (Q1, Q2) < C (Q1) + (Q2)
Suppose steak and chicken dinners could be
introduced in a restaurant or two restaurants, one
for chicken dinners and the second for the steak
dinners.
It is cheaper to produce both products in the same
restaurant, than to produce them in two
restaurants (one introduces chicken, and one
introduces steak), because the production of the
dinners separately would require duplication of
many common facilities such as ovens,
refrigerators, tables, the building and so forth.
Cost complementarity will be existed in a multiple
product cost function when the marginal producing
cost of one product is reduced when the output of
another product is increased.
The cost function exhibits cost complementarity
if:
MC Q2 = f(Q1) = (Q1,Q2)
 Q2
Complementarity cost:
It means if an increase in the output of product Q1
(fish) leads to decreasing of the marginal cost of
Q2(steak) and vice versa>
it means: .. MC Q1 = f(Q2) and,
MC Q2 = f( Q1)
Suppose:
C (Q1,Q2) = F + a Q1Q2 + (Q1) 2 + (Q2)2

MC Q1 = a Q2 + 2 Q1
When a< 0, negative relation, an increase in Q2
(steak) reduces the marginal cost of producing product
Q1(fish) and an increase in Q1 reduces the marginal
cost of Q2. Thus, if a < 0, this cost function exhibits
cost complementarity. If a > 0, there are no cost
complementarities and there is no economies of scope.
 In the long run all production factors are variables;
the firm could change all factors(both capital and
labor) and chooses the best size of the firm to
minimize AC in the long run. The firm could adjust
the fixed factors according to the optimal firm size
and optimizes the scale of operation.
 The behavior of the total cost in the long run will
be controlled by returns of scale law, (decreasing
– constant – increasing).

 The relationships between the average cost in

the short run and the long run represented in
figure (3):
 Now: the firm can produce Q1 with average cost
ACs, if the firm produce Q1 with the average cost
C2 in short run,. suppose the average cost in the
long run curve is ACL by adjusting the fixed
factors to optimize its operation and its scale in
the long run, it can produce Q1 with average cost
C1 on the long run average cost curve ACL, not
C2 that lies on the short run curve ACS.
 adjusted its fixed cost to achieve lower average
cost of producing Q2 at average cost C2L on the
average cost in the long run (ACL). In the long run
 The firm move from C1L to C2L.
 The long run average cost curve (LRAC) IN Figure (3)
defines the minimum average cost of producing
alternative levels of output.
 Allowing for optimal selection of all variable factors
of production (fixed and variable factors).
 Thelong run average cost curve is the lower
envelope of all the short run average cost
curves.
 Thismeans that the long run average cost
lies below every point on the short run
average cost curves, except the points that
the short run average cost curves tangent
(equals) with the long-run average curves.
 Each average cost reflects certain size of the
 firm. In the long run, the firm's manager is
free to choose the optimal size of the firm
for producing the desired level of output.

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