Unit 4B: Theory of Costs of 1

Production
Introduction: In this part, we will see the meaning &
behaviors of costs of production, r/ship b/n production
(output) & costs (i.e. cost function both in the SR & LR
 To produce goods & services, firms need factors of production o
simply inputs.
 Firms acquire these inputs by buying them from resource
suppliers.
Cost is, therefore, the monetary value of inputs used in
production of an item.
Thus the basic factors underlying the ability & willingness of firms
to supply a product in the market is the cost of production.
Thus, cost of production
 Provides the floor to pricing.
 Forms the basis for any managerial decisions: such as
 price to quote,
 whether to accept a particular order or not,
 whether to abandon or add a product to existing product lin
etc.
 2

What makes cost analysis

difficult?
Cost analysis is made difficult by the
effects of
 unforeseen inflation i.e in the future
 unpredictable changes in technology, and
 the dynamic nature of input and output
markets.
 3

The Nature of Costs

Classification of Costs:- costs are
classified depending on the purpose for
which the cost data are being outlined.
Some categories of Costs are:
 Money Cost Vs Real Costs ;
 Explicit Cost Vs Implicit Cost ;
 Private Costs Vs Social Costs ;
 Economic Cost Vs Accounting Cost;
 Fixed Vs Variable Costs;
 Tangible Vs Intangible Costs;
 Internal Vs External Costs
 Incremental Costs Vs Sunk Costs etc.
 4

Cost Functions
Cost Function: is an expression that shows
the algebraic relation b/n the cost of production
& various factors which determine it.
 Cost of production depends on the level of output
produced, technology of production, prices of
factors, etc.
 Hence; cost function is a multivariable function
given symbolically as;
C = f(Q, T, Pi )
Where;
C - is total cost of production,
Q - is the amount of output produced,
T – is the available technology of production,
Pi – is the price of the ith input.
 5

Short-Run Costs Vs. Long-Run

Costs b/n SR costs & LR
Economics theory distinguishes
costs.
 The classification directly related to the production processes in
short-run & long-run period of time.
Short-Run Costs: are cost of production in the SR period
(the time period which is so short that it is not possible for a
particular producer to alter or change its plant size).
 Hence, the firm works with whatever equipment & factor size it
already has.
 Short-run costs thus, are the costs over a period during which
some factors of production are fixed.
 Thus, in the short-run there are both variable & fixed costs.
The Long-Run Costs: are the cost over a period long
enough to permit the change of all factor of
production.
 In the long-run period the firm can acquire new machinery or it
can also build new building for production purpose.
 6

Analysis of Costs in the Short

Run
Our analysis of cost in SR shows the r/ship b/n input used
& output produced in the Short Run production process.
 Thus for SR production period we consider that cost as a
function of output, Q (which is only determined by variable
inputs, like labour) (as capital/technology & price is constant)
More formally we write:
 For SR production C = f(Q) - cost is a function of
output ; Where : C is cost & Q is output produced.
 We begin our analysis of SR costs by defining in detail
the various short run costs in relation to production.
i.e. in cost-output relation we use cost concepts such as
 Total Cost (TC),
 Average Cost (AC) and
 Marginal Costs (MC).
 7

Short-Run Cost Functions

Total Cost = TC = f(Q)
Total Fixed Cost = TFC
Total Variable Cost = TVC
TC = TFC + TVC Average Total Cost = ATC = TC/Q
Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/
ATC = AFC + AVC
Marginal Cost (MC) = TC/Q = TVC/
Q TFC TVC TC AFC AVC ATC MC
0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
 8

Total Cost (TC)

All costs incurred in the SR is called Total Cost (TC).
Total Cost (TC):- is the sum of the value of all inputs
used over any given period to produce goods.
 It is the sum of all fixed & all variable costs
incurred at each level of output produced.
Thus; we see that in SR,the Total Costs of production
has/splits into two components:
 Fixed Cost, FC, which is borne by the firm whatever
level of output it produces, &
 Variable Cost, VC, which varies with the level of output.

Consequently, Total Costs can be given algebraically as:

Total Costs = Total Fixed Costs + Total Variable Costs
TC = TFC + TVC
 9

Total Fixed Cost (TFC)

By TFCs, we mean a cost which doesn’t vary with the level of
output.
 Are costs that will not vary with the level of output produced.
 Once such cost is incurred its level will remain unchanged
regardless of the level of output produced.
Some of the examples of TFC include:
 Salaries of administrative staff (Secretary, Management, Guards, etc).
 Expenses for building depreciation and repairs.
 Expenses for land and maintenance
 The rent of building used for production, etc.
All these costs are regarded as TFCs b/c whether
 the firm produces much output or zero output, these costs are
unavoidable,& TF
Cost Curves -TFC Curves: Graphically, C
 the firm can avoid FCs only if it shuts down the business stops
TFC is denoted by a straight line parallel
operation.
to the output axis. $ 100
 The point of intersection of the TFC line with
the cost axis (vertical axis) shows the amount of
the fixed.
 For example if the level of fixed cost is $ 100,
 10

Total Variable Cost (TVC)

Variable costs, on the other hand, include all
costs which directly vary with the level of
output.

The variable costs include:

 The cost of raw materials
 The cost of direct labor
 The running expenses of fixed capital such as
fuel, electricity power, etc.

 Are costs which will vary with the level of output produced
 These costs are dependent on the amount of output
produced.
 If the firm wants to produce more of its product then it has
 11

The TVC curve has an inverse s- shape

The shape indicates the law of variable proportions in
production.
According to this law,
 at the initial stage of production with a given plant, as
more of the variable factor (s) is employed,
 its productivity increases; and
 hence, the TVC increases at a decreasing rate.
 This continues until the optimal combination of the fixed &
variable factors is reached.
 Beyond this point, as increased quantities of the variable
factors(s) are combined with the fixed factor(s) the productivity
of the variable factor(s) declined,
 which results in an increase of TVC by an increasing rate.

Thus, the TVC has an inverse

s-shape due to the law of
diminishing marginal returns.
 12

The Total Cost & its curve.

As Total cost is the summation of TFCs & TVCs at
any level of output;
 The TC curve is obtained by vertically adding the
TFC & the TVC at each level of output.
 Thus, the shape of the TC curve follows the shape
of the TVC curve. i.e. the TC has also an inverse S-
shape.
 But the TC curve doesn’t start from the origin as that of
the TVC curve.
 It starts from the point where the TFC curve intersects
the cost
Generally, axis
the (y-axis).
three cost
curves together looks like the
following fig.
 The TC & TVC curves has an
inverse S- shape.
 The vertical distance b/n them
(TFC) is constant.
 13
Short Run Average Costs & Marginal
Costs
In the short run, in addition to fixed cost, variable cost &
total costs, we have other costs :
Average (or Per unit costs) & Marginal Costs that are derived
from fixed, variable & total costs.
Average Fixed Cost (AFC): is fixed cost incurred per
unit of output produced & is calculated as; AFC = TFC/Q ,
Where TFC represents Total Fixed cost & Q is total output.
Since TFC is constant, increase the level of output will
continuously decrease AFC.
As the level of output increases the AFC
curve is continuously decreasing curve,
but decreases at a decreasing rate & can
never be zero (unless TFC is zero).
 Thus, AFC gets closer & closer to zero as the
level of output increases, b/c a fixed AFC
amount of cost is being divided by
increasing level of output.
 Graphically, the AFC is a rectangular hyper
parabola.
 14

Average Variable Cost (AVC)

AVC:-is the TVC per unit of output produced.
 The AVC is similarly obtained by dividing the
TVC with the corresponding level of output.
 i.e. AVC = TVC/Q , Where TVC represents Total
Variable Cost & Q is total output.

AVC has in general U shape curve reflecting the

law of diminishing return.

Graphically, the AVC at

each level of output is
derived from the slope of a
line drawn from the origin
to the point on the TVC
curve corresponding to the
particular level of output. Fig: AVC Curve.
 15

Average Total Cost (ATC)

ATC or simply, Average Cost: is total cost per unit of
output produced.
 It shows the amount of cost incurred to produce each
unit of successive outputs.
 is obtained by dividing the TC by the corresponding level
of output; i.e. ATC = TC/Q
 Or it is a summation of AFC and AVC ( ATC = AFC + AVC)
TC TVC  TFC TVC TFC
Or equivalently,ATC      AVC  AFC
Q Q Q Q

 ATC will have the same “U”

shape curve as AVC.
 It drops sharply at the
beginning b/c both AFC and
AVC are falling. But it will
raise when AVC raises.
Fig: ATC Curve.
 16

Marginal Cost (MC)

Marginal Cost (MC): is defined as the additional
cost that the firm incurs to produce one extra unit
of the output.
 It is the increment in TCs or TVCs due to production of one
more units of output in the production process.
 It is the change in TC which results from a unit change in
output i.e. MC is the rate of change of TC or TVC with respect to
output.
 Or MC simply it measures
dTC the
dVCslope
 dFCof dVC
both TC
dFC& VC
dVCcurves.
Mathematically MCMC 
is given 
by: MC = 
∆TC/∆Q = ∆TVC/∆Q.

dQ dQ dQ dQ dQ
Or equivalently,
dFC
; as 0
dQ
MC have “U” shape curve as
AVCs.

Fig: MC Curve.
 17

R/ship among Unit Cost Curves in

SR
 By putting all unit cost curves including MC in the same
quadrant
The r/shipweb/n AVC &can
ATCsee clearly the r/ship among different
unit
 Ascost curves.
can be seen from figure; AVC curve
 reaches
The graph below depicts
its minimum the
point at Q1 SR average cost curves.
output
& ATC reaches its minimum point at Q2.
 the minimum of ATC occurs to the right
of the minimum point of the AVC (see
the figure
 the MC curve passes through the
minimum point of both ATC & AVC
curves.
 AVC, ATC & MCs have U-shaped curves,
reflecting the law of variable Q1 Q2
proportions i.e.
AVC initially decreases b/c of increasing b/c of these behavior o
return to scale of SR production AVCC the ATCC also has
initially AVC then increases b/c of: SR U shape (same
behavior).
 18

Relationship among Unit Cost curves cont…

 As we seen above both AVC & ATC are U – shaped, reflecting the
law of diminishing return, however, the minimum of ATC occurs to
the right of the minimum point of the AVC;
 this is due to the fact that ATC includes AFC which continuously
decreases as the level of output increases.
 After the AVC has reached its lowest point & starts rising, its rise
is over a certain range is more than offset by the fall in the
AFC,
 so that the ATC continues to fall (over that range) despite the increase
in AVC.
 However, the rise in AVC eventually becomes greater than the fall
in AFC so that the ATC starts increasing.
In general the following relation can be
 The AVC approaches the ATC asymptotically as output increases.
obtained from the graph.
 When MC is below the AVC & ATC, both
AVC & ATC are falling
 When MC is above the AVC & ATC (MC >
AVC , MC >ATC), both AVC & ATC are
raising
 MC intersects both AVC & ATC at their
minimum point.

 19

Example 1
Given the cost function,
3 2
TC 3Q  2Q  10Q  100

i.Find FC,VC,AFC,AVC,ATC and MC

functions?
ii.Find also quantities where AVC & ATC
attain their minimum values.
Solution:-
 20

Example 1
3 2
Given the cost function,TC 3Q  2Q  10Q  100
Find TFC, TVC, AFC, AVC, ATC and MC
functions?
Solution:- FC 100
VC 3Q 3  2Q 2  10Q
FC 100
AFC  
Q Q
VC 3Q 3  2Q 2  10Q
AVC   3Q 2  2Q  10
Q Q
TC 3Q 3  2Q 2  10Q  100 100
ATC   3Q 2  2Q  10 
Q Q Q
dTC dVC dFC dVC dFC
MC     9Q  2 ; as 0
dQ dQ dQ dQ dQ
 21

Examples 2
1. Suppose the total out put of a factory charges
100 units to 200 units, when the variable input
changes from 5 to15 units .
Correspondingly, TVC changes from 1000 birr to
1500 birr and the FC equals birr 400. Then
Determine
a. The MC of producing the extra unit.
b. The AC of production at the initial level
c. The MP of the labour.
C (Q) 4Q 2  Q  150
2. Suppose the cost function is :
Then find ;
a. TFC,TVC & AC of producing 5 units.
b. MC of the 5th unit
c. Is AC is falling or rising at producing 5th
unit.
 22
The R/ship b/n SR per unit Production & Cost
Curves
Now, let us see important relation that per unit production
curves (AP & MP of the variable input) & per unit cost
curves (AVCis&that:
The r/ship MC) have . per
the SR
unit
cost curves (AVC & MC curves)
are
the mirror reflection (along the
horizontal axis) of the SR
This is b/c: curves (AP & MP
production L L
 When APL increases, AVC decreases;
curves).
 When APL reaches its maximum,
AVC reaches its minimum point, &
 Finally when APL starts to fall, AVC
curve starts to rise.
 Shortly we can observe that:
 Maximum of MP corresponds
to the minimum of
MC
 23

Long Run Production:

Production with two variable
Remember that longinputs
run is a period of time
(planning horizon) which is sufficient for the firm
to change the quantity of all inputs.
 If we assume for example ,that the firm uses two
inputs (labor and capital).
 The firm can now produce its output in a variety
of ways by combining different amounts
of labor and capital.
 i.e. Either by using a great deal of labor & very little
capital or a great deal of capital & very little labor or
moderate amount of both.
 If both labor and capital are variable inputs, the
production function in LR will have the form. Q = f (L, K)
To analyze LRP, we make use of isoquants.
 24

Iso-quants and Iso-quant

An isoquant is a curve that shows all possible
Map
combinations of inputs that can yield equal (or the
same) level of output.
 isoquant shows the flexibility that firms have when
making decision
 Which they can usually obtain a particular output (Q)
by substituting one input for the other.
Isoquant map: is a collection of different isoquant curves
each representing a specific out put level.
 Each isoquant represents a different level of output and
the level of out puts increases as we move up and to the
 The figure shows
right.
isoquants and
isoquant map.
 25

Prosperities of isquants:
 Isoquants slope down ward
 The further an isoquant lays away from the
origin, the greater the level of output
 Isoquants do not cross each other.
 Standard isoquants are convex to the origin
The slope of an isoquant: Marginal Rate
Of Technical Substitution (MRTS): Amount
of one input that must be substituted for another to
maintain constant output
Algebraically, Slope of an isoquant curve:
MRTS = K/L = MPL/MPK < 0
Special Shapes of Isoquants
 Linear isoquants,
 L-shaped Isoquants,
 Kinked isoquants and
 Smooth, convex isoquants: the standard one
 26

Optimal Combination of Inputs: Isocost

Line
Isocost lines represent all
combinations of two inputs that a
firm can purchase with the same total
Capital=K
Or
cost.
 An isocost line is the locus points denoting
all combination of factors that a firm can
purchase with a given monetary
outlay, given prices of factors. Isocost
line
 Suppose the firm has C amount of cost
out lay (budget) and if prices of labor
& capital are w & r respectively.
 The equation of the firm’s isocost line is
given as: C wL  rK Labor=L

K & L are quantities of capital & labor

 Isocost lines have most of the same properties as that
respectively.
budget lines
Note The slope of the isocost line is given by the factor price ratios
that:
 27

Optimal Combination of Inputs:

Equilibrium of the firm: Choice of optimal combinati
of factors of production.
The points of tangency b/n the isoquant & isocost
curves depict optimal input combinations a differen
activity levels.

Point D, E & F are at optimal

combination of inputs.
 28

Case1: Maximization of output subject to cost

constraint
The equilibrium point (economically efficient combination) is
graphically defined by the tangency of the firm’s isocost
line (showing the budget constraint) with the highest
possible isoquant.
At this point, the slope ofMP the
L
isocost
Capital line (w/r) is equal to
MRTS L , k 
the slope of the isoquant, MPK

Q3
The condition
w MPof equilibrium
MPL under
MPK this case
K 1
is, E
 L
or  Q2
r MPK w r Q1
This is the first order(necessary)
condition. L1
Labor
The second order (sufficient) conditon
Note that:
is that isoquant must be convex to the
 E is the equilibrium point.
origin.
 K1 and L1 are the optimum
combination of capital & labor
that maximize output or
 29

Numerical example
Suppose the production function of a firm
is given as
1/ 2 1/ 2
0 .5 L K
prices of labor and capital are given as Birr
5 and Birr 10 respectively, and the firm
has a constant cost out lay of Birr 600.

Find the combination of labor and capital that

maximizes the firm’s output. i.e.
a. Find the optimal combination of factors of
production that maximize firms output
b. Find the maximum output
c. What is the slope of isoquant at optimum
 30
Solution:
MPL MPK MPL w
The condition of equilibrium  or 
X w r MPK r
MPL  0.25L 1 / 2 K 1 / 2
is: L
X 1/ 2  1/ 2
MP 
i.e. K K  0. 25 L K
0.25 L 1/ 2 K 1/ 2 $5 1
1/ 2  1/ 2
 
0.25 L K $10 2
Thus, theK 1
 equilibrium exists
 L 2 K ...................................(1)
L 2
when,
The constraint equation is:
wL  rK C or 5 L  10 K 600.........(2)
 Solving equation (1) and (2) would give us the
optimal combination of L and K.
L=60 units and K=30 units.
 Thus, the firm should use 60 units of labor
and 30 units of capital to maximize its
production (out put).
 The maximum out put can be found by
 31

Case -2: Minimization of cost for a

given level of output
In this case, consider an entrepreneur (a
firm) who wants to produce a given output
with minimum cost outlay.
 i.e. we have a single isoquant which denotes
the desired level of output, but there are a set
of isocost lines which denotes the different
cost outlays.
 Higher isocost lines denote higher production
costs.
 Production costs of a desired level of output
will therefore be minimized when the
isoquant line is tangent to the lowest
possible isocost line.
 32

Example:-
Suppose a certain contractor wants to
maximize Profit from building a
bridge.
The contractor uses both Labor & Capital,
& efficient combinations of Labor &
Capital that are sufficient 1to
/ 2 make
1/ 2 a
bridge is given by 0.25 LtheKfunction:
If the prices of Labor (w) & Capital (r) are
Birr 5 & Birr 10 respectively.

Find the least cost combination of L and

K, and the minimum cost.
 33

Solution: The contractor wants to build one bridge. Thus,

1 1
0.25as:
the constraint equation can be written LK 2 2
1 ,
1 1

so that MPL 0.125 L K2 2

1 1
the marginals :MPK 0.125 L K 2 2

1 1

The equilibrium condition is 0.125 L K 2 2

5
MP L w 

1 1
0.125 L K 2 2 10
MPK r K 1
  L 2 K
L 2

Substituting L= 2K in the constraint equation we obtain

K =2 2 and L =
4 2

Therefore, efficient combination (least cost combination)2 of2L =

and K4 =2 and
The least cost is
C 20 2  20 2 40 2
 34

Self Exercise
1. Suppose the production function of a firm is given as
q = 4l2 + 3lk + 6k2 and the firm has a constant cost
out lay of: l + k = 56.
Find the combination of labor and capital that maximizes
the firm’s out put.

2. The production function of the firm is given as: q =

64l3/4k1/4
Labor costs 96 Birr per unit and capital costs 162 Birr per
unit so that the firm decides to produce 3456 units of
output (q).
a.Determine the amount of labor and capital that should be
utilized so as to minimize costs.
b.Calculate the minimum cost.

3. A firm is faced with the problem of maximizing the

production function Q = (l + 80)k subject to a constant
cost of: 2l + k = 100