Unit 8: Theory of Production Costs

Cost Concepts

Actual Costs- It refers to the cost actually incurred in money terms. Such costs are recorded in the
books of account of the firm. Eg Cost incurred by the firm in payment for labor, material, plant, building,
machinery, equipments, travelling and transport.

Opportunity Costs- It is second best use of resources which is foregone for availing the gains from the
best use of resources. For eg A businessman with his limited resources can start either a business of
printing or a lathe workshop. The expected income from printing is Rs 20000 and lathe workshop is Rs
15000. Obviously he will do printing business as the expected income is more in printing than lathe. In
this case he has foregone the opportunity of next best business i.e. lathe workshop. Thus Rs 15000 is
the opportunity cost in this case.
 Theory of Production Costs

Fixed Costs- are those which remain fixed in volume for a certain given output. They do not vary with
variation in output between zero and certain level of output. For eg in case of textile plants producing
10 lakh metres of cloth per year the costs on account of plant and machinery, building will remain
constant at all level of output from 1 metre to 1 lakh metres. This costs are called as fixed costs.

Variable Costs- Variable costs are those which vary more or less proportionately with the output are
known as variable cost. In the above example costs of raw materials, labor, electric power, running cost
of fixed capital such as fuel, ordinary repairs, maintenance are variable costs.
Average and Marginal Cost
Marginal cost is the change in total cost when another unit is produced; average cost is the total cost divided by
the number of goods produced.

Key Points
•The marginal cost is the cost of producing one more unit of a good.
•Marginal cost includes all of the costs that vary with the level of production. For example, if a company needs to
build a new factory in order to produce more goods, the cost of building the factory is a marginal cost.
•Economists analyze both short run and long run average cost. Short run average costs vary in relation to the
quantity of goods being produced. Long run average cost includes the variation of quantities used for all inputs
necessary for production.
•When the average cost declines, the marginal cost is less than the average cost. When the average cost increases,
the marginal cost is greater than the average cost. When the average cost stays the same (is at a minimum or
maximum), the marginal cost equals the average cost.
Key Terms
•Marginal cost: The increase in cost that accompanies a unit increase in output; the partial derivative of the cost
function with respect to output. Additional cost associated with producing one more unit of output.
•Average cost: In economics, average cost or unit cost is equal to total cost divided by the number of goods
produced.
 Long run costs have no fixed factors of production, while short run
Short Run and Long Run Costs costs have fixed factors and variables that impact production.

Key Points
• In the short run, there are both fixed and variable costs.
• In the long run, there are no fixed costs.
• Efficient long run costs are sustained when the combination of outputs that a firm produces results in the desired
quantity of the goods at the lowest possible cost.
• Variable costs change with the output. Examples of variable costs include employee wages and costs of raw
materials.
• The short run costs increase or decrease based on variable cost as well as the rate of production. If a firm manages
its short run costs well over time, it will be more likely to succeed in reaching the desired long run costs and goals.
Key Terms
•Variable cost: A cost that changes with the change in volume of activity of an organization.
•Fixed cost: Business expenses that are not dependent on the level of goods or services produced by the business.
 Theory of Production Costs

Cost Function- It is the relationship between Cost and its determinants and is represented as
follows-
C=f(Q, T, Pf, K)
C-Total Cost
Q-Quantity produced
T - Technology
Pf- factor price
K-Capital fixed factor.
Short Run Cost Function- In the short run all the determinants of cost other than output Q are
constant. So the cost function function will be
C=f(Q).
• Total cost (TC): total cost equals total fixed cost plus total variable costs (TC = TFC + TVC).
• Variable cost (VC): the cost paid to the variable input. Inputs include labor, capital, materials, power, land, and
buildings. Variable input is traditionally assumed to be labor.
• Total variable cost (TVC): same as variable costs.
• Fixed cost (FC): the costs of the fixed assets (those that do not vary with production).
• Total fixed cost (TFC): same as fixed cost.
• Average cost (AC): total costs divided by output (AC = TFC/q + TVC/q).
• Average fixed cost (AFC): the fixed costs divided by output (AFC = TFC/q). The average fixed cost function
continuously declines as production increases.
• Average variable cost (AVC): variable costs divided by output (AVC = TVC/q). The average variable cost curve is
normally U-shaped. It lies below the average cost curve, starting to the right of the y axis.
• Marginal cost (MC): the change in the total cost when the quantity produced changes by one unit.
• Cost curves: a graph of the costs of production as a function of total quantity produced. In a free market economy,
firms use cost curves to find the optimal point of production (to minimize cost). Maximizing firms use the curves to
decide output quantities to achieve production goals.
Relationship between Cost and Output in the Short Run:
Total Cost(TC)- It is defined as the total cost incurred to produce a given quantity of output. In short run
total cost is composed of 2 major elements i.e. Total Fixed Cost (TFC) & Total Variable Cost(TVC).
TC= TFC + TVC
TFC remains fixed in short run for a certain level of output and TVC varies with variation in the output.
Average Total Cost- It is obtained by dividing total cost (TC) by the quantity of output produced (Q).
ATC = TC/Q
Similarly AVC= TVC/Q, , and AFC=TFC/Q
Marginal Cost(MC)- It is the addition to the total cost on account of producing one additional unit of
product or it is cost of marginal units produced.
MC=∆TC/∆Q

Since ∆TC=∆TFC+∆TVC
In short run ∆TFC=0
Therefore ∆TC=0+∆TVC
∆TC=∆TVC hence, MC= ∆TVC/∆Q
 Impact of Marginal Cost on Average Cost

Q TC AFC AVC ATC MC

TFC TVC
(units) = TFC + TVC = TFC / Q =TVC / Q = TC / Q = ΔTC / ΔQ
0 140 - 140 - - - -
10 140 70 210 14.0 7.0 21.0 7
20 140 110 250 7.0 5.5 12.5 4
30 140 180 320 4.7 6.0 10.7 7
40 140 280 420 3.5 7.0 10.5 10
50 140 450 590 2.8 9.0 11.8 17
60 140 720 860 2.3 12.0 14.3 27
70 140 1120 1260 2.0 16.0 18.0 40
80 140 1680 1820 1.8 21.0 22.8 56
 Theory of Production Costs

1.Average fixed cost (AFC) :

. AFC decreases throughout the output (Q) range.
b. If we extend the output range further to the right, AFC moves closer and closer to the horizontal
axis (Q - axis).
c. WHY? AFC = TC / Q and AFC decreases as Q increases
2. Average variable costs (AVC) :
a. The average variable cost curve is U - shaped.
b. AVC first decreases, reaches a minimum, and the increases.
c. WHY? Something you learned a little earlier known as the LAW OF DIMINISHING RETURNS and
the LAW OF INCREASING COSTS
 Theory of Production Costs

3. Average total costs (ATC) :

a. ATC has similar shape of AVC. However, it falls faster than AVC in the beginning and rises slower
after reaching its minimum point.
b. WHY?
ATC = AFC + AVC
AFC and AVC both fall in the beginning, at some point
however, AVC begins to rise while AFC continues to fall.
When the increase in AVC OUTWEIGHS the decrease in AFC, the ATC will begin to increase forming the
familiar U - shaped curve
 Theory of Production Costs

4. Marginal cost (MC) :

a. This curve also decreases at first, reaches a minimum, then increases.
b. Relationship between MC and Average costs :
When MC < AVC AVC are decreasing
When MC > AVC AVC are increasing
c. MC intersects AVC and ATC at their minimum and this level of output at which the TC will
be mminimum.
 Theory of Production Costs

Long Run Cost Curves

1.In the long run all costs are variable. Therefore, this curve is actually a long run average variable
cost curve, but since we know all costs are variable in the long run, we just call it the LAC.
2. The LAC is constructed form a series of short run average total cost curves associated with a series
of different output levels (Q).
3. The LAC is the points which are tangent to the minimums of the short run average total cost (SAC)
curves associated with each output level.
Theory of Production Costs