C H A P T E R 6 T H E O R Y O F C O S T

Theory of Cost

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CHAPTER 6

Definition of Production Cost

Production cost means:a. Amount of money spent in the process of

production. b. Such an examples:

Wages to labour Interest on capital Rent to land owners

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Cost Conceptsi) Implicit cost (Economic Cost)

The value of input services that are used in production which are not purchased in the market.

ii) Explicit cost (Economic Cost / Accounting Cost)

The value of resources purchased for production

iii) Opportunity cost (Economic Cost)

Value of the best alternative forgone

iv) Social cost (Economic Cost)

The total cost of production of a product and includes direct and indirect costs incurred by the society. Ex: water pollution from industrial waste contaminating rivers.


Production Costs in The Short Run

Types of cost in short-run

Fixed Cost

Variable Cost

Total Cost


Production costs in the short run

1. Total Fixed Cost (TFC)Refers to money spent on fixed input.

Total fixed cost has no relationship with output.

Total fixed cost remains constant throughout the production period even though output changes.

TFC incurred before any production or business takes place. Examples rent on building.


2. Total Variable Cost (TVC)Money spent on variable inputs.Refers to the cost of input that change with output. When output is zero, total variable cost is also zero. As the output increases, the TVC will also

increases. The TVC changes in response to a changes in

quantity or output. Examples; raw materials, payment to workers.


3. Total Cost (TC)Is the sum of costs of all inputs: fixed and

variable inputs used to produce goods and services.

In other words, the total cost is an aggregate expenditure incurred by a firm in producing goods and services.

Total cost defined as = TFC +TVC


Relationship between output, TFC, TVC and TC

Cost

Output

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K3

K2

K1

Q1

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TFC

TVCTC

Important Concepts

i. Average Variable Cost (AVC) is the variable cost per unit of output

ii. Average Fixed Cost (AFC) is the fixed cost per unit of output

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AFC=TFC/Q; where Q is the quantity output

AVC=TVC/Q; where Q is the quantity output


iii. Average Total Cost (ATC or AC) is the total cost incurred per unit output and it is also known as unit cost or average cost.

or

iv. Marginal cost (MC) is the change in total cost associated with producing an additional unit of output. Since TC is a summation of TFC and TVC, any change in total cost necessarily emerges from changes in either fixed or variable cost.

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MC=TC/Q = TVC/Q; where TFC=0

ATC=TC/Q; where Q is the quantity output

ATC=AVC + AFC


TotalCost

AverageCost

Marginalcost

Output TFC TVC TC (TFC+TVC)

AFC (TFC/Q)

AVC

(TVC/Q)ATC

(TC/Q)MC

(TC/Q)

0 20 0 20 - - - -

1 20 15 35 20 15 35 15

2 20 25 45 10 12.5 22.50 10

3 20 30 50 6.67 10 16.67 5

4 20 35 55 5 8.75 13.75 5

5 20 45 65 4 9 13 10

6 20 65 85 3.33 10.83 14.16 20

7 20 90 110 2.86 12.86 15.72 25


Machine Labour TPL APL (TP/L)

MPL(TP/L)

The Law of Marginal Returns

Stage of Production

1 1 3 3 -The Law of Increasing

Marginal ReturnsStage 1

1 2 7 3.5 4

1 3 33 11 26

1 4 50 12.5 17

The Law of Diminishing

Marginal Returns

1 5 65 13 15

1 6 75 12.5 10

Stage 21 7 80 11.43 5

1 8 80 10 0

1 9 78 8.67 – 2Negative

Marginal Returns Stage 31 10 72 7.2 – 6

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Short run Average Total Cost Curve

Cost / Price (RM)

15 (Q) Quantity

(units) 13Zulkhairi Nisa-Sg Petani Campus

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8

7

AVC

AFC

MC ATC or AC

AFC, AVC, ATC & MC The AVC, AFC, ATC and MC are u-shaped due to the law of diminishing

marginal returns

As more variable inputs are employed in order to increase the output, the APP will increase initially and the AVC curves decrease

Beyond certain point, the APPL will reach its maximum then decreases, and at the same time the AVC starts to increase. This is the reason why the AVC is u-shaped.

The ATC is a sum of AVC and AFC and it is u-shaped because as output increases, AFC continues to decline but AVC starts to increase.

The initial rise in AVC is not sufficient to offset the continuing decrease in AFC.

Eventually, AVC increase more than the decline in AFC, so that the ATC curves increases.

At relatively large quantities of output, ATC increase due to the MC and the law of diminishing marginal returns.


• The ATC curves reached it maximum point at output 0Q2 at which the firm operates most efficiently.

• If the firm produces output less than 0Q2 the inputs are not fully utilized at the ATC will be relatively higher.

• Contrary, if the firm produces more than the 0Q2, the inputs such as machineries are over utilized and it will increase the ATC.

• The vertical distance between ATC and AVC curves reflects the value of AFC.

• As output increases, the vertical distance diminishes and approaches to zero.

• It shows that the AFC curves falls continuously as output increased.

• It starts with relatively high cost but becoming smaller as output increases; such overhead cost fall continuously as they are spread across larger amount of output.

• The MC curves reflects the slope of TC curve

• Since there is no change in fixed cost, the MC must have increased due to the increase in TVC.


Relationship between MC, AVC and ATC

• The AFC curves falls as output expands, steeply at first but then more gradually

• When the ATC and AVC curves are rising, its corresponding MC curve is above it

• When the ATC and AVC curves are falling, its corresponding MC curve is below it

• The AVC curves fall initially, then reaches its minimum point and rises as output increases

• The MC curves intersects the lowest point of the ATC and AVC curves


Long run cost curves

• Is the curves that shows the minimum cost of producing any given output when all the inputs are variable

• The LRAC curve is derived by a series of short run average cost (SAC) curves

• Tangential points of the SAC are joined and make up the LRAC

• The long run is a period where firms plan how to minimize the average cost


Minimizing Cost of Production in The Long Run

SRAC1

SRAC2

SRAC3

0 Q1 Q2 Q3

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C1

C2

C3C4C5C6

Cost (RM)

Output


The Shape of LRAC

• The LRAC is u-shaped because of the law of increasing returns to scale (economies of scale) and the law of decreasing returns to scale (diseconomies of scale) occurs

• The law of increasing returns to scale refers to, as output increases in the long run, the LRAC curve will fall due to internal and external economies of scale which would bring about increasing return to scale and decreasing cost

• The law of decreasing returns to scale refers to as output increases further in the long run, the LRAC curve will rise because of internal and external diseconomies of scale which will bring about decreasing return to scale and increasing cost


Diseconomies of scaleEconomies of scale

Increasing returns to scale

Decreasing returns to scale

Constant returns to

scale

LONG RUN AVERAGE COST (LRAC) CURVE

Cost (RM)

SRAC3

SRAC2

SRAC1

LRAC

A C

B

Quantity (units)

0 Q1 Q2 Q3

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Economies of Scale

• Economies of scale refer to the advantages of large scale of production.

• It is used to explain why LRAC curve falls when the firm expands and increase its output. Increasing return to scale or decreasing cost industry is associated with economies of scale.

Factors that influence the internal economies of scale:

i) Labor specializationii) Financial economiesiii) Managerial economiciv) Technological economicsv) By products


Diseconomies of Scale

• Diseconomies of scale refer to the disadvantages of large scale of production.

• It is used to explain why LRAC curve rise when the firm expands and increase its output. Decreasing return to scale or increasing cost industry is associated with diseconomies of scale.

Factors that influence the internal diseconomies of scale are:i) Managerial difficultiesii) Low moraleiii) Higher input pricesiv) Marketing diseconomies


Concept of Revenue

• Total revenueIs the value of firm’s sales. Total revenue refers to the total amount of money that a firm can obtain from the sales of its product. TR=P*Q

• Average revenueDefined as the total revenue per unit output sold. AR=TR/Q

• Marginal revenueRefers to the change in total revenue resulting from one unit increase in quantity sold. An additional increase in total revenue when one unit increase in quantity sold. MR=TR/Q


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C H A P T E R 6 T H E O R Y O F C O S T