THEORY OF COSTS

Lecture 4
Some key terms
• Revenues

• Costs

• Profits
Element of Costs
Fixed
Fixed and
and Variable
Variable Costs
Costs
• Total output is a function of variable inputs and fixed
inputs.
• Therefore, the total cost of production equals the fixed
cost (the cost of the fixed inputs) plus the variable cost
(the cost of the variable inputs), or…

TC  FC  VC
Element of Costs
Fixed
Fixed and
and Variable
Variable Costs
Costs
• Fixed Cost

• Does not vary with the level of output

• Cost paid by a firm that is in business regardless of the level of

output

• Variable Cost

• Cost that varies as output varies

 Concepts of costs
• Total costs- represents all the costs
(implicit and explicit) involved in
producing a given level of output. TC
Costs

• TC= FC + VC VC

• FC- fixed costs- do not vary with

output, have to be incurred even if
production is zero- e.g, depreciation,
rent, insurance. FC

• VC-variable costs- vary directly with

output, e.g, labour cots, costs of raw
material.

qty
Cost in the Short Run
• Average Total Cost (ATC) is the cost per unit of output, or
average fixed cost (AFC) plus average variable cost
(AVC). This can be written:

TFC TVC
ATC  
Q Q
Cost in the Short Run
• Average Total Cost (ATC) is the cost per unit of output, or
average fixed cost (AFC) plus average variable cost
(AVC). This can be written:

TC
ATC  AFC  AVC or
Q
Concepts of costs
• Average Costs:

• AC-Average total costs = TC/Q: AC= VC+FC

• AVC- Average variable costs= VC/ Q
• AFC- Average Fixed Costs= AFC/Q

• Marginal Costing
• MC= Δ TC/ Δ Q
Revenue Concepts
TR= price *qty

AR = TR / Q

MR= Δ TR / Δ Q

Concepts of Profit
Normal profits- TR= TC, break even

Abnormal Profits – TR> TC

MAX Profits- produce at MC = MR
 The production decision
• For any output level, the firm attempts to minimize
costs

• Assume the firm aims to maximise profits

• Profits depend on both COSTS and REVENUE

• Marginal cost (MC) is the rise in total cost if output

increases by 1 unit

• Marginal revenue (MR) is the rise in total revenue if

output increases by 1 unit
Maximising profits
If MR > MC, an increase
in output will increase
MC, MR

MC profits.
If MR < MC, a decrease
in output will increase
E profits.
So profits are maximised
MR when MR = MC at Q1
(as long as the firm
covers variable costs)
0 Q1 Output
Firm’s Output Decision
MR>MC Raise
MR<MC Cut
MR=MC Stay
1 2 3 4 5 6 7
Output FC VC Total Price TR £ Profit
Cost £ £ £
0 5 0 5 - 0 -5
1 5 20 25 21 21 -4
2 5 31 36 20 40 4
3 5 39 44 19 57 13
4 5 46 51 18 72 21
5 5 54 59 17 85 26
6 5 64 69 16 96 27
7 5 76 81 15 105 24
8 5 90 95 14 112 17
9 5 106 111 13 117 6
10 5 124 129 12 120 -9
MR , MC and the Output choice

Output MR MC MR-MC Output

Decision
0 - - -
1 21 15 6
2 19 11 8
3 17 8 9
4 15 7 8
5 13 8 5
6 11 10 1
7 9 12 -3
8 7 14 -7
9 5 16 -11
10 3 18 -15
Using MR and MC to determine output
When MC>MR Decision is to increase
output as the addition to
revenue is greater than the
addition to costs, so total
profits will increase
When MC<MR Decision is to decrease
output as the addition to
costs is greater than the
addition to revenue, so total
profits can be increased by
decreasing output
When MC=MR Optimal output- profit
maximising output
 Effect of a change in costs or revenue on
output
When there is a change in TC- is it caused by FC OR VC ?

If by FC then no change in output- as no impact on MC

If by VC- change in MC and on equilibrium output

When there is a change in demand- affect TR – affect MR-

hence affecting equilibrium output.
Objectives of a Firm

• Maximise profits

• Maximise sales

• Goodwill

• Maximise subsidies or grants from govt

• Can you think of other objectives????

Cost Curves for a Firm Total cost
is the vertical TC
Cost 400 sum of FC
($ per and VC.
year) VC
Variable cost
increases with
300 production and
the rate varies with
increasing &
decreasing returns.

200

Fixed cost does not

100 vary with output
50 FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output
Cost Curves for a Firm
Cost
($ per
100
unit)
MC

75

50 ATC
AVC

25

AFC
0 1 2 3 4 5 6 7 8 9 10 11 Output (units/yr.)
Cost Curves for a Firm
• The line drawn from
P TC
the origin to the
400
tangent of the variable VC

cost curve:
300
• Its slope equals AVC
• The slope of a point on
VC equals MC 200

• Therefore, MC = AVC at A
7 units of output (point 100
FC
A)
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output
Cost Curves for a Firm
• Unit Costs Cost
($ per
unit)

• AFC falls continuously 100

MC
• When MC < AVC or
75
MC < ATC, AVC &
ATC decrease 50
ATC
• When MC > AVC or AVC

MC > ATC, AVC & 25

ATC increase AFC

0 1 2 3 4 5 6 7 8 9 10 11
Output (units/yr.)
Cost Curves for a Firm
• Unit Costs Cost
($ per
unit)

• MC = AVC and ATC at 100

minimum AVC and MC

75
ATC
• Minimum AVC occurs 50
ATC
at a lower output than AVC
minimum ATC due to 25

FC AFC
0 1 2 3 4 5 6 7 8 9 10 11
Output (units/yr.)
Short Run V/S Long Run

• Short run-a period where at least one factor of production

is fixed in ss

TC= FC +VC

• Long run- a period where all factors of production are

variable, that their ss is elastic

TC= VC as FC is Zero
 Law of diminishing marginal returns- Short Run

In the short run some factors are fixed in supply. As such as

more of the variable factors are added to the fixed ones in
order to increase output, initially, MC falls but eventually it
rises. This is known as the law of marginal variable
proportions

MC is u-shaped in the short run- initially as output increases

TC increases at a decreasing rate (MC falls) but eventually it
increases at an increasing rate (MC rises)

ATC is thus U-shaped in the short run- due to some factors

which are fixed in ss
 Average Total cost

Cost
($ per unit
of output

ATC

Output
q
 Long-Run Average
and Marginal Cost
Cost
($ per unit LRAC
of output

IRS, E.O.S DRS, D.O.S

CRS, Optimum size or

Minimum efficient scale

Output
 Returns to scale in the long run
In the long run all factors are variable so we can have :
• Increasing returns to scale-economies of scale-LRAC falls
• Output increases more than in proportion to inputs, e.g doubling all inputs-
trebles output
• The % change in output is greater than the % change input.
• For example: An additional 1 tonne of sugarcane brings 1.5 tonnes of sugar
• Decreasing returns to scale-diseconomies of scale- LRAC rises
• Output increases less than in proportion to inputs, e.g increase all inputs by
100%- output increases by only 40%
• For example: An additional 1 tonne of sugarcane brings only 0.5 tonnes of
sugar
• Constant returns to scale- LRAC constant
Output increases in the same proportion as inputs, e.g double all inputs, output
also doubles

Hence AC can take different shapes in the long run

The relationship between AC & MC

• When MC below AC, it slopes downwards

• When MC above AC, it slopes upwards

• MC cuts AC at its minimum

• Minimum efficient scale [MES] – level of output at which the

firm has exhausted all its economies of scale, AC becomes
horizontal , or this is achieved at its minimum point for U-
shaped AC
Long-Run Cost Curves

• Long-Run Average Cost (LAC)

• In the long-run:

• Firms experience increasing and decreasing returns to scale and

therefore long-run average cost is “U” shaped.

Long-Run Average
and Marginal Cost
Cost
($ per unit
of output LMC

LAC

Output
Long-Run Cost Curves

• Long-Run Average Cost (LAC)

• Long-run marginal cost leads long-run average cost:

• If LMC < LAC, LAC will fall

• If LMC > LAC, LAC will rise

• Therefore, LMC = LAC at the minimum of LAC

Exercise
• A firm is operating in the short run and hires capital (K)at
£11/unit and labour (L) £10/unit. You are given the following
K L output K L FC VC TC AFC AVC ATC
input input cost cost
10 1 10

10 2 20

10 3 35

10 4 45

10 5 50

10 6 52
Complete the table above

• What can you conclude about the law of diminishing

returns?-justify your answer

• What are the main reasons for economies and

diseconomies of scale?