Post on 13-Jul-2015
S O N U C H O W D H U R Y
THEORY OF COST
CHAPTER OUTLINE
Rationale behind theory of cost
Cost meaning
Short run and Long run cost
INTRODUCTION
Firm’s objective is to maximize profit for a given production
technology. (Assumption)
How a firm will determine its profit-maximizing combination of
output by minimizing costs for this given level of output?
Profit maximizing requires deciding
How much output to produce
How much of various inputs to use in producing this output
Constraints on maximizing profit are
Technological relationship between output and inputs (characterized by a
production function)
Prices of inputs
Prices of outputs
Determining profit-maximizing combination of inputs and outputs may be decomposed
into two parts
Firm will minimize cost for a given level of output
Firm will determine its profit-maximizing output
To determine profit-maximizing equilibrium, will first consider how to produce a given
level of output at least possible cost
Minimizing cost for a given level of output is a necessary condition for profit
maximization
Cost theory is related to production theory, they are often used
together. However, the question is usually how much to produce,
as opposed to which inputs to use.
That is, assume that we use production theory to choose the
optimal ratio of inputs (eg. 2 fewer engineers than technicians),
How much should we produce in order to minimize costs and/or
maximize profits?
MEANING OF COST
Cost means the amount of expenditure (actual or estimated)
which is to be incurred for obtaining any particular
commodity or advantage or facility.
Economists are concerned with economic profit and hence
economic costs.
Economic costs include both explicit costs and implicit costs.
Explicit costs are costs that involve monetary payments such as
the costs of materials and labour.
Implicit costs are costs that do not involve monetary payments
such as the costs of the owner’s labour and financial capital.
An increase in output will require an increase in the
quantity of factor inputs which will lead to an increase in
costs.
The theory of cost is the study of how the cost of
production changes as the output level changes.
SHORT-RUN THEORY OF COST
Distinction between fixed costs and variable costs
Fixed costs are costs that do not vary with the output level as they
are associated with fixed factor inputs
Fixed costs will still be incurred even if the firm shuts down
production. Examples of fixed costs are interest payments on
loans for the purchase of capital goods (factories and machinery),
insurance premiums and rent.
Variable costs are costs that vary directly with the output level as
they are associated with variable factor inputs. In other words, an
increase in the output level will lead to an increase in variable
costs
Variable costs will not be incurred if the firm shuts down
production
Examples of variable costs are the costs of materials and direct
labour.
Total cost
Total cost (TC) is the cost of
all the factor inputs needed to
produce an amount of output.
In the short run, total cost is
the sum of total fixed cost
(TFC) and total variable cost
(TVC) and is positively related
to the output level.
Marginal cost
Marginal cost (MC) is the additional cost resulting from producing one more unit of output.
Marginal cost = change in total cost / change in output
Average cost
Average cost (AC) is the cost per unit of output.
Mathematically,
AC = Total Cost/Quantity.
Marginal Cost and Average Cost
Total cost, Marginal Cost, Variable Cost
Optimum capacity
If a firm produces the output level that corresponds to the lowest point on the average cost curve, it is producing at optimum capacity.
LONG-RUN THEORY OF COST
In the long run all factors of production become variable.
the entrepreneur has number of choices t change the plant size and level of output.
the long run cost curve is also known as planning curve.
the long run average cost curves is derived from short run average cost curves.
Characteristics:
Also called envelope curve
No portion of LAC can lie above any portion of SAC.
If the plant size is increased further than the optimum size, there will be diseconomies of scale and cause LAC to move upwards.
Complete the short run cost schedule of a hypothetical firm.
OutputTFC TVC TC MC AFC AVC ATC
1 50 25
215
3 20
4 135
5 35
End of The Topic