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