Theory of Cost

1. S O N U C H O W D H U R Y
THEORY OF COST

2. CHAPTER OUTLINE
 Rationale behind theory of cost
 Cost meaning
 Short run and Long run cost

3. 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

4.  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

5.  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?

6. 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.

7.  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.

8.  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.

9. 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.

10.  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.

11. 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.

12. 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

13. Average cost
 Average cost (AC) is the
cost per unit of output.
 Mathematically,
 AC = Total
Cost/Quantity.

14. Marginal Cost and Average Cost

15. Total cost, Marginal Cost, Variable Cost

16. 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.

17. LONG-RUN THEORY OF COST
 In the long run all factors of production become
variable.
 the entrepreneur has number of choices to 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.

19. 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.

20. Complete the short run cost schedule of a
hypothetical firm.
Output
TFC TVC TC MC AFC AVC ATC
1 50 25
2
15
3 20
4 135
5 35

21. End of The Topic