COST OF PRODUCTION/THEORY OF COST

Learning Objectives

• define cost of production and cost function

• identify the determinants of a cost function
• describe different types of costs
• classify nature of the costs in short-run
• compare the nature of the cost curves in the short run
• derive and illustrate the long-run average cost curve and
marginal cost curve.
 Introduction
 The term ‘cost of production’ refers to the total
amount of money spent on the production of a
commodity.

 The producer has to employ factors of production.

He pays to them for their services.

 Every producer has to decide what quantity of the

commodity he should produce. His decision depends
on his cost of production of the commodity.
 Cost Function
 A cost function expresses the relationship
between cost and its determinants.
C = f (S, O, P, T.......)

 (Where C= Cost, f= function of, S= size of plant,

O=level of output, P=Price of inputs and T=
technology)
 Determinants of Cost Function

1) Size of plant
2) Output level
3) Prices of inputs
4) State of technology
5) Managerial and administrative Efficiency
 Cost Concepts and Classifications

 Money cost
 Opportunity Cost
 Accounting Cost and Economic cost
 Private cost and Social cost
 Money Cost /Nominal Cost
Term cost of production refers to the money expenses
incurred in the production of a commodity

It includes
• Cost of raw materials
• Wages and salaries of labour
• Expenses on power and electricity
• Interest on capital
• Other expenses like advertisement, insurance premium
and taxes
 Opportunity Cost
• The opportunity cost of any good is the next best
alternative good that is sacrificed or forgone.

• If there is no sacrifice involved ,then the opportunity

cost is zero.
 Accounting Cost or Explicit Cost
Accounting costs or explicit costs are the payments
made by the entrepreneur/Producer to the suppliers of
various productive factors.

• wages to the laborers

• prices for the raw materials purchased
• fuel and power used
• rent for the building hired for the production work
• the rate of interest on the borrowed capital and the
taxes paid.
 Economic cost

The economic cost includes not only the explicit cost but
also the implicit cost.

Implicit costs are the cost of entrepreneur’s own factors

or resources

 The normal return on capital invested by the

entrepreneur,
 Wages or salary for his own services
 Rent of the land and buildings belonging to him and
used in production
Thus Economic cost = Explicit cost + Implicit cost.
 Private Cost and Social cost

Private Cost
• Private cost is the cost incurred by a firm for
production.

• It includes both implicit costs and explicit costs.

 Social Cost
Social cost is the total cost to society. It includes both
private costs plus any external costs.
The social cost involved in building and running an
airport can be split up into:

Private Costs of Airport

Cost of constructing airport.
Cost of paying workers to run airport

External Cost of Airport

Noise and air pollution to those living nearby.
Risk of accident to those living nearby.
Loss of landscape.
Private costs are those incurred by the firm producing
the goods/services, whereas social costs are those paid
by society.

For instance, cars.

The production costs and the cost of raw materials etc...
are all private costs,

• the CO2 emissions and the damage they cause to the

environment is an additional social cost

• when an oil refinery discharges its waste in the river

causing water pollution, Such a pollution results in
tremendous health hazards which involve costs to the
society as a whole.
• Social costs are greater than private costs.

• These problems are called “externalities” i.e.,

they are external to the firm producing them.

• They can be Negative Externalities (which harm

society) or Positive Externalities (which help).

Social cost = private cost + externality (if any)

 Negative Externalities
Negative externalities occur when production and/or
consumption impose external costs on third parties outside
of the market for which no appropriate compensation is
paid. This causes social costs to exceed private costs
Common Types of Negative Externalities By Producers

• Air pollution, e.g., smoky factory chimneys.

• Soil pollution, especially by farm chemicals
• Water pollution, e.g., rainwater run-off containing
farming pesticides and fertilizers.
• Noise pollution. Do you live near an airport or by a
building site?
Some Types of Negative Externalities by Consumers
• Pollution of air and water.

• Soil pollution

• Litter on streets; decomposing rubbish in land-fill

sites.

• Noise pollution, e.g., motorcycle noise in urban areas,

especially when the baffles have been deliberately
removed from the silencer.
• Vandalism; graffiti on walls.

• Smoking and alcohol abuse

 Positive Externalities
A positive externality is a benefit that is enjoyed by a third-party as a result
of an economic transaction. Third-parties include any individual,
organization, property owner, or resource that is indirectly affected. which
boost social welfare.

Examples include:

• Education generally.
• Health Facility especially in poor Third World
countries.
• The provision of playing fields at or near schools so that the
health and sporting skills of the children improves.
• Free museums and art galleries that can encourage the poor
and uneducated to widen their horizons, educate themselves,
and generally improve.
Cost Analysis
1.Traditional Approach of Cost curves
2.Modern Approach of Cost Curves
•

Types of Costs
On the basis of time period costs are studied in two
parts

1. Costs in Short-run
2. Costs in Long-run
 Costs in the Short-run
Short-run refers to that period of time in which some
factors of production are fixed and others are
variable.

1.Fixed Costs
2.Variable Costs
 Fixed Costs

• The fixed costs are those costs that do not vary with the
size of its output.

• Even if the production is zero, fixed costs remain the

same and that can be eliminated only by shutting down.

• Example: Rent of land and buildings, salary of

permanent staff, interest on fixed capital, insurance
premium.
 Since TFC is constant,
its graph is a horizontal line.

Rs

TFC

Quantity
 VARIABLE COSTS
• Variable costs are those costs which vary as the level
of output varies.

• When the production is zero, variable cost is also

zero.

• Example: Expenses on raw materials, fuel and

power, transport costs
 The TVC curve is Upward Sloping.

Rs TVC

Quantity
 Total Costs

Total cost is the sum of the total variable cost and

total fixed cost.

TC = TFC + TVC

TC: - Total Cost

TFC: - Total Fixed Cost
TVC: - Total variable Cost
 Total Cost

TC TC = TFC + TVC
Rs
The TC curve looks like
the TVC curve, but it is
shifted up, by the
amount of TFC.
TFC

Quantity
 Marginal Cost
Marginal cost is the addition made to the total cost by
the production of one more unit of a commodity.

MCn = TCn – TCn-1

MCn = Marginal cost
TC n = Total cost of producing n units
TC n-1 = Total cost of producing n-1 units
 Shape of Marginal Cost Curve

• The marginal cost curve is ‘U’ shaped.

• The shape of the cost curve is determined by the law of

variable proportions.

• If increasing returns (economies of scale)is in operation, the

marginal cost curve will be declining, as the cost will be
decreasing with the increase in output.

• When the diminishing returns (diseconomies of scale) are in

operation, the MC curve will be increasing as it is the situation
of increasing cost.
 Average Fixed Cost
• Average fixed cost is total fixed cost divided by
total output.

• Since total fixed cost is a constant quantity, average

fixed cost will steadily fall as output increases;
• when output becomes very large, average fixed cost
approaches zero. Average fixed cost curve is a
rectangular hyperbola.
TFC
AFC = [AFC = Average fixed Cost, TFC = Total Fixed cost, Q: Number of units of
Q
output produced]
The AFC Curve Slopes Downward & Gets Closer
& Closer to the Horizontal Axis.

Rs

AFC
Quantity
 Average Variable Cost
• Average variable cost is total variable cost divided by total
output.

• Average variable cost curve is ‘U’ Shaped. As the output

increases, the AVC will fall up to normal capacity output due
to the operation of increasing returns.

• But beyond the normal capacity output, the AVC will rise due
to the operation of diminishing returns.
TVC
AVC = [AVC = Average Variable Cost, TVC = Total Variable Cost,Q = Number of
Q
units of output produced]
 Average Variable Cost

Rs

AVC

Quantity
 Relationship Between Average Variable Cost and
Average Physical Product

• Average variable cost is inversely related to average

physical product.

• When AP is increasing, AVC is decreasing. When AP is

at its maximum, AVC attains a minimum value.

• When AP is decreasing, AVC is increasing.

• In production function, AP measures the efficiency of the
variable input, while AVC provides the same measure for
cost curves.

• When AVC is decreasing, the efficiency of the variable

input is increasing;

• efficiency is at a maximum level when AVC is a minimum

• When efficiency is decreasing AVC is increasing.

 Average Cost

• Average cost is total cost divided by output.

• Average costs are a key cost in the theory of the firm
because they indicate how efficiently scarce resources are
being used.

TC
AC = OR AC = AFC + AVC
Q

• [TC: Total Cost, AC: Average Cost, AFC: Average Fixed Cost,
AVC: Average Variable Cost, Q: Number of units of output
produced].
 Average Total Cost
Like AVC, ATC is
Rs U-shaped, but it reaches
ATC its minimum after AVC
reaches its minimum.
This is because
ATC = AVC +AFC &
AFC continues to fall &
AVC
pulls down ATC.

Quantity
 Short-Run Cost
The ATC curve is also U-
shaped.

• The MC curve is very

special.

• Where AVC is falling, MC

is below AVC.

• Where AVC is rising, MC is

above AVC.

• At the minimum AVC, MC

equals AVC.
 Short-Run Cost
• Similarly, where ATC is
falling, MC is below ATC.

• Where ATC is rising, MC is

above ATC.

• At the minimum ATC, MC

equals ATC.
Relationship Between Marginal and Average Costs

If MC > ATC, then ATC is rising

If MC = ATC, then ATC is at its minimum
If MC < ATC, then ATC is falling

If MC > AVC, then AVC is rising

If MC = AVC, then AVC is at its minimum
If MC < AVC, then AVC is falling
43
 Short-Run Cost
Cost Curves and Product Curves
– MC is at its minimum at the same output level at which
marginal product is at its maximum.

– When marginal product is rising, marginal cost is falling.

– AVC is at its minimum at the same output level at which

average product is at its maximum.

– When average product is rising, average variable cost is

falling.
Short-Run Cost &
Product Curves
Figure shows these
relationships.
 Short-Run Cost
Shifts in Cost Curves
The position of a firm’s cost curves depend on two factors:

 Technology

 Prices of productive resources

 Shifts in Cost Curves

Technology
• A technological change that increases productivity
shifts the product curves upward and the cost curves
downward.

• If a technological change results in the firm using

more capital, the average fixed cost curve shifts
upward and at low levels of output, the average total
cost curve may shift upward. At large output levels,
average total cost decreases.
 Shifts in Cost Curves
Prices of factors of production
• An increase in the price of a factor of production
increases costs and shifts the cost curves upward.

• An increase in fixed cost does not affect the variable

cost or marginal cost curves (TVC, AVC, and MC
curves).

• An increase in variable cost does not affect the fixed

cost curves (TFC and AFC). The total cost curves
(TC and ATC curves) are affected by a price change
for any factor of production.
Why AC Curve is a “U” – Shaped Curve?

• Behaviour of AFC and AVC

• Law of Variable Proportions
 Behaviour of AFC and AVC
• AC is the sum of AFC and AVC. As the production increases,
AFC goes on falling and AVC also goes on falling.
• AC curve is falling up to its minimum point. At this minimum
point, the firm is making full use of its production capacity.

• If firm produces beyond this normal capacity, AFC will

continue to fall, but AVC will begin to rise. Rising of AVC will
make the AC to rise also.

• After the minimum point of AC curve, rate of increase in AVC

in much more than the rate decrease in AFC. Consequently
its cumulative effect is reflected in the upward rising of AC
curve.
 Law of Variable Proportions

• The ‘U’ shape of the short-run average cost curve can also be
explained in terms of the law of variable proportions.

• When the quantities of a variable factor like labour are

increased in equal quantities, production rises till fixed factors
are used to their maximum capacity.

• In this stage, the average costs of the firm continue to fall as

output increases, because it operates under increasing returns
due to various internal economies.

• When the variable factors are increased further, this would lead
to diseconomies of production and diminishing returns. Due to the
working of the law of variable proportions the short-run average
cost curve is U-shaped.
 Fixed Cost Variable Cost Total Cost
Labor Quantity
Rs Rs Rs
1 16 160 80 240
2 40 160 160 320
3 60 160 240 400
4 72 160 320 480
5 80 160 400 560
6 84 160 480 640
7 82 160 560 720
 Fixed Variable Total Marginal Average Total Average
Labor Quantity
Cost Cost Cost Cost Cost Variable Cost
1 16 160 80 240 5.00 15.00 5.00
2 40 160 160 320 3.30 8.00 4.00
3 60 160 240 400 4.00 6.60 4.00
4 72 160 320 480 6.60 6.60 4.40
5 80 160 400 560 10.00 7.00 5.00
6 84 160 480 640 20.00 7.60 5.70
Table 3. Different Types of Costs