CHAPTER Four2 - Introduction To Economics by Ahmed A.

CHAPRER 4: THEORY OF PRODUCTION
AND COSTS
4.2. Theory of Costs
1
THE DIFFERENT COST TYPES
 Cost: is the monetary value of inputs used in the production
 Two types of cost of a product
 Social cost: is the cost of producing an item to the society
 Private cost: is the cost of producing an item to the individual
producer.
 Private
cost of production can be measured in two ways:
 Economic cost and accounting cost
A. Economic cost: the cost of all inputs used to produce the item.
Economic cost = Explicit costs + opp. cost + other Implicit cost
2
CONT.
 Explicit costs – are out of pocket expenses for the
purchased inputs.
 Implicit cost – The estimated monetary cost for non-
purchased inputs (or imputed cost of self-owned or self
employed resources based on their opportunity costs;)
 Opportunity Cost - the economic cost of an input used in a
production process is the value of output sacrificed elsewhere.
The principle of opportunity cost of an input is the value of
foregone income in best alternative employment.
B. Accounting cost: refers to the cost of purchased inputs

only. It is the explicit cost or outlay of production only. 3
ECONOMIC VS. ACCOUNTING
PROFIT
 Economic cost = Explicit costs + Implicit cost
 Accounting cost = Explicit costs

 Accounting profit = Total revenue – Accounting cost
= Total revenue – Explicit cost
 Economic profit =Total revenue – Economic cost
=(Explicit cost + Implicit cost)
 Economic profit will give the real profit of the firm since all
costs are taken into account. Accounting profit of a firm will be
greater than economic profit by the amount of implicit cost.
4
TOTAL, AVERAGE AND MARGINAL COSTS IN THE
SHORT RUN
 A cost function shows the total cost of producing a given
level of output. It can be described using equations, tables
or curves, as follows:
 C = f (Q)
 In the short run, total cost (TC) can be broken down in to

two – total fixed cost (TFC) and total variable cost (TVC).
 TFC is those costs that do not vary as the firm change its
output level.
• Examples: salaries of administrative staff, expenses for
building, expense for depreciation and repairs, rent for land
and rent of building. 5
COSTS OF PRODUCTION
Total Total
Fixed Variable Total Marginal Average
Q Cost Cost Cost Cost Cost
0 100 0 100 - -
1 100 30 130 30 130
2 100 50 150 20 75
3 100 60 160 10 53.3
4 100 65 165 5 41.25
5 100 75 175 10 35
6 100 95 195 20 32.5
7 100 125 225 30 32.14
8 100 165 265 40 33.12
9 100 215 315 50 35
10 100 275 375 60 37.5
6
… CONCEPTS … CONT’D
 TVC refers to the cost that changes as the amount of

output produced is changed.
 Examples - purchases of raw materials, payments to
workers, electricity bills, fuel and power costs.
 Total variable cost increases as the amount of output
increases.
 If no output is produced, then total variable cost is zero
 In general, the short run total cost is given as:

 TC = TFC + TVC
7
… CONCEPTS … CONT’D
 As the level of output increases, total cost of the firm also increases.
 The TVC has an inverse S-shape. The shape indicates the law of
variable proportions in production, (MP);
 At the initial stage of production productivity increases. Hence,
the TVC increases at a decreasing rate. This continues until the
optimal combination of the fixed and variable factor is reached.
 Beyond this point, as increased quantities of the variable factor
are combined with the fixed factor, the productivity of the
variable factor declines, and the TVC increases at an increasing
rate.
 Finally, the shape of the TC curve follows the shape of the TVC
curve. 8
TC
TVC
TFC
TC
(Total Cost)
TVC
(Total Variable
Cost)
TFC
(Total Fixed
Cost)
0 Q
9
Fig. COST CURVES
AFC Per unit costs
AFC = TFC/Q.
As more output is produced, the Average Fixed
Cost continuously decreases.
AFC
(Average Fixed Cost)
0 Q10
TVC The Average Variable Cost at a point
on the TVC curve is measured by the
AVC
slope of the line from the origin to that
point.
AVC=TVC/Q
The short run AVC falls initially, TVC
(Total Variable Cost)
reaches its minimum, and then starts to
increase. Hence, the AVC curve has U-
shape and the reason behind is the law
of variable proportions.
Minimum AVC
0 q1 Q11
CONT.
 Average total cost is the total cost per unit of output.

ATC = TC/Q
 ATC= AVC + AFC
 Marginal cost is defined as the additional cost that a firm

incurs to produce one extra unit of output.
 MC = dTC/dQ = dTVC/dQ
 Given inverse S-shaped TC and TVC curves, MC initially

decreases, reaches its minimum and then starts to rise.
12
GRAPHICALLY,
13
EXAMPLE
 Suppose the short run cost function of a firm is given by:
TC=2Q3 –2Q2 + Q + 10.
A. Find the expression of TFC & TVC

B. Derive the expressions of AFC, AVC, AC and MC
C. Find the levels of output that minimize MC and AVC and then find the
minimum values of MC and AVC
14
06/08/24
QUESTIONS OR
COMMENTS?
Thank you!!!
15

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CHAPRER 4: THEORY OF PRODUCTION

4.2. Theory of Costs

B. Accounting cost: refers to the cost of purchased inputs

 Accounting cost = Explicit costs

 In the short run, total cost (TC) can be broken down in to

 TVC refers to the cost that changes as the amount of

 In general, the short run total cost is given as:

 Average total cost is the total cost per unit of output.

 Marginal cost is defined as the additional cost that a firm

 Given inverse S-shaped TC and TVC curves, MC initially

A. Find the expression of TFC & TVC

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