UNIT 7 THEORY OF COSTS

Structure
7.0 7.1 7.2 Objectives Introduction Costs in the Short Run
7.2.1 7.2.2 7.2.3 7.2.4 7.2.5 7.2.6 7.2.7 Fixed Cost Variable Cost Total Cost Average Fixed Cost Average Variable Cost Average Total Cost Marginal Cost

7.3 7.4 7.5 7.6 7.7 7.8 7.9

Relationship between Average Cost and Marginal Cost Curves Relationship between Cost and Product Curves Costs in the Long Run Let Us Sum Up Keywords Some Useful Books Answers or Hints to Check Your Progress Exercises

7.0 OBJECTIVES
After going through this unit you will be in aposition to: distinguish between various types of costs; represent these cost concepts graphically; identify the relationship between various types of costs; distinguishbetween long run and short run costs; and identify the relationship between long run and short run cost curves.

7.1 INTRODUCTION
In our day-to-day life we come acrossthe term cost in various contexts. The amount , of money we pay for the purchase of a good or hiring a service is generally considered m as cost to us. But for a production unit or f cost means the amount paid towards purchase of inputs use&inthe production of good or service. We have seen in the beginning of this course that there are four factors of production, viz., land, labour, capital and crganisation. Out of these labour (L) and capital (K) are two primary inputs for production (see TJnit 6). Payment made for the use of these inputs is cost. Since the amount of output produced depends upon level of inputs the cost of production depends upon the level of output.

Theory of P~.odllctiolland Costs

-

If we do not specifj properly, the definition of cost may be ambiguous. Therefore, the concept of cost will be taken up in the negt section.

7.2 COSTS IN THE SHORT RUN

By now you must be familiar with the term short run. You use the term for aperiod of time when at least one of the inputs cannot be varied. Examples of fixed inputs in the short run are machines, building, etc.
'

7.2.1 Fixed Cost

Let us consider aproduction process using two inputs K and L only. Here the level of capital input in the form of machines and tools cannot be changed in the short run wlile amount of labouu-can be. The machines once purchased by the firm cannot be disposed off easily. Similarly,the size ofthe building used for production and godown cannot be changed as and when wished. The firm would require a longer period of time to cl~ange inputs. such The cost incurred on all fixed inputs by the firm is totalfixed cost or sinqdyJxed cost (FC). Note that whatever be the level of output produced, the fixed cost remains same. Thus fixed cost is constant for a firm. If the amount of capital used by the firm is KOand its rental price is r, then

The fixed cost is also called the overhead cost. When represented in a graph FC curve is a horizontal straight line as given in Fig. 7.1. The figure indicates that fixed cost remains constant for all levels of output.

Fig. 7.1: Horizontal axis sllows output in number o f units. Thevertical axis shows fixed cost in rupees. This figtlre depicts the information contained in 1st and 2nd columns ofTable 7.1.

7.2.2 Variable Cost

Vuricrhle Cosl (VC),on the other hand, is the cost incurred on variable inputs. As mentioned above labour is one example ofvariable input. To appreciate the idea of variable input consider the examples like: given the maclines in a factory producing shoes an increase in butput call be brought about by illcreasing the amount of labouu. or the quantity of raw n~ateiials.

Often, labour use of increases with increase in the level of output. Accordingly, the cost of hiring labour also increases. Hence, we see that variable cost depends upon the level qfoz~finlt. labour is paid a wage rate w and L1 amount of labour If is used for producing Q1units of output, then

Tbcory of Costs

At this point you may be wondering about the shape ofthe VC curve. Is it a straight line or curve? Does it slope upward or downward? To answer these questions we have to visualise the shape of the total product (TP) curve discussed in the previous ~mit. You know from the previous unit that there are two types of increase in the TP curve. In the beginning it increases at an increasing rate and then slows down to increase at a decreasing rate. Since fixed cost remains the same in the short nm production process, the increase in cost is entirely due to increase in variable cost. The shape of the VC curve reflects exactly the opposite behaviour of TP curve. When TP curve increases at an increasing rate VC curve increases at a decreasing rate and vice versa. Thus, variable cost increases at a slower pace in the beginning. In the second stage, after the point of inflexion, the TP curve shows diminishing returns. During this stage the variable cost will increase at a faster pace.
Fig. 7 2 .

vc
4

L j
Inflexion point
VC
0

QI

Fig. 7.2 shows relation between variable cost and level of output. Point Q,on the horizontal axis corresponds with the level of output 5 in Table 7.1.
2

Such a behavior can be seen from Table 7.1. Upto 5 units of output VC increases at a decreasing rate. Afienvards it increases at an increasing rate. In Fig. 7.2 Q , level of output is the dividing line between the two stages.

T l ~ e o r y f P r o d u c t i o ~and c o s t s o ~

Table 7.1: Output and Costs

Q
0

FC 128 128 128 128 128 128 128 128 128 128 128 128

VC

TC 128 184 218 236 244 248 254 268 296 344 418 618

AFC
00

AVC

ATC
00

MC

0 56 90 108 116 120

56 45 36 29 24 21 20 21 24 29

1 2 3 4

128 64 42.7 32 25.6 21.3 18.3 16 14.22 12.8 11.6

184 109 78.7 61 49.6 42.3 38.3 37 38.22 41.8 56.1

56

34
18 8 4

5
6
7

126
140 168 216 290 390

6
14 28 48 74 100

8
I

9 10 11

35.5

7.2.3 Total Cost

Total cost isthe sum of fixed cost and variable cost. Therefore, we can write,

Total cost consists of two components FC and VC. Out of these FC is constant. But VC depends on level of output. Hence, TC also depends on level of output. For a higher level of output TC is higher. Fig. 7.3 shows the shape of TC curve. There is an equal gap between TC and VC curves as can be seen from the figure. The difference is equal to the level of fixed cost, which is constant for all levels of output.
Fig. 7.3

Fig.7.3: This figure brings together information ofFig. 7.1 and Fig. 7.2. We obtaln TC curve by vertically adding up FC and VC.

7.2.4 Average Fixed Cost

Average fixed cost (AFC) is defined as fixed cost divided by level of output. Symbolically, .
(,

T h e o r y o f Costs

FC AFC (QI) = Ql

As you know FC is constant for any level of output. Hence AFC declines as Q increases. Such a feature can be seen fiom Table 7.1 also. AFC is 128when Q = 1 and 25.6 when Q= 5. See that while FC is constant for all levels of output AFC varies according to level of output. Let us look into the graphical representation of AFC curve in Fig. 7.4. It has the shape of a rectangular hyperbola. It does not touch either axis although moves quite closer. For zero output AFC is infinity. On the other hand for a large quantity of output AFC is negligible.
Fig. 7.4

Fig.7.4

shows average fixed cost curve of a firm. Area under the curve is equal to level of output (Q) multiplied by AFC and therefore equals total fixed cost.

7.2.5 Average Variable Cost (AVC)

It is the variable cost divided by units of output, viz.,

Let us see the graphicalpresentation of AVC. In Fig.7.5 the upper panel shows the VC curve. In this curve AVC will be - at output level Q1.Similarly at output
OQl

MQ1

levels Q2 and Q3 AVC are -and oq respectively. These levels of AVCs are
OQ2

NQ2

PQ3

shown directly in the lower panel of Fig. 7.5.

I

Theory o f Production rncl Costs

Fig. 7.5

AVCA AVC

Q1

Q2

Q3

b Q

Fig. 7.5 shows derivation of AVC from VC. At each level of output, AVC is slope of a straight line joining origin with VC at that level of output.

Again from the upper panel of Fig. 7.5, we notice that the ratio

MQ,

(=AVC at

Q, ) is equal to the slope of the line OM. similarly for output Q2the AVC is equal

to -which is equal to the slope of the line ON. Thus, we can find out the b~
OQ2

NQ2

at any level of output by measuring the slope of the line from the origin to the correspondingpoint on the VC curve. Notice another feature of AVC. The slope at output Q, is more than the slope at Q2. Hence AVC is higher at Q1 than at Q2. On the other hand, AVC is less at Q2 than at Q3.T~LIS, obvious that AVC declines in the beginning, reaches a minimum it is and then starts increasing.

7.2.6 Average Total Cost

Average total cost (ATC) is the sum of AFC and AVC at the level of output under consideration. Suppose at the level Q, ,

As AFC and AVC both depend upon the level of output, ATC also changes according~to output level. Fig. 7 . 6 shows the ATC curve, which is obtained by vertically adding the AFC y - ~AVC. d

Fig. 7.6

Theory of Costs

Fig.7.6: We add up AVC and AFC at each level of olrtput to obtain ATC. This ATC is also called average cost ofproduction, or simply AC. Note the U-shape of AC.

Just we derived the AVC curve from the VC curve by taking the slope of the line froin the origin, we can derive ATC also in a similar way fiom the TC curve. Refer back to Fig.7.3 and Fig. 7.5. The ATC at output level Q, is given by - which
OQ,
MQl

is the slope of the line OM fiom the origin. Slope of TC can be measured at all levels of output in a similar manner. This will provide us with the ATC curve and one is plotted in Fig. 7.6. Two observations can be made from ATC curve above. First, it is U-shaped. It declines in the beginning, reacl~es minimum and then increases. The minimum a poii~ts ATC and AVC need not be at the same level of output (see Fig. 7.6). of Minimum level ofATC is at a higher level output compared to minimum point of AVC. This feature can be observed from Table 7.1. While the minimuill point of AVC is at Q = 7, it is at Q = 8 in case of ATC. So, for some levels of output (the output range Q 1Q2 in Fig. 7.6) ATC declines even though AVC is increasing. This is due to the fact that decline in AFC outweighs rise in AVC .

7.2.7 Marginal Cost

Marginal Cost (MC) is the increase in total cost due to production ofan additional unit 06output. Syinbolically,

. _
In Fig. 7.7 we depict the change in TC as output increases from Q, to Q, . With the increases of output from Q to Q2 (= AQ) we see that TC increases fr&n MQI to NQ2 (=AC). Thus, at Q ,

A/('

=-(=

ATC
AQ

G ) . Sinlilarly we can find out MC for

PiV

any change in output level. But here MC-isover a discrete change in output, not at a point of output. Hence in order to find out MC at any point on the TC curve, we have to consideran infinitesinla1change in output. Those of you who are familiar with calculus may say that we can obtain such a measure of MC by taking limit value of , . Thus MC can be found out by taking O partial derivative of TC with respect to Q. Syi~~bolically,
A 7'c'

Theory of Production and Costs

You have seen earlier that FC is constant and does not change if output increases by one unit. The increase in TC for production of an additional unit of output is entirely due to increase in VC. Therefore, MC = AVCIAQ. Going by the derivative formula we can define

Fig. 7 7 .

n :

Fig. 7.7: En~phasises point that slope oftotal cost curve at each level ofoutput can be the interpreted as marginal cost at that output.

Now, we will go a step further. You know that the MC is equal to

F. point QI At

we found out that MC = f$. But this is equal to the slope of the tangent line tl drawn on the TC curve at point Q, .
Let us go back to Table 7.1. In the table see that when output increases from 0 to 1 unit TC increases from Rs. 128 to Rs. 184, that is, by Rs.56. Hence MC is Rs. 56. But when output increases from 1 unit to 2 units then TC increases from Rs. 184 to Rs, 2 18. i.e., by Rs. 34. Hence MC is Rs. 34 at this level of output. Similarly we can calculate MC at all levels ofoutput.

Check Your Progress 1

1) Define the following concepts.
i) Variable Cost

............................................................................................................
ii) Marginal Cost

ii3) Average Fixed Cost

7.3 RELATIONSHIP BETWEEN AVERAGE COST AND MARGINAL COST CURVES

By now you are familiar with the shapes of cost curves. Let us look into the relationshipsbetween them. Take the relationship between ATC and MC first. From the previous section we know that ATC is the slope of the line fiom the origin to the point on&e TC curve. On the other hand, MC is the slope of the tangent to the TC curve on the point concerned. For the output level Q, (see Fig. 7.8), the corresponding level of TC is Q,M. On the TC curve consider the point M. At this point ATC is given by tht slope ofthe line OM. But MC at this point is slope ofthe tangent t .The slope of the line OM is greater than the slope oft Hence ATC>MC at level of output Q

T h e o ~ y Costs of

Now consider the level of output Q2.At this levek the corresponding point on the TC curve is N. At N, ATC is the slope of the line fiom the origin OR while MC is slope of the tangent at point N, which is equal to OR. Thus we find that ATC is equal to MC at Q2.
Fig. 7.8

Fig. 7.8: is quitean interesting figure. We go through steps involved in Fig. 7.5 to get ATC, Then, we plot slopes of total cost curve at all tho* points. The resulting curve, as explained in Fig. 7.7 above is MC. Also notethat MC has a shape similar to AC and cuts A c at its minimum point.

Theory of' Production and Costs

Take the level of output level Q3. The correspondingpoint on t eTC is P. At P we h see that slope of OP is less than the slope of t2. Thus ATC<MC. Consider the point L. Here the slope of the tangent is zero and MC reaches a minimum at the corresponding level of output (Q4).In fact, before Q4level of output, the slope of TC is negative. Hence MC is declining. On the other hand, after Q4 level of output, slope is positive. Hence MC is increasing. At Q4, the TC curve has a point of inflexion. In the beginning ATC>MC (up to the level of output Q2).At Q2,ATC = MC. After Q2 ,MC>ATC. Observe the relationship which has emerged. Note another fact that at Q2 level of output ATC is the minimum. Thus ATC = MC at the level of output where ATC is minimum. Below this level of output, MC is lower than ATC and above this level MC is greater than ATC. Hence, MC crosses ATC from below at the ilzinimum level of ATC.

Check Your Progress 2

1) For a cost function TC = 53 +0.5 Q + 0.2 Q~ find out

............................................................................................................
Average Variable Cost

...........................................................................................................
iiii Margind Cost

PRODUCT CURVES
There is a close,relationship between production and cost. From the theory of production discussed in the previous unit we have the following definitions in the short run (where labour is the only variable input and capital is fixed) for average and marginal product:

. In the short run, we know that MC = - This can be represented as AQ

t

A TC

A Me=--- ( wL ) AQ

"A

AQ

(since w is constant) = -

W '

M P ~

where

.Thus, MC will be minimum where MPL is maxim~un. Higher will

be MC where MQ is lower. Meilce MC curve will be the inverse of the MPLcurve

Theory of Costs

discussed in the previous unit. Siinilarly from the A PLcurve we can derive the AVC curve:
np, whereL = AC Thus AVC is the inversely related to APL. e When A is maximh AVC is minimum and vice versa.
AVC =

=A=

'

Fig. 79 .

Fig. 7.9: MC and AVC curves are drawn as mirror images of MP and AP respectively. This is done because there exists an inverse relationship between these two curves.

In the previous unit we have seen that MPLcuts APLfrom above at the maximum MPL point of APL. In the upper panel of Fig. 7.9, we see that at output level Q2, curve crosses APLfrom above. Thus at Q2,APL= MPL. ~ bthe maximum point t The of MPL is at output level Q1that is less than Q2. minimum point of MC On corresponds to the maxinlum point of.MPL,which is at Q,. the other hand the minimum point of AVC correspondsto maximum point of APLwhich is at output level Q2. Thus in the lower panel of Fig. 7.9 we see that MC crosses AVC from

Theory of Production and Costs

below at the minimum point of AVC. Recall that data in Table 7.1 gave us similar shapes of AC and MC in Fig. 7.8 above. MC did cut ATC at Q2 level of output and at that point ATC was minimum. MC cuts both AVC and ATC at their minimum points.

Check Your Progress 3

1) Explain the relationship between average product and average variable cost curves.

2) Explain how MC is the inverse of MP.

...................................................................................................................

7.5 COSTS IN THE LONG RUN

In the long run all inputs are variable. The fr can easily liquidate all the capital im assets in the long run.Thus no cost remains fixed in the long run. There is only variable cost, which is equal to total cost. This change affects the shape of cost curves in the long run. The long run total cost curve (LTC) starts fiom the origin. Recall that short runTC starts fiom the vertical axis. In Fig. 7.10 we have drawn an LTC curve. As in the case of short run cost curves we can draw long run average total cost curve (LAC) and long runmarginal cost curve (LMC).
Fig. 7.9

I
J

Fig. 7.1 0: Long run total cost curve is nothing but long run variable cost. Followingthe methodology of Fig. 7.8 above, we have drawn L A C and L M C in this figure. Again notice, both L A C and L M C areU-shaped but this U is rather wider I than the U in Fig. 7.8. Also note that L M C cuts L A C at the latter's minimum point

Again LAC is defined as LTC/Q and is given by the slope of the line from the origin to the point on the LTC. In Fig. 7.10, 'LAC at output PI
=

Theory of Costs

2 .This is equal to

the slope of the line OM. Similarly LAC at other levels of output can be found out. From LTC we can also find out long run marginal cost (LMC). This is given by the slope of the tangent line to LTC curve at the concerned point. In Fig. 7.10, LMC at output Q1 is the slope of the tangent tl .The relationshipbetween LAC and LMC is similar to that in the short run. In the beginning LAC>LMC upto the level of output Q2. At Q2, LAC = LMC. After Q2 LMC>LAC. At Q2 level of output see that LAC is the minimum. Thus LAC = LMC at the level of output where LAC is minimum. Below this level of output LMC is lower than LAC and above this level LMC is greater than LAC. Hence, LMC crosses LAC from below at the minimum level of LAC. Now we turn to relationship between short run and long run cost curves. In the long run, as firms enter into the industiy,the industry expands. This creates business environment conducive for economising costs through better utilitsation of transport facilities. When many industries come together in one place, we have an industrial concentration through the development of auxiliary industriessupplying raw materials and encouraging skill formation. Again, high concentration increases cost of distribution, cost of living, and also creates sc"an:ityof inputs specific to the industry. Due to external economies in the first stage of expansion and then the diseconomies, the long runaverage cost curve declines first then increases. Thus, the LAC is also 'U' shaped, like the SAC, but is flatter.
Fig. 7.1 1

In Fig. 7.1 1 for output OM in the short iun, the average cost of production is VM in SAC,. But in the long run. the iinn will choose to establish a larger plant to produce this output and operate on SAC2. This reduces the average cost to V', where V', is the point at which SAC2 is tangent to LAC. In this case, economies of scale operate and each successive plant Size will have a lower minimum average cost. Accordingly, SACSslide down to indicate dimii~isllii~g i ~ i ~ ~ u m cost. SAC, im average is the plant-size coiresponding to the minimum long-111u average cost, V, M . On the other hand, when diseconoillies of scale operate, each successive large plant will have higher minimunl avesagekost e.g., for SAC4,average minimum cost is M2V2. If we draw a curve tangent to every SAC, we get a long run average cost curve as an envelope of short run average cost curves. This long run average cost

Theory of Production and Costs

curve is a 'U' shaped curve. This is tangent to the falling portion of the SAC while economiesof scale operate, but it is tangent to the rising portion while diseconomies operate. The minimum point on LAC is a point of tangency with one of the SACS, here SAC,, at its minimum point. When both long run internal and external economies and diseconomiesare absent and minimum average cost is the same for all plant sizes, the returns to scale are constant and the minimum average cost is also constant .

Check Your Progress 4

1) In what respects long run cost curve is different from short run cost curve?

...................................................................................................................
2) Explain the relationship between LAC and LMC.

3) State the reasons for the 'U' shape of the short run average cost curve in three sentences.

4) Why do the internal economies and diseconomies operate in the long run and how do they affect the shape of the long run average cost curve ?

5) Explain briefly the operation of external economies and diseconomies in an

industry.

6) Is the following statement correct? The marginal cost curve cuts the average cost curve at its minimum point.

Theory of Costs

...................................................................................................................
...................................................................................................................

Cost for firm is the due to payments made towards purchase of inputs. Some of the inputs like capital may be fixed in the short runwhile others may be variable. In this unit we defined seven types of cost concepts, viz., Fixed Cost, Variable Cost, Total Cost,Average Fixed Cost, Average Variable Cost, Average Total Cost and Marginal Cost. We showed the shape of the cost curves for all these cost concepts and establishedthe link between them.
.

Also we discussed the inverse relationship between cost and product curves. The difference between long run and short runcost curves is briefly discussed in the unit.

Average cost Average Fixed Cost

: Total cost divided by level of output. : Fixed Cost divided by level of output. It is a

downward slopingcurve in the shapeof a rectangular hyperbola.

Average Variable Cost Cost Cuwes Fixed Cost Total Cost Variable C O ~

: Total Variable Cost divided by level of output.

: Representation of cost concepts graphically : The cost i n c d on inputs,which are fixed in nature

in the short run. Capital is one exampleof fixed input.

: Sum of Variable Cost and Fixed Cost is Total Cost

of production.
: Cost incurred on variable inputs. Labour is avariable

input. Hence expenditure on wage paid to labour is variable cost.

7.8 SOME USEFUL BOOKS

As in the previous unit (Production function). Add to the list Frank, R. H., 1991, Microeconomics and ~ehqvior, McGraw Hill Inc., Singapore.

Theory of P r o d ~ ~ r t i oand Costs n

7.9 ANSWERS OR HINTS TO CHECK YOUR PROGRESS EXERCISES

Check Y o d r o g r e s s 1

1 1

1) These concepts have been defined in the text (See Section 7.2).
Check Your Progress 2

1) In the cost function TC = 53 +0.5 Q + 0.2 Q~

fixed cost is 53. This remains constant whatever be the level of output.

iii) MC is 0.5 + 0.4 Q

Check Your Progress 3

1) Section 7.4 explains the inverse relationship between average product and average variable cost. 2) Go through the text in Section 7.4.
Check Your Progress 4
1) Section 7.5 depicts the relationship betweenLMC andLAC. Go through the text.