In The Name of Allah, The Most Beneficent, The Most Merciful

Basic Economics
Cost of Production:
Traditional Theory of Cost

Dr. Sayyid Salman Rizavi

 Cost of Production
••Production
  process requires inputs.
•Payment/Reward to inputs is needed to hire them
•Production inputs: Labor, Capital, Land & Organization
•Reward to inputs: Wage, Interest, Rent & Profit
•Cost of production may be defined as the sum of rewards to all
factors of production.
• Cost is a function of the level of output

• Short Run: All inputs are not variable

• Long Run: All inputs vary.
 Types of Costs & Definitions
• Total Cost (TC or C): The sum of all types of costs. This may
include fixed and variable costs
• Fixed Cost (FC): The cost that does not vary with the level of
output. It exists only in the short run.
• Fixed cost may include: Interest on capital, Depreciation on land
and fixed assets, Salaries of permanent employees, Rent on land
etc.
• Variable Cost (VC): The cost that varies with the level of output.
• Variable cost may include: Cost of raw material, Wages of
contract labor, Advertisement expenses, Insurance and taxes,
Marketing and transport, etc.
 Types of Costs & Definitions
•• Marginal
  Cost (MC): Marginal Cost is the rate of change in Total
Cost i.e. Change in the Total Cost per unit of change in output

• Averages of all costs may be obtained by dividing by the output

, ,

• The Marginal Cost Curve is U-shaped. This is based on Law of

Variable proportions where Marginal Product Curve is Inverted-U
shaped and the marginal cost moves in the inverse direction of
Marginal Cost.
Why is the Marginal Cost U-shaped?
This is based on Law of Variable Proportions. Assume that Cost of every additional
Labor is Rs. 100 Labor Input Marginal Marginal Cost
(Additional Labor Product
will cause Additional (Change in
Cost of Rs. 100 = ) outpur)
1
1 2
2
When Marginal Product 2 3
rises, Marginal Cost falls 2
3 3
4
and when Marginal
4 5
Product falls , marginal 3 4
cost will rise. This is why 5 4
Marginal Cost Curve 6
4 3
5
would be U-shaped. 7 2
5
8 4
1

6 3

7 2

8 1
 Cost of Production
Q FC VC TC MC AFC AVC AC • Fixed cost exists
0 10 - 10 - - - - at zero output as
well. Total Cost
1 10 10 20 10 10 10 20 is equal to fixed
2 10 18 28 8 5 9 14 cost at zero
output.
3 10 24 34 6 3.3 8 11.3 • MC first falls
4 10 28 38 4 2.5 7 9.5 then rises.
• Continuously
5 10 30 40 2 2 6 8 Add MC to get
6 10 34 44 4 1.67 5.67 7.34 the next VC/TC.
• Divide a cost by
7 10 40 50 6 1.43 5.71 7.14
output to get its
8 10 48 58 8 1.25 6 7.25 average.
9 10 58 68 10 1.11 6.4 7.51 • MC, AVC & AC
are U-shaped.
10 10 70 80 12 1 7 8
11 10 84 94 14 0.9 7.63 8.53
12 10 100 110 16 0.83 8.33 9.16
• The above are short run costs as we see that fixed costs exist (are non-zero).
 Short Run Cost Curves
Costs Costs
TC VC

MC

AC
AVC

FC

AFC

O Output O Output
 Properties of Cost Curves
• FC is a horizontal straight line.
Costs
TC VC
• VC and TC continuously rise with
output. See how they are parallel
and change their shape.

• VC is initially zero but TC is

initially equal to FC.

• The slope of TC and VC is actually

equal to MC which first falls and
FC then rises.

• The distance between VC and TC is

equal to FC.
O Output O
 Properties of Cost Curves
Costs • AFC continuously falls but never
intersects the x-axis (never is zero).

• MC is U-shaped (based on the law

MC of variable proportions).

• AVC and AC fist decline and then

rise (U-shaped).
AC

AVC
• MC intersects AC and AVC at their
minimum points.

• The distance between AC and AVC

AFC is equal to AFC. (becomes less and
less as AFC falls)
O Output
 MC intersect AC & AVC at their minimum points. Why?

Let’s take an example: Suppose we have three numbers 2, 4 & 6. The average is 4.
Now suppose that a new (additional; marginal) number is added which is less than the
existing average (let it be 3). Now we have four numbers (2, 4, 6 & 3) with the average as
3.75 which is less than the previous average. (3.75 < 4).
So it is clear that: When the ‘marginal’ is less than the ‘average’, the average falls.

Let’s modify the example: Suppose we have three numbers 2, 4 & 6. The average is 4.
Now suppose that a new (additional; marginal) number is added which is greater than
the existing average (let it be 5). Now we have four numbers (2, 4, 6 & 5) with the average
as 4.25 which is greater than the previous average. (4.25 > 4).
So it is clear that: When the ‘marginal’ is greater than the ‘average’, the average
increases.
• Now please apply the above two facts and arrive at a conclusion.
• Apply this concept to the relationship of Marginal and Average Product that was
discussed in the lecture on Law of Variable Proportions.
 Short Run Average Cost, Plant Size and Capacity
• Short Run Cost Curve represents a specific plant size.
• Different points on the short run cost curve show different capacity
utilization. • The plant size is designed to
produce an output level ‘o’
AC

• Point ‘b’ shows an output level on

a the minimum point of AC. The
plant is optimally utilized.
AC
c
b • Point ‘a’ shows an output level on
the falling portion of AC. The
plant is under utilized.

O Q • Point ‘c’ shows an output level on

𝒒 𝟏 𝒒 𝟐 𝒒 𝟑 the falling portion of AC. The
plant is over utilized.

Why does average cost increase if the plant size is under-utilized or over-
utilized?
 The Envelope Curve: Long Run Average Cost Curve
• Long Run cost curve is formed by many short run cost curves
Costs • Every short run cost curve shows
a specific plant size.
• Initially the firm produces . The
SAC1
demand may increase and plant
SAC2
SAC3 may be over-utilized in the short
run at point ‘a’. On , at point a,
when the firm sees that the plant
is continuously over-utilized then
they may plan to expand. The
new plant size is represented by .
The optimum output for second
𝑄 plant is .
O 𝑄
 1 a 𝑄
 2 b  3 • When the second plant size is
Output also continuously over-utilized at
When three points with different cost and output
  point ‘b’, the firm may expand
combinations (, & ) are joined, we get the Long again to a third plant size
Run Average Cost Curve. represented by
LAC is also the LAVC (there are no fixed costs in
the long run.
 Mathematical Representation of Costs
 
The total Cost may be represented with a cubic equation with two restrictions; First, the
coefficient of the cubic term must be non-zero and, Second, that the coefficient of the
quadratic term is negative.

Differentiating w.r.t Q will give the Marginal Cost Function.

Average Cost may be obtained by dividing the total cost by the level of output ‘Q’.

Try getting the equations for all costs including the above if the cost function is:

What does the term 1000 show?