MICROECONOMICS

ECO 211
Theory of Cost and Cost
Curves
 Continuing a Culture of
excellence…

Presented by

Dr. Elvis Ozegbe

Economics Department
Pan-Atlantic University

Email:
eozegbe@pau.edu.ng
 Expected Learning Outcome
Introduction
Define the nature of a firm’s implicit and explicit costs
Distinguish between the traditional short-run and long-run costs.
Distinguish between fixed, and variable costs and between total, average and
marginal costs.
Explain the relationship between the firm’s short-run and long-run average total
cost curves
Show how the U-shape of the long-run average total cost curve is explained
using the concepts of economies of scale.
 What is Cost of Production
To the economist, the cost of producing any goods or service is its opportunity
costs.
That is, the value of the other goods and services forgone by not employing the
resources in their best most profitable alternative.

Money Cost of Production: These are the total money expenses incurred by a
firm in producing a commodity.

They include wages, and salaries of labour, cost of raw materials, expenditure on
machines and equipment, depreciation charges on machines, buildings, interest on
capital borrowed, expenses on power light, fuel advertisement, transportation,
insurance charges and types of taxes.
Explicit costs, Implicit Costs and Economic
Profit
In economics, costs include both explicit and implicit costs.

Explicit costs are the actual, out of pocket expenditures of the firm to
purchase or hire the services of the factors of production it needs.

The explicit costs of a firm are:

The wages it must pay to hire labour,
The interest to borrow money capital,
The rent on land, buildings, and
The purchases of machines, raw materials, etc. used in production process.
 Implicit Cost of Production
Implicit costs are the costs of the factors owned by the firm, and used in its
own production processes.

Implicit costs are estimated from what these factors could earn in their best
alternative use or employment.

In addition to the explicit costs, a firm must consider such implicit costs as
follows:
The wage that the entrepreneur would earn as a manager for somebody else,

The interest the entrepreneur would get by supplying his money capital if lent to
someone else in a similarly risky business,

The rent on his owned land and buildings, if he were not using them himself, etc.
 Economic Profit

Only if total revenue received from selling the

output exceeds both its explicit and implicit costs
is the firm making an economic or pure profit.
Economic Profit
 Cost Function
Cost functions describes the available efficient methods of production at any one
time.

Economic theory distinguishes between short-run costs

and long-run costs.

Short-run costs are costs over a period during which some factors of production
(capital equipment, etc.) are fixed.

The long-run costs are the costs over a period long enough to permit the
change of all factors of production.

In the long-run, all factors of production become variable.

 Cost Function Cont’d
Graphically, costs are shown on two-dimensional diagrams, and such curves implies that
COST is a function of OUTPUT,

i.e. C= f(X), ceteris paribus (meaning all other factors which determine costs are
constant).

Any point on a cost curve shows the minimum cost at which a certain level of output
may be produced.

This is the optimality implied by the points of a cost curve.

Usually this optimality is associated with the long-run cost curve.

However, a similar concept may be applied to the short-run, given the plant of the firm
in any one period.
 The Traditional Theory of Cost
Traditional theory of cost distinguishes between the short-run and long-run.

The short-run is the period during which some factor(s) is fixed.

The long-run is the period over which all factors become variable.

In the traditional theory of the firm, total costs (TC) are split into two:

Total fixed costs (TFC) and total variable costs (TVC).

Thus, TC=TFC+TVC
 Short-Run Costs
Total Fixed Cost Total Fixed Cost Curve

In the short-run, there are total fixed costs, total

variable costs and total costs

Total fixed costs, TFC are the costs which the firm
incurs in the short-run for its fixed inputs.

Total fixed costs, TFC are constant regardless of

the level of output, and whether a firm produces
or not.

An example of the TFC is the rent which a

producer must pay for the factory building over the
life of the lease.
 Short-run Costs (2)
Total variable costs, TVC are the costs incurred by the firm for the variable inputs it uses.

Total variable costs, TVC vary directly with the level of output produced.

Examples of TVC are raw material costs, and some labour costs.

Total costs, TC are equal to the sum of total fixed costs and total variable costs.
 Short-run Costs (2)
Total Variable Cost Total Variable Cost Curve

Total variable costs, TVC are the costs

incurred by the firm for the variable inputs it
uses.
Total variable costs, TVC vary directly with
the level of output produced.

Examples of TVC are raw material costs, and

some labour costs.
Total costs, TC are equal to the sum of total
fixed costs and total variable costs.
Short-run Costs
Short-run Costs
 Short-Run Costs
From figure 1, see that regardless of the level of output, TFC is $12.

It is reflected in figure 1 that, the TFC curve is parallel to the output / quantity axis.

TVC is zero when output is zero, and rises as output increases.

The shape of TVC curve is of an upward progression.

At every output level, TC equals TFC plus TVC

For this reason, the TC curve has the same shape as the TVC curve and in this case, is
every where $12 above it in figure 1 or every where 50 above it in figure 2.
Short-Run Costs
 Short-Run Per Unit Costs
Although total costs are very important, per unit costs or average costs are even more
important in the short-run analysis of the firm.

We can obtain a deeper understanding of total costs by analyzing the behaviour of

average cost and marginal cost.

From the total-cost curves, we obtain average-cost curves.

The short-run per unit costs that we consider are the Average Fixed Costs, Average
Variable Costs, Average Total Costs (or Average Costs), and Marginal Costs.

The short-run per unit costs or average costs measures can be derived from each of the
total costs measures.
Short-Run Per Unit Costs
 Short-Run Per Unit Costs
Average fixed costs, AFC is total fixed cost
per unit of output. Average fixed costs, AFC equals total fixed
cost divided by output.
Average variable costs, AVC is total variable
cost per unit of output. Average variable costs, AVC equals total
variable cost divided by output.
Average total costs, ATC or AC is total cost
per unit of output. Average total costs, ATC or AC equals total
costs divided by output.
Marginal costs, MC is the increase in total
cost that result from an increase in output. Also, ATC or AC equals AFC plus AVC.
Over the output range with increasing marginal Marginal costs, MC equals the change in TC or
returns, marginal cost falls as output increases.
the change in TVC divided by change in
Over the output range with diminishing marginal output.
returns, marginal cost rises as output increases.
 Short-Run Per Unit Costs
Graphically, the AFC is a rectangular hyperbola.

On the other hand in summary, the traditional theory of costs postulates that in the
short-run the cost curves (AVC, ATC or AC, and MC) are U-shaped, reflecting the law
of variable proportions.

In the short-run, with a fixed plant, there is a phase of increasing productivity (falling
unit costs) and a phase of decreasing productivity (increasing unit costs) of the variable
factor(s).

Between these two phases of plant operation, there is a single point at which unit costs
are at a minimum.

When this point on the SATC or SAC is reached the plant is utilised optimally, i.e., with
the optimal combination (proportions) of fixed and variable factors.
The Short-Run Average Fixed Cost Curve
Short-Run Average Variable Fixed Curve
Short-Run Average Total Cost Curve
Practical Exercise in Class
Solution to Practical Exercise
Average Fixed Cost Analysis
 Average & Marginal Cost Analysis
While the AFC curve falls continuously as output
is expanded, the AVC, the AC or ATC and the MC
curves are U-shaped.
The MC curve reaches its lowest point (at an
output level) than either the AVC curve or the
AC curve.

Also, the rising portion of the MC curve

intersects the AVC and AC curves at their lowest
points.

This is always the case.

The rising portion of the MC curve illustrates the

supply curve.
 Profit Maximization
Profit is defined as total revenue (TR) minus total cost (TC) i.e.
∏ = TR – TC
where, ∏ stands for profit.
Total revenue simply means the total amount of money that a firm receives from sales of
its goods or services.
Thus, TR = p.q i.e. p multiplied with q.
where, p is the price, and q is the quantity the firm sells.

Marginal revenue is the change in total revenue, from (or due to) at least one unit change
in quantity i.e.
MR = ∆TR / ∆q
where, ∆TR is the change in total revenue, and ∆q is the change in quantity.

Total cost means the cost of all factors of production.

 Profit Maximization (2)
A firm makes profit when it is able to recover more than her entire production
costs from the sale of her goods or services.

A firm expects her total revenue from the sale of her goods or services to be
at least equal to or more than her entire production costs.

A firm thus take profit when total revenue exceed total costs.

On the other hand, a situation of loss would arise when the firm’s total
revenue is less than total costs.

When a firm’s total revenue equals her total costs i.e. TR = TC, such a
situation is referred to as the BREAK EVEN CONDITION.
Application of Calculus to Solve Economic
Problems
Thank you

eozegbe@pau.edu.ng