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THEORY OF COSTS
Short Run
Decision making in different time
periods
 Short run for the firms and very short run for
the industry.
 Long run for th...
Theory of costs
• Costs of a firm is incurred to establish the
production unit and to purchase different
factors of produc...
Theory of costs
Fixed costs
Fixed costs are expenses that does not
change in proportion to the activity of a
business.
Fix...
Theory of costs
Fixed cost does not change with the
volume of production.
costs

100

TFC

O

Q
Theory of costs
Variable costs
Variable costs change in direct
proportion to the activity of a business
such as sales or p...
Theory of costs
For example, a manufacturing firm pays for
raw materials. When activity is decreased,
less raw material is...
Total costs for firm X

Output TFC
(Q)
(£)

100

0
1
2
3
4
5
6
7

80

60

12
12
12
12
12
12
12
12

40

20

TFC
0
0

1

2

...
Total costs for firm X

Output TFC TVC
(Q)
(£)
(£)

100

0
1
2
3
4
5
6
7

80

60

12
12
12
12
12
12
12
12

0
10
16
21
28
4...
Total costs for firm X

Output TFC TVC
(Q)
(£)
(£)

100

0
1
2
3
4
5
6
7

80

60

12
12
12
12
12
12
12
12

0
10
16
21
28
4...
Total costs for firm X
100

TVC
80

Diminishing marginal
returns set in here

60

40

20

TFC
0
0

1

2

3

4

fig

5

6

...
Total costs for firm X

Output TFC TVC
(Q)
(£)
(£)

100

0
1
2
3
4
5
6
7

80

60

12
12
12
12
12
12
12
12

0
10
16
21
28
4...
Output TFC TVC
(Q)
(£)
(£)

100

0
1
2
3
4
5
6
7

80

60

12
12
12
12
12
12
12
12

Total costs for firm X

TC
(£)

0
10
16...
Output TFC TVC
(Q)
(£)
(£)

100

0
1
2
3
4
5
6
7

80

60

12
12
12
12
12
12
12
12

Total costs for firm X

TC
(£)

0
10
16...
Total costs for firm X
TC

100

TVC
80

Diminishing marginal
returns set in here

60

40

20

TFC
0
0

1

2

3

4

fig

5
...
Average fixed cost
Average fixed cost (AFC) = TFC/Q
where TFC = fixed cost, Q = total number of
units produced.

Unit fixe...
Average Fixed costs
Costs

AFC
O

Q
Average variable cost
Average variable cost (AVC) is the TVC of a firm
divided by the total units of output (Q).
AVC = TVC...
Average cost
Average cost (AC) is the TC of a firm divided by
the total units of output (Q).
AC = TC/Q = AFC + AVC
costs

...
Marginal Cost
The additional cost incurred to produce one
additional unit of output is called the
Marginal Cost (MC).
MC =...
MC
The marginal cost curve is U-shaped.
Marginal cost is relatively high at small
quantities of output - then as productio...
Marginal costs

Costs (£)

MC

Diminishing marginal
returns set in here

x

Outputfig
(Q)
Numerical Example
Q

TFC

TVC

TC

AFC

0

100

0

100

1

100

20

120

100

2

100

37

137

50

3

100

52

152

33.33
...
Average and marginal costs
MC

AC

Costs (£)

AVC

z
y
x
AFC

Outputfig
(Q)
LONG RUN
Long run cost curves
The Long run average cost (LRAC or LAC)
curve illustrates - for a given quantity of
production - the ...
LRAC
LRAC curve is derived from a series of short
run average cost curves.
It is also called the ‘Envelope curve' since it...
LAC
The LRAC curve is U-shaped, reflecting
economies of scale when it is negativelysloped and diseconomies of scale when i...
LAC
In some industries, the LRAC is L-shaped,
and economies of scale increase
indefinitely. This means that the largest
fi...
Costs

Long-run average cost curves

Economies of Scale

LRAC

O

Output
fig
long-run average cost curves

Costs

Diseconomies of Scale

O

Output
fig

LRAC
Costs

long-run average cost curves

O

Constant costs
LRAC

Output
fig
Long-run Costs
• Long-run average costs
– assumptions behind the curve
• factor prices are give
• state of technology and ...
A typical long-run average cost curve

Costs

LRAC

O

Output
fig
Costs

A typical long-run average cost curve

O

Economies
of scale

Constant
costs

Output
fig

Diseconomies
of scale

LR...
Long-run Costs
• Long-run average costs
– assumptions behind the curve
• factor prices are give
• state of technology and ...
Costs

Long-run average and marginal costs

Economies of Scale

LRAC
LRMC
O

Output
fig
Long-run average and marginal costs

Costs

LRMC

O

Diseconomies of Scale

Output
fig

LRAC
Costs

Long-run average and marginal costs

O

Constant costs
LRAC = LRMC

Output
fig
Long-run average and marginal costs

Initial economies of scale,
then diseconomies of scale

LRAC

Costs
O

LRMC

Output
f...
Long-run Costs
• Long-run average costs
– assumptions behind the curve
• factor prices are given.
• state of technology an...
Envelope Curve
The envelope curve is based on the point of
each short-run ATC curve that provides
the lowest possible aver...
Deriving long-run average cost curves: plants of fixed size
SRAC1 SRAC
2

SRAC3

Costs

1 factory
2 factories

O

SRAC5
SR...
Deriving long-run average cost curves: factories of fixed size
SRAC1 SRAC
2

SRAC3

SRAC5
SRAC4

Costs

LRAC

O

Output
fi...
Costs

Deriving a long-run average cost curve: choice of factory size

Examples of short-run
average cost curves

O

Outpu...
Deriving a long-run average cost curve: choice of factory size

Costs

LRAC

O

Output
fig
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Theory of costs, micro economics

  1. 1. THEORY OF COSTS Short Run
  2. 2. Decision making in different time periods  Short run for the firms and very short run for the industry.  Long run for the firms and short run for the industry.  Very long run for the firms and long run for the industry.
  3. 3. Theory of costs • Costs of a firm is incurred to establish the production unit and to purchase different factors of production. • Cost of a firm (TC) is classified into two broad categories - Fixed cost (TFC) and Variable cost (TVC). i.e. TC = TFC + TVC • However, nothing is fixed in the long run.
  4. 4. Theory of costs Fixed costs Fixed costs are expenses that does not change in proportion to the activity of a business. Fixed costs include overheads (rent, insurance-premium, interests), and also direct costs such as payroll (particularly salaries).
  5. 5. Theory of costs Fixed cost does not change with the volume of production. costs 100 TFC O Q
  6. 6. Theory of costs Variable costs Variable costs change in direct proportion to the activity of a business such as sales or production volume. In retail, the cost of goods is almost entirely variable. In manufacturing, direct material costs, wages, fuel costs are examples of variable costs.
  7. 7. Theory of costs For example, a manufacturing firm pays for raw materials. When activity is decreased, less raw material is used, and so the spending for raw materials falls. When activity is increased, more raw material is used and spending therefore rises. Although tax usually varies with profit, which in turn varies with sales volume, it is not normally considered a variable cost.
  8. 8. Total costs for firm X Output TFC (Q) (£) 100 0 1 2 3 4 5 6 7 80 60 12 12 12 12 12 12 12 12 40 20 TFC 0 0 1 2 3 4 fig 5 6 7 8
  9. 9. Total costs for firm X Output TFC TVC (Q) (£) (£) 100 0 1 2 3 4 5 6 7 80 60 12 12 12 12 12 12 12 12 0 10 16 21 28 40 60 91 40 20 TFC 0 0 1 2 3 4 fig 5 6 7 8
  10. 10. Total costs for firm X Output TFC TVC (Q) (£) (£) 100 0 1 2 3 4 5 6 7 80 60 12 12 12 12 12 12 12 12 0 10 16 21 28 40 60 91 TVC 40 20 TFC 0 0 1 2 3 4 fig 5 6 7 8
  11. 11. Total costs for firm X 100 TVC 80 Diminishing marginal returns set in here 60 40 20 TFC 0 0 1 2 3 4 fig 5 6 7 8
  12. 12. Total costs for firm X Output TFC TVC (Q) (£) (£) 100 0 1 2 3 4 5 6 7 80 60 12 12 12 12 12 12 12 12 0 10 16 21 28 40 60 91 TVC 40 20 TFC 0 0 1 2 3 4 fig 5 6 7 8
  13. 13. Output TFC TVC (Q) (£) (£) 100 0 1 2 3 4 5 6 7 80 60 12 12 12 12 12 12 12 12 Total costs for firm X TC (£) 0 10 16 21 28 40 60 91 12 22 28 33 40 52 72 103 TVC 40 20 TFC 0 0 1 2 3 4 fig 5 6 7 8
  14. 14. Output TFC TVC (Q) (£) (£) 100 0 1 2 3 4 5 6 7 80 60 12 12 12 12 12 12 12 12 Total costs for firm X TC (£) 0 10 16 21 28 40 60 91 TC 12 22 28 33 40 52 72 103 TVC 40 20 TFC 0 0 1 2 3 4 fig 5 6 7 8
  15. 15. Total costs for firm X TC 100 TVC 80 Diminishing marginal returns set in here 60 40 20 TFC 0 0 1 2 3 4 fig 5 6 7 8
  16. 16. Average fixed cost Average fixed cost (AFC) = TFC/Q where TFC = fixed cost, Q = total number of units produced. Unit fixed costs decline along with volume, following a rectangular hyperbola. As a result, the total unit cost of a product will decline as volume increases.
  17. 17. Average Fixed costs Costs AFC O Q
  18. 18. Average variable cost Average variable cost (AVC) is the TVC of a firm divided by the total units of output (Q). AVC = TVC/Q costs AVC Y O Q
  19. 19. Average cost Average cost (AC) is the TC of a firm divided by the total units of output (Q). AC = TC/Q = AFC + AVC costs AC Z O Q
  20. 20. Marginal Cost The additional cost incurred to produce one additional unit of output is called the Marginal Cost (MC). MC = dC/dQ
  21. 21. MC The marginal cost curve is U-shaped. Marginal cost is relatively high at small quantities of output - then as production increases, it declines - then reaches a minimum value - then rises. This shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal returns (the law of diminishing marginal returns).
  22. 22. Marginal costs Costs (£) MC Diminishing marginal returns set in here x Outputfig (Q)
  23. 23. Numerical Example Q TFC TVC TC AFC 0 100 0 100 1 100 20 120 100 2 100 37 137 50 3 100 52 152 33.33 4 100 80 180 25 5 100 120 220 20 6 100 165 265 16.67 AVC AC MC 20 120 20 18.5 68.5 17 17.33 50.67 15 20 45 28 24 44 40 27.5 44.17 45
  24. 24. Average and marginal costs MC AC Costs (£) AVC z y x AFC Outputfig (Q)
  25. 25. LONG RUN
  26. 26. Long run cost curves The Long run average cost (LRAC or LAC) curve illustrates - for a given quantity of production - the average cost per unit which a firm faces in the long run (i.e. when no factors of production is fixed).
  27. 27. LRAC LRAC curve is derived from a series of short run average cost curves. It is also called the ‘Envelope curve' since it envelops all the short run average cost curve. The curve is created as an envelope of an infinite number of short-run average total cost curves.
  28. 28. LAC The LRAC curve is U-shaped, reflecting economies of scale when it is negativelysloped and diseconomies of scale when it is positively sloped. In perfect competition, the LRAC curve is flat at the point of equilibrium – in this stage the firm is enjoying constant returns to scale.
  29. 29. LAC In some industries, the LRAC is L-shaped, and economies of scale increase indefinitely. This means that the largest firm tends to have a cost advantage, and the industry tends naturally to become a monopoly, and hence is called a natural monopoly. Natural monopolies tend to exist in industries with high capital costs in relation to variable costs, such as water supply and electricity supply.
  30. 30. Costs Long-run average cost curves Economies of Scale LRAC O Output fig
  31. 31. long-run average cost curves Costs Diseconomies of Scale O Output fig LRAC
  32. 32. Costs long-run average cost curves O Constant costs LRAC Output fig
  33. 33. Long-run Costs • Long-run average costs – assumptions behind the curve • factor prices are give • state of technology and factor quality are given • firms choose least-cost combination of factors
  34. 34. A typical long-run average cost curve Costs LRAC O Output fig
  35. 35. Costs A typical long-run average cost curve O Economies of scale Constant costs Output fig Diseconomies of scale LRAC
  36. 36. Long-run Costs • Long-run average costs – assumptions behind the curve • factor prices are give • state of technology and factor quality are given • firms choose least-cost combination of factors – shape of the LRAC curve – a typical LRAC curve – long-run average and marginal cost curves
  37. 37. Costs Long-run average and marginal costs Economies of Scale LRAC LRMC O Output fig
  38. 38. Long-run average and marginal costs Costs LRMC O Diseconomies of Scale Output fig LRAC
  39. 39. Costs Long-run average and marginal costs O Constant costs LRAC = LRMC Output fig
  40. 40. Long-run average and marginal costs Initial economies of scale, then diseconomies of scale LRAC Costs O LRMC Output fig
  41. 41. Long-run Costs • Long-run average costs – assumptions behind the curve • factor prices are given. • state of technology and factor quality are given. • firms choose least-cost combination of factors.
  42. 42. Envelope Curve The envelope curve is based on the point of each short-run ATC curve that provides the lowest possible average cost for each quantity of output.
  43. 43. Deriving long-run average cost curves: plants of fixed size SRAC1 SRAC 2 SRAC3 Costs 1 factory 2 factories O SRAC5 SRAC4 5 factories 3 factories Output fig 4 factories
  44. 44. Deriving long-run average cost curves: factories of fixed size SRAC1 SRAC 2 SRAC3 SRAC5 SRAC4 Costs LRAC O Output fig
  45. 45. Costs Deriving a long-run average cost curve: choice of factory size Examples of short-run average cost curves O Output fig
  46. 46. Deriving a long-run average cost curve: choice of factory size Costs LRAC O Output fig
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