Micro Economics –ECO402 VU

LESSON 18
THEORY OF COSTS

INTRODUCTION
The production technology measures the relationship between input and output. Given the
production technology, managers must choose how to produce. To determine the optimal level
of output and the input combinations, we must convert from the unit measurements of the
production technology to dollar measurements or costs.

MEASURING COST: WHICH COSTS MATTER?

ACCOUNTING COST VS. ECONOMIC COST

Accounting Cost is the actual expenses plus depreciation charges for capital equipment
whereas economic cost is the cost to a firm of utilizing economic resources in production,
including opportunity cost.

OPPORTUNITY COST
Cost associated with opportunities that are foregone when a firm’s resources are not put to
their highest-value use.

AN EXAMPLE
A firm owns its own building and pays no rent for office space. Does this mean the cost of
office space is zero?

SUNK COST
Sunk cost is expenditure that has been made and cannot be recovered. It should not influence
a firm’s decisions.

AN EXAMPLE
A firm pays $500,000 for an option to buy a building. The cost of the building is $5 million or a
total of $5.5 million. The firm finds another building for $5.25 million. Which building should the
firm buy?

FIXED AND VARIABLE COSTS

Total output is a function of variable inputs and fixed inputs. Therefore, the total cost of
production equals the fixed cost (the cost of the fixed inputs) plus the variable cost (the cost of
the variable inputs), or…
TC = FC + VC
Fixed Cost does not vary with the level of output whereas Variable Cost is the cost that varies
as output varies.

Fixed Cost is the Cost paid by a firm that is in business regardless of the level of output and
sunk cost is theCost that have been incurred and cannot be recovered.

Personal Computers: most costs are variable

– Components, labor
Software: most costs are sunk
– Cost of developing the software
Pizza
– Largest cost component is fixed

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Micro Economics –ECO402 VU

COST IN THE SHORT RUN

Marginal Cost (MC) is the cost of expanding output by one unit. Since fixed costs have no
impact on marginal cost, it can be written as:

∆ VC ∆ TC
MC = =
∆ Q ∆ Q

Average Total Cost (ATC) is the cost per unit of output, or average fixed cost (AFC) plus
average variable cost (AVC). This can be written:
TFC TVC
ATC = +
Q Q
Average Total Cost (ATC) is the cost per unit of output, or average fixed cost (AFC) plus
average variable cost (AVC). This can be written:
TC
ATC = AFC + AVC or
Q

THE DETERMINANTS OF SHORT-RUN COST

The relationship between the production function and cost can be exemplified by either
increasing returns and cost or decreasing returns and cost. With increasing returns, output is
increasing relative to input and variable cost and total cost will fall relative to output. With
decreasing returns, output is decreasing relative to input and variable cost and total cost will
rise relative to output.

For Example: Assume the wage rate (w) is fixed relative to the number of workers hired. Then:
∆VC
MC =
∆Q

VC = wL

w∆L
MC =
∆Q

∆Q
∆MPL =
∆L

∆L 1
∆L for a 1 unit ∆Q = =
∆Q ∆MPL
ŠIn conclusion:
w
MC =
MPL

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Micro Economics –ECO402 VU

A FIRM’S SHORT-RUN COSTS ($)

Rate Fixed Variable Total Marginal Average Average Average
of cost cost cost cost fixed variable total
output (FC) (VC) (TC) (MC) cost cost cost
(AFC) (AVC) (ATC)
0 50 0 50 ---- ---- ---- ----
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.5 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5

Consequently (from the table), MC decreases initially with increasing returns i.e; 0 through 4
units of output and then MC increases with decreasing returns i.e; 5 through 11 units of output.

Total cost
Cost is the vertical TC
sum of FC
($ per 400 and VC.
year) VC
Variable cost
increases with
300 production and
the rate varies with
increasing &
decreasing returns.
200

Fixed cost does not

100 vary with output
50 FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output

Cost 100
($ per
unit) MC
75

50 ATC
AVC

25

AFC
0 1 2 3 4 5 6 7 8 9 10 11 Output (units/yr.)

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Micro Economics –ECO402 VU

The line drawn from the origin to the tangent of the variable cost curve:
• Its slope equals AVC
• The slope of a point on VC equals MC
• Therefore, MC = AVC at 7 units of output (point A)

Unit Costs
• AFC falls continuously
• When MC < AVC or MC < ATC, AVC & ATC decrease
• When MC > AVC or MC > ATC, AVC & ATC increase
• MC = AVC and ATC at minimum AVC and ATC
• Minimum AVC occurs at a lower output than minimum ATC due to FC

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