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Topic Name

"Theory of cost"

Group members name

Muhammad Ijaz (Leader)
ID:( 091420-181)
Muhammad Qasim
Muhammad Ibrahim
Ahmad Mehmood
Muhammad Waleed Sehgal
Muhammad Awais Amjad

Content of Theory of cost
Cost theory
Body contents
Cost concept
Short run and Long run in economics
Average and Marginal Cost Relationship
Law of Diminishing return
Equilibrium of Firm


Cost theory and production related to each other these terms are often used
together. However, the question is usually how much to produce, as opposed to
which inputs to use. That is, assume that we use production theory to choose the
optimal ratio of inputs how much should we produce in order to minimize costs
and maximize prots? We can also learn a lot about what kinds of costs matter for
decisions made by managers, and what kinds of costs do not.

Cost function are derived function they are derived from the production function, which describe
the available efficient methods of production at any time. Economic theory distinguish between
short run and long run cost. short run cost are the cost over a period during which some factor of
production are fined the long run costs are the cost over a period long enough to permit the
change of all factors of production. In the long run all factor become variable.
Discuss how a firm will determine its profit-maximizing combination of output by minimizing
costs for this given level of output. Firm objective is to maximize profit for a given production
technology. Firms that do not do so are driven out of market by competitive forces. Objective of
a profit-maximizing firm is consistent with maximizing utility of firm owners under three
assumptions , Prices are fixed, Profits are no stochastic, Firm managers can be controlled by
owners. determine profit-maximizing equilibrium, will first consider how to produce a given
level of output at least possible cost
the internal economics of scale relate only to the long run and are built into the shape of the long
run cost curve the internal economics effect the prices of the factor are production or the
production function. The traditional theory of cost is U shaped some recent development in the
theory of cost which reject the U shaped.

Cost theory:
Two types of costs associated with production Fixed Cost and Variable Cost. In the short-run, at least one
factor of production is fixed, so firms face both fixed and variable cost. The shape of the cost curves in
the short run reflect the law of diminishing returns.

Cost concept:
Actual Costs are the total money incurred by a firm in producing a commodity or service. e.g.
wages and salaries, cost of raw materials, expenses on machines or capital goods, power charges,
transportation, advertisement, interest expenses, taxes, etc
Implicit costs
Refers to the value of the inputs that are owned and used by the firm in its own production
activity. These includes the highest salary that the entrepreneur could earn in his best alternative
employment and the highest return that the firm could receive from investing its capital in the
most rewarding alternative use or renting its land and buildings to the highest bidder.
Explicit cost
Are actual expenditures of the firm to hire, rent, or purchase the inputs it requires in
production. These includes the wages to hire labor, the rental price of capital, and the purchase price
of raw materials and semi finished products.
Variable costs
Are costs that vary with the volume of output or Variable costs change in direct proportion to the
activity of a business such as sales or production volume.
Fixed costs
Fixed cost does not change with the volume of production. Or it do not vary with output in the
Opportunity cost
Is the cost of missed opportunity or alternative forgone in having one thing rather than the other.
Measurement of opportunity cost is difficult.

Marginal cost
Is the addition to the total cost by producing an additional unit of output. e.g.
MC = change in TC/change in TO

Short run and Long run in economics:
Short-run is defined as a time period during which some factors of production are fixed and
others are variable.
In the Long-run all factors of production are variable. It is important to note that these periods
are not defined by any specified length of time but instead are determined by the variability of
factors of production.
Short run cost function:
Average total cost is the average per-unit cost of using all of the firms inputs (TC/Q)
Average variable cost is the average per-unit cost of using the firms variable inputs (TVC/Q)
Average fixed cost is the average per-unit cost of using the firms fixed inputs (TFC/Q)

Average Total Cost = ATC = TC/Q
Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
Marginal Cost = TC/Q = TVC/Q

Long-Run Cost Curves
The long run period is a series of short run periods. The long run is the period of time during which:
o Technology is constant
o All inputs and costs are variable
o The firm faces no fixed inputs or costs

Long-Run Total Cost = LTC = f(Q)
Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = LTC/Q
Long-Run Cost Curves

Average and Marginal Cost Relationship:
If average costs are falling then marginal costs must be less than average while if average
costs are rising then marginal must be more than average. Marginal cost on its way up
must cut the cost curve at its minimum point.
MC < AV, then AC
MC > AC, then AC
MC = AC, AC will be at minimum
The marginal cost and average cost curves are related
When MC exceeds AC, average cost must be rising
When MC is less than AC, average cost must be falling
This relationship explains why marginal cost curves always intersect average cost curves
at the minimum of the average cost curve.

Average and Marginal Cost curve:

Law of Diminishing return:
According to law of economics as the number of new employees increases, the marginal
product of an additional employee will at some point be less than the marginal product of the
previous employee.

Diminishing return

Law of Diminishing return Graph:

0 2 4 6 8 10
Total Pdt
Avge Pdt
Marginal Pdt
Equilibrium of Firm:

Firms will produce in such a way that the profit is maximized. Firms will not change the production
function at equilibrium output. When we going to increase labor there will be come a point where
production going to decrease from each previous unit by increasing more labor and then tend to negative.
So the entrepreneur try to get maximum benefit against expenditure spend on the labor.
Profit = TR-TC
TR = P x Q (price x quantity)
AR = TR/Q = (P x Q)/Q = P