5.

0 COST THEORY
EXPLICIT COSTS AND IMPLICIT
COSTS
Explicit Costs- Costs that involve actual
money payments
e.g raw materials, salaries, rent,
utilities
Implicit Costs- Value of forgone
opportunities but do not involve an actual
money payment
-value of inputs owned and used by firm
in its own production activity
e.g forgone rent from own building
forgone salary for entrepreneurs own
services
Forgone interest on own money or
financial capital
1

Accounting Costs= explicit costs

Economic costs=Explicit cost + implicit costs
Accounting Profit= Total revenue explicit
costs
Economic profit= Total revenue-explicit costsimplicit costs
Decision making: If economic profit > 0, a
person should continue the business
project

SHORT RUN COST FUNCTIONS

1. Total cost= Total Variable cost + Total
Fixed Costs
TC= TVC +TFC
2. TVC-Costs that vary with the level of
output
e.g labor costs
3. TFC-Costs that do not vary with the
level of output
e.g rent
4.

AVC= TVC
Q

5.

AFC=TFC
Q
ATC=TC or ATC=AFC + AVC
Q
MC= d(TC)
dQ

6.
7.

MC
ATC
AVC

AFC
Output (Q)

Relationship between AVC & MC

1. MC > AVC-------AVC increases
2. MC < AVC-------AVC decreases
3. MC = AVC-------AVC minimum
Relationship between ATC & MC
1. MC > ATC-------ATC increases
2. MC < ATC-------ATC decreases
3. MC = ATC-------ATC minimum

Decision making of firm:

To find quantity that minimizes cost functions
e.gd(TC)/ dQ = 0
d(TVC)/dQ= 0
d(AVC)/dQ = 0
d(MC)/dQ = 0
d(AC)/dQ = 0
** Solve for Q that minimizes each function

DERIVATION OF LONG RUN AVERAGE

COST (LRAC)
AC

SRAC1
SRAC2
SRAC3
SRAC4

LRAC
Output

LRAC-shows the minimum average cost

when a firm can make adjustment in the
long run
LRAC- envelope curves consisting the
declining portion of all SRAC curves
6

LAGRANGIAN MODEL: MINIMIZE

COST FUNCTION SUBJECT TO OUTPUT
CONSTRAINT
e.g TC = 4x 2 + 6y2+ 2xy
Constraint (Q): x + y = 40
LTC = 4x 2 + 6y2+ 2xy - (x + y -40)
Solution: x=25
y=15
=230
Interpretation of
1 unit increase in output constraint will increase
TC by RM 230