CHAPTER FOUR

THEORY OF COST

Friday, December MICROECONOMICS

6, 2019 Lecture notes: By Addisu T. @UOG, 2016
 Definition:
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 The cost of production of a commodity is the aggregate

prices paid for the factors of production used in
producing that commodity.
 In other words cost of production explains the money
value of inputs.
 Actual Cost Versus Opportunity
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Cost
 Actual cost – are those which are actually incurred by the firm in
payment for labor, material, plant, building equipment etc.
 The total money expenses recorded in the books of accounts are
actual costs.
 Hence this comes under accounting cost concept.
 Opportunity cost – is the value of the best alternative
surrendered when a choice is made.
 It is the opportunity lost for example when a medical doctor
deciding to open his own private clinic will forgo his opportunity
of being hired in a government hospital.
 This is economic cost concept.
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 Private, External and Social Costs
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 Private costs: are those costs which are actually incurred or

provided for by all individual or a firm o the purchase of goods and
services from the market.
 External cost – are those costs not borne by the firm ( or not
covered by the firm who cause it), but is incurred by others in the
society. A firm /producer can transfer such costs to others who are
not responsible for causing it. This includes the disutility or
negative externality created through air, water and noise pollutions
to the society.
 Social cost – Implies the cost which a society bears on account of
production of a commodity. As a result a true cost to the society
must include all costs, regardless of the persons on whom its
impact falls and its incidence as to who bear them.
Social Cost = private Cost + External Cost
 Implicit Cost and Explicit Cost
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 Explicit costs- are those costs which are actually paid by the
firm. They include wages and salaries, price of raw materials;
amounts paid on fuel, advertisement, taxes etc.
 These costs are actual or out-of-pocket expenditures the firm
incurs to purchase in puts.
 Implicit costs – are implied value of the entrepreneur’s own
resources and services.
 In other words, implicit costs are costs which self owned and
self – employed resources could have earned in their best
alternative use.
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 Cost and Output Relations
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 Short Run Cost of Production:-in the short run, input are

divided in to two: fixed and variable inputs. Likewise short run
costs are divided I into fixed and variable costs.
 Total Cost (TC):-represents the value of the total resources used
in the production of goods and services, it includes both fixed and
variable costs.
 Average Cost (AC) – is the cost per unit of output. And is
calculated as: AC =TC/Q
 Marginal Cost (MC) – is the addition to the total cost on
account of producing one additional unit of a product.
MC = ∆TC/∆Q = dTC/dQ
 Total Variable Cost (TVC) – are costs which are incurred on
the employment of variable factors of production.
 Contd….
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 Total Fixed Cost (TFC) – costs which do not change over

a certain level of output. Here note the following algebraic
relationships between the above measurements of costs. TC
= TVC + TFC
AC = TC/ Q and AC = TVC/ Q + TFC / Q
But TVC/Q = AVC, and also TFC/Q = AFC; Hence, AC= AVC
+ AFC.
 In addition; MC = d (TC)/dQ = d (TF C + TVC) / dQ, but
d(TFC) = 0
Hence; MC = d(TVC)/ dQ
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 Cost schedule for short run production
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Q TFC TVC TC AFC AVC AC MC

0 50 0 50 -- -- -- --
1 50 50 100 50 50 100 50
2 50 78 128 25 39 64 28
3 50 98 148 16.7 32.7 49.5 20
4 50 112 162 12.5 28 40.5 14
5 50 130 180 10 26 36 18
6 50 150 200 8.5 25 33.5 20
7 50 175 225 7.1 25 32.1 25
8 50 204 254 6.3 25.5 31.8 29
9 50 242 292 5.6 26.9 32.4 38
10 50 300 350 5 30 35 58
11 50 385 435 4.5 35 39.5 85
 Total cost curves
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As you can see from figure

TFC remains constant
irrespective of output level.
TC and TVC shows an
increasing trend first at a
decreasing rate and then
increase by an increasing rate.
The pattern of TC and TVC
curves is the same because TC is
the sum ofTFC and TVC.

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 Average and Marginal cost curves
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MC curve first falls (its slope is negative)

and reach its minimum at point A, beyond
this minimum point it starts to rise (its
slope becomes positive).
AVC first falls and reaches its minimum at
point B. Beyond its minimum point it
starts to rise and its slope becomes
positive. At the minimum of AVC, MC is
equal to AVC.
The AC curve first fall until it reaches its
minimum at point C. Beyond its minimum
point it rises (its slope become positive).
AC is also equal to MC at its minimum.
AC is always above AVC and the two can’t
be equal.
 Contd…
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 Whenever MC is below AVC & AC, both curves decline

 When MC is equal to AVC & AC both curves reach their respective
minimum, and
 When MC is above the average curves, they start to increase.
 When we see the relation between AC and AVC, since AC is sum of
AVC and AFC the trend of AC is determined by these two costs.
When both decline AC declines if the decrease in AFC is greater
than the increase in AVC, AC declines; on the other hand if the
decrease in AFC is less than an increase in AVC, AC increases.
 Furthermore the distance between AC and AVC curves narrow
down. Since AFC continuously declines,
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 Cost Functions and cost curves
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1. Linear cost function

 A linear cost function Takes the form TC= a +bQ where a and b
are constants and Q is output level.
 Then AC and MC can be calculated as:-
AC = TC/Q = a/Q + bQ /Q = a/Q +b &
MC = d(TC)/dQ = b
 Example for a cost function given as TC= 5 + 20Q, derive AC
and MC function and draw the graph?
AC = TC / Q = 5 + 20 ,
MC = d(TC ) / dQ = 20,
TFC = 5 ,TVC = 20Q
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 Contd…
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 2. Quadratic cost function
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 A quadratic cost Function is given as TC = a + bQ + Q2,

where a and b are constants. AC and MC can be obtained as:
AC = TC/Q = a/Q + b+ Q &
MC = d(TC)/dQ = b + 2Q
 Example: - Given a quadratic cost function as: TC =
4+9Q+Q2, determines AC and MC and also draw the graph?
AC = TC/Q = 4/Q+ 9 + Q ,
MC = dTC/dQ= 9+2Q and
TFC = 4 ; TVC = 9Q + Q2
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 Contd…
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 3. Cubic cost functions
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 A cubic cost function is of the form; TC= a+ bQ – CQ2 + Q3

where a, b and c are constants. AC and MC can be derived as:-
AC = TC/Q = a/Q +b – cQ+Q2 and
MC = d(TC)/dQ = b -2CQ + 3Q2
 Given a cost function as: C = Q3 - 12Q2 + 60Q + 100,
where Q is the level of output, determines AC and MC and
also draw the graph?