Theory of Production: Cost Theory

Cost Theory

There are 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.

Type of Cost

Cost Theory: Fixed Cost

Fixed Cost are costs that do not vary with different levels of production and exist even if output is zero. Ex: rent

Cost Theory: Average Fixed Cost

Average Fixed Cost = Fixed Costs/Quantity.

Cost Theory: VariableCost

Variable Costs are costs that vary with level of output. Ex: electricity

marginal cost

Marginal Cost is the increase in cost by producing one more unit of the good.

Cost Theory: Total CostTotal Cost = Fixed Cost + Variable Cost)

Cost Theory: Average CostAverage Total Cost = Total Cost/Quantity. (Total Cost = Fixed Cost + Variable Cost)

Average Variable Cost = Variable Costs/Quantity.

Marginal Cost, Average Cost, Average Variable Cost

Marginal Cost, Average Cost, Average Variable Cost

Note: 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

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