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 – 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: VariableCostVariable Costs – costs that vary with level of output. Ex: electricity

Marginal Cost – 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.

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

Marginal Cost, Average Cost, Average Variable Cost


About

Prateek Agarwal loves Economics, so he decided to set up Intelligent Economist as a way to share his passion for Economics with world. After completing his undergraduate degree in Economics at U.S.C., Prateek is now working in the Healthcare industry.


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