Theory of Production: Cost Theory

In the Cost Theory, there are two types of costs associated with production – Fixed Costs and Variable Costs.

In the short-run, at least one factor of production is fixed, so firms face both fixed and variable costs. The shape of the cost curves in the short run reflect the law of diminishing returns.

Cost Theory

Cost Theory – Types of Costs

A. Fixed Cost

Fixed costs are costs that do not vary with different levels of production and fixed costs exists even if output is zero. Example: rent or salaries.

Cost Theory: Fixed Cost

In the above diagram, the fixed cost remains constant regardless of the quantity produced.

B. Average Fixed Cost

Average Fixed Cost = Fixed Costs/Quantity.

Cost Theory: Average Fixed Cost

In the above diagram, we see that when the quantity produced is low, the average fixed cost is very high  and this cost lowers as the quantity produced increases.

For example, if the Fixed Cost is $100 and initially you produce 2 units then the average fixed cost is $50. If you start producing 20 units then the average fixed cost falls to $5.

C. Variable Costs

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

Cost Theory: VariableCost

In the above diagram, the variable cost curve starts from zero. It means when output is zero, the variable cost is zero, but as output increases the variable cost increases. It keeps increasing to a point that economies of scale cannot lower the per unit cost anymore hence the steep incline.

D. Marginal Cost

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

marginal cost

The Marginal Cost curve is U shaped because initially when a firm increases its output, total costs as well as variable costs start to increase at a diminishing rate. At this stage, due to economies of scale and the Law of Diminishing Returns, Marginal Cost falls till it becomes minimum. Then as output rises, the marginal cost increases.

E. Total Cost

Total Cost = Fixed Cost + Variable Cost

Cost Theory: Total Cost

When the output is zero, variable costs are also zero. But we have fixed costs which is where the Total Costs start. The Total Cost remains parallel to the Variable Cost and the distance between the two curves is the Fixed Cost.

F. Average Total Cost

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

Cost Theory: Average CostAverage 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.

If Marginal Cost less than Average Variable Cost, then Average Cost goes down.

If Marginal Cost is greater than Average Variable Cost, then Average Cost goes up.

If Marginal Cost is equal to Average Variable Cost, then Average Cost will be at minimum.

Importance of Distinction between Fixed and Variable Costs

This distinction is important in cost theory. Every firm has the object to maximize profits or minimize losses, if losses are unavoidable. At times the price of the product may not cover average total cost. Then the firm will have to decide whether to shut down or produce some output.

1. Decision to Shut Down the Firm

The producer may not cover the total costs, if the price of the product is less than the short-run average cost. Then the distinction between fixed cost and variable cost is important.

If the price does not cover average variable costs, the firm prefers to shut down. In other words if the total revenue (total sale proceeds) does not cover total variable costs, the firm must shut down. Otherwise, its total loss will be greater than the fixed costs. It will produce something only when the price covers average variable cost and part of the average fixed costs. The output at which marginal cost is equal to marginal revenue keeps losses minimum.

2. Break-Even Point

At times the firm may not make any profit. It just pays to produce a given output. Total revenue is just equal to total cost. The firm has crossed the losses zone and is about to enter the zero profit zone. The output at which total revenue becomes equal to total cost represents break-even point.


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