Costs and Factor Inputs

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Written by: Edmund Quek

CHAPTER 6 THE THEORY OF COST

LECTURE OUTLINE 1 2 2.1 2.2 2.3 2.4 2.5 2.6 3 3.1 3.2 3.3 INTRODUCTION SHORT-RUN THEORY OF COST Distinction between fixed cost and variable cost Total cost Marginal cost Average cost Relationship between marginal cost and average cost Optimum capacity LONG-RUN THEORY OF COST Cost minimisation in the long run Long-run average cost Productive efficiency

References John Sloman, Economics William A. McEachern, Economics Richard G. Lipsey and K. Alec Chrystal, Positive Economics G. F. Stanlake and Susan Grant, Introductory Economics Michael Parkin, Economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics

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Page 1

Written by: Edmund Quek

1

INTRODUCTION

Explicit costs are costs that involve monetary payments such as the costs of materials and labour. Accounting costs include only explicit costs. Implicit costs are costs that do not involve monetary payments such as the costs of the owner’s labour and financial capital. Economic costs include both explicit costs and implicit costs. Economists are concerned with economic profit and hence economic costs. An increase in output will require an increase in the quantity of factor inputs which will lead to an increase in costs. The theory of cost is the study of how the cost of production changes as the output level changes. This chapter gives an exposition of the theory of cost.

2 2.1

SHORT-RUN THEORY OF COST Distinction between fixed costs and variable costs

Fixed costs are costs that do not vary with the output level as they are associated with fixed factor inputs. In other words, an increase in the output level will not lead to an increase in fixed costs. Fixed costs will still be incurred even if the firm shuts down production. Examples of fixed costs are interest payments on loans for the purchase of capital goods (factories and machinery), insurance premiums and rent. Variable costs are costs that vary directly with the output level as they are associated with variable factor inputs. In other words, an increase in the output level will lead to an increase in variable costs since more variable factor inputs are needed to produce more output. Variable costs will not be incurred if the firm shuts down production. Examples of variable costs are the costs of materials and direct labour (labour provided by factory workers).

2.2

Total cost

Total cost (TC) is the cost of all the factor inputs needed to produce an amount of output. In the short run, total cost is the sum of total fixed cost (TFC) and total variable cost (TVC) and is positively related to the output level.

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Written by: Edmund Quek

TC Curve

In the above diagram, since fixed costs do not vary with the output level, the TFC curve is horizontal. However, since more variable factor inputs are needed to produce more output, the TVC curve is upward-sloping. Since TC is the sum of TFC and TVC, the TC curve is geometrically similar to the TVC curve, except that the former is higher than the latter by TFC at each output level. From the first unit of output to Q0, the firm is experiencing increasing marginal returns. In other words, each additional unit of the variable factor input is adding more to total output than the previous additional unit. Therefore, each additional unit of output requires fewer units of the variable factor input to produce and this makes the TC and the TVC curves rise at a decreasing rate (i.e. the slopes of the TC and the TVC curves are decreasing). After Q0, the firm is experiencing diminishing marginal returns. In other words, each additional unit of the variable factor is adding less to total output than the previous additional unit. Therefore, each additional unit of output requires more units of the variable factor input to produce and this causes the TC and the TVC curves to rise at an...
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