Micro Economics I, Econ 111 4.

Theory of Costs

CHAPTER FOUR
THEORY OF COST

Introduction

Cost functions are derived functions. They are derived from the production function,
which describes the available efficient methods of production at any one time.

Economic theory distinguishes between short-run and long-run costs. Short-run costs
are the costs over a period during which some factors of production (usually capital
equipment and management) are fixed. The long-run costs are those costs over a
period long enough to permit the change of all factors of production. In the long-run
all factors become variable.

Both in the short-run and in the long-run, total cost is a multivariable function, that is,
total cost is determined by many factors. Symbolically long-run cost function can be
written as

C = f (X,T,Pf)

and the short-run cost function as

C = f (X,T,Pf,K)

Where C = Total Cost, X = Output, T = Technology, P f = Prices of factors, K = Fixed

factor(s).

Graphically, costs are shown on two-dimensional diagrams. Such curves imply that
cost is a function of output, C=f(X), ceteris paribus (other things being equal or
unchanged). The clause ceteris paribus implies that all other factors which determine
costs are constant. If these factors do change, their effect on costs is shown
graphically by a shift of the cost curve. This is the reason why determinants of cost.
Other than output, are called shift factors. Mathematically there is no difference
between the various determinants of costs. The distinction between movements along
the cost curve (when output changes) and shifts of the curve (when the other
determinants change) is convenient only pedagogically, because it allows the use of
two-dimensional diagrams. But it can be misleading when studying the determinants
of costs. It is important to remember that if the cost curve shifts, this does not imply
that the cost function is indeterminate.

The factor technology is itself a multidimensional factor, determined by the physical

quantities of factor inputs, the quality of the factor inputs, the efficiency of the
entrepreneur, both in organizing the physical side of the production (technical
efficiency of the entrepreneur), and in making the correct economic choice of
techniques (economic efficiency of the entrepreneur). Thus, any change in these
determinants (e.g., the introduction of a better method of organization of production,
the application of an educational program to the existing labor) will shift the

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Micro Economics I, Econ 111 4. Theory of Costs

production function, the application of an educational program to the existing labor)

will shift the production function, and hence will result in a shift of the cost curve.
Similarly the improvement of raw materials or the improvement in the use of the same
raw materials will lead to a shift downwards of the cost function.

The short-run costs are the costs at which the firm operates in any one period. The
long-run costs are planning costs or ex ante (based on prior assumptions or expectations)
costs, in that they present the optimal possibilities for expansion of the output and
thus help the entrepreneur is in a long-run situation, in the sense that he can choose
any one of a wide range of alternative investments, defined by the state of technology.
After the investment decision is taken and funds are tied up in fixed-capital
equipment, the entrepreneur operates under short-run conditions; he is on a short cost
curve.

A distinction is necessary between internal (to the firm) economies of scale and
external economies. The internal economies are build into the shape of the long-run
cost curve, because they accrue to the firm from its own action as it expands the level
of its output. The external economies arise outside the firm, from improvement (or
depreciation) of the environment in which the firm operates. Such economies
external to the firm may be realized from actions of other firms in the same or in
another industry. The important characteristic of such economies is that they are
independent of the actions of the firm, they are external to it. Their effect is a change
in the prices of the factors employed by the firm, they are external to it. Their effect
is a change in the prices of the factors employed by the firm (or in a reduction in the
amount of inputs per unit of output), and thus cause a shift of the cost curves, both the
short-run and the long-run.

In summary, while the internal economies of scale relate only to the long-run and are
built into the shape of the long-run cost curve, the external economies affect the
position of the cost curves; both the short-run and the long-run cost curves will shift if
external economies affect the prices of the factors and/or the production function.

Any point on a cost curve shows the minimum cost at which a certain level of output
may be produced. This is the optimality implied by the points of accost curve.
Usually the above optimality is associated with the long-run cost curves. Usually the
above optimality is associated with the long-run cost curve. However, a similar
concept may be applied to the short-run, given the plant of the firm in any one period.

SHORT-RUN COSTS

The Traditional Theory

Traditional Theory distinguishes between the short run and the long run. The short
run is the period during which some factor(s) is fixed; usually capital equipment and
entrepreneurship are considered as fixed in the short run. The long run is the period
over which all factors become variable.

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 Micro Economics I, Econ 111 4. Theory of Costs

In the traditional theory of the firm total costs are split into two groups: total fixed
costs and total variable costs:

TC = TFC + TVC

The fixed costs include:

(a) Salaries of administrative staff
(b) Depreciation (wear and tear) of machinery
(c) Expenses for building depreciation and repairs
(d) Expenses for land maintenance and depreciation

Another element that may be treated in the same way as fixed costs is the normal
profit, which is a lump sum including a percentage return on fixed capital and
allowance for risk.

The variable costs include:

(a) The raw materials
(b) The cost of direct labor
(c) The running expenses of fixed capital, such as fuel ordinary repairs and
routine maintenance.

Total fixed cost is graphically denoted by a straight line parallel to the output axis
(fig.1). The total variable cost is the traditional theory of the firm has broadly an
inverse – S shape (fig. 2) which reflects the law of variable proportions. According to
this law, at the initial stages of production with a given plant, as more of the variable
factor(s) is employed, its productivity increases and the average variable factor(s)
employed, its productivity increases and the average variable cost falls. TC

C TVC
TVC
TFC

TFC

O X O X O X
Fig. 1 Fig. 2 Fig. 3

This continues until optimal combination of the fixed and variable factors is reached.
Beyond this point as increased quantities of the variable factor(s) are combined with
the fixed factor(s) the productivity of the variable factor(s) declines 9 and the AVC
rises). By adding the TFC and TVC we obtain average cost curves. The average
fixed cost is found by dividing TFC by the level of output:

AFC = TFC
X

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Micro Economics I, Econ 111 4. Theory of Costs

Graphically the AFC is a rectangular hyperbola, showing at all its points the same
magnitude, that is, the level of TFC (fig. 4). The average variable cost is similarly
obtained by dividing the TVC with the corresponding level of output:

AVC = TVC
X

AFC

O X
Fig.4

Graphically the AVC at each level of output is derived from the slope of a line drawn
from the origin to the point on the TVCVC curve corresponding to the particular level
of output. For example fig.5 the AVC at X 1 is the slope of the ray Oa, the AVC at X 2
is the slope of a ray through the origin declines continuously until the ray becomes
tangent to the TVC curve falls initially as the productivity of the variable factor(s)
increases, reaches a minimum when the plant is operated optimally (with the optimal
combination of fixed and variable factors), and rises beyond that point fig.6.
C
TVCC
C
SAVC

0 x1 x2 x3 x4 X O x1 x2 x3 x4 X
Fig. 5 Fig. 6

The ATC is obtained by dividing the TC by the corresponding level of output:

TC TFC  TVC
ATC    AFC  AVC
X X

Graphically the ATC curve is derived in the same way as the SVAC. The ATC at any
level of output is the slope of the straight line from the origin to the point on the TC
curve corresponding to that particular level of output (fig.7). The shape of the ATC
reaches a minimum at the level of optimal operation of the plant (X M) and
subsequently rises again (fig.8). The U shape of both the AVC reflects the law of

4
TC
Micro Economics I, Econ 111 4. Theory of Costs

variable proportions or law of eventually decreasing returns to the variable factor(s) of

production. The marginal cost is defined as the change in TC which results from a
unit change in output. Mathematically the marginal cost is the first derivative of the
C
TC function. Denoting total cost by C and output by X we have MC  .
X

SATC

O x1 x2 xM xL X
O x1 x2 xM xL X
Fig.7
Fig. 8
Graphically the MC is the slope of the TC curve (which of course is the same at point
as the slope of the TVC). The slope of a curve at any one of its points is the slope of
the tangent at that point. With an inverse S shape of the TC (and TVC) the MC curve
will be U-shaped. In fig.9, we observe that the slope of the tangent to the total-cost
curve declines gradually, until it becomes parallel to the X-axis (with its slope being
equal to zero at this point), and then starts rising. Accordingly we picture the MC
curve in fig.10 as U shaped.
C
TC SMC

In summary:
0
the
XA
traditional
X
theory of costs postulates
O XA
that in the
X
short run the cost
curves (AVC,Fig.9ATC and MC) are U shaped, reflecting the law of variable proportions.
Fig.10
In the short run with a fixed plant there is a phase of increasing productivity (falling
unit costs) and a phase of decreasing productivity (increasing unit costs) of the
variable factor(s). Between these two phases of plant operation there is a single point
at which unit costs are at a minimum. When this point on the SATC is reached the
plant is utilized optimally, that is with the optimal combination (proportions) of fixed
and variable factors.

The relationship between ATC and AVC

The AVC is a part of the ATC, given ATC=AFC+AVC. Both AVC and ATC are U-
shaped, reflecting the law of variable proportions. However, the minimum point of
the ATC occurs to the right of the minimum point of the AVC (fig.11). This is due to

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Micro Economics I, Econ 111 4. Theory of Costs

the fact that ATC includes AFC, and the latter falls continuously with increase in
output. After the AVC has reached its lowest point and starts rising, its rise is over a
certain range offset by the fall in the AFC, so that the ATC continues to fall despite the
increase in AVC. However, the rise in AVC eventually becomes greater than the fall
in the AFC so that the ATC starts increasing. The AVC approaches the ATC
asymptotically as X increases.
C

SMC SATC
a SAVC

AFC

O X1 X2 X
Fig.11

In fig.11 the minimum AVC is reached at X 1 at while the ATC is at its minimum at X 2.
Between X1 and X2 the fall in AFC more than offsets the rise in AVC so that the ATC
continues to fall. Beyond X2 the increase in AVC is not offset by the fall in AFC, so
that ATC rises.

The relationship between MC and ATC

The MC cuts the ATC and the AVC at their lowest points. We will establish this
relation only for the ATC and MC, but the relation between MC, but the relation
between MC and AVC can be established on the same lines of reasoning.

The MC is the change in the TC for producing an extra unit of output. Assume that
we start from a level of n units of output. If increase the output by one unit the MC is
the change in total cost resulting from the production of the (n+1)th unit.

The AC at each level of output is found by dividing TC by X. Thus the AC at the

TCn
level of Xn is ACn 
Xn

TCn 1
and the AC at the level Xn+1 is ACn 
X n 1
clearly TCn 1  TCn  MC

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Micro Economics I, Econ 111 4. Theory of Costs

Thus:

(a) If the MC of the (n+1)th unit is less than Can (the AC of the previous n units)
the ACn+1 will be smaller than the ACn.

(b) If the MC of the (n+1)th unit is higher than ACn (the AC of the previous n
units) the ACn+1 will be higher than the ACn.

So long as the MC lies below the AC curves, it pulls the latter downwards when the
MC rises above the AC, it pulls the latter upwards. In fig.11 to the left of a the MC
lies below the AC curve, and hence the latter falls downwards. To the right of a the
MC curve lie above the AC curve, so that AC rises. It follows that at point a, where
the intersection of the MC and AC occurs, the Ac has reached its minimum level.

The Modern Theory of Short-run Costs

The U-shaped cost curves of the traditional theory have been questioned by various
writers both on theoretical a priori and on empirical grounds. As early as 1939
George Stigler suggested that the short-run average variable cost has a flat stretch
over a range of output which reflects the fact that firms build plans with some
flexibility in their productive capacity. The reasons for this reserve capacity have
been discussed in detail by various economists. As in the traditional theory, short-run
costs are distinguished into average variable costs (AVC) and average fixed costs
(AFC).

The Average Fixed Cost

This is the cost of indirect factors, that is the cost of the physical and personal
organization of the firm. The fixed costs include the costs for:

(a) the salaries and other expenses of administrative staff

(b) the expenses for maintenance of buildings,
(c) the wear and tear of machinery (standard depreciation allowances),
(d) the expenses for maintenance of buildings,
(e) the expenses for the maintenance of land on which the plant is installed and
operates..
The planning of the plant (or the firm) consists in deciding the size of these fixed,
indirect factors, which determine the size of the plant, because they set limits to its
production. Direct factors such as labor and raw materials are assumed not to set
limits on size; the firm can acquire them easily with a figure for the level of output
which entrepreneur anticipates selling, and he will choose the size of plant which will
allow him to produce this level of output more efficiently and with the maximum
flexibility. The plant will wants to have some reserve capacity for various reasons.

The businessman will want to be able to meet sensational and cyclical fluctuations in
his demand. Such fluctuations cannot always be met efficiently by a stock-inventory

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Micro Economics I, Econ 111 4. Theory of Costs

policy. Reserve capacity will allow the entrepreneur to work with more shifts and with
lower costs than a stock – piling policy.

Reserve capacity will give the businessman greater flexibility for repairs for broken
down machinery without disrupting the smooth flow of the production process.

The entrepreneur will want to have more freedom to increase his output if demand
increases. All businessmen hope for growth. In view of anticipated increases in
demand the entrepreneur builds some reserve capacity, because he would not like to
let all new demand go to his rivals, as this may endanger his future old on the market.
It also gives him some flexibility for minor alternations of his product, in view of
changing tastes of customers.

Technology usually makes it necessary to build into the plant some reserve capacity.
Some basic types of machinery may not be technically fully employed when
combined with other small types of machines in certain numbers, more of which may
not be required given the specific size of the chosen plant. Also such basic machinery
may be difficult to install due to time – lags in the acquisition. The entrepreneurs will
thus buy from the beginning such a ‘basic’ machine which allows the highest
flexibility, in view of future growth in demand, even though this is a more expensive
alternative now. Furthermore some machinery may be so specialized as to be
available only to order, which takes time. In this case such machinery will be bought
in excess of the minimum required at present numbers, as a reserve.

Some reserve capacity will always be allowed in the land and buildings, since
expansion of operations may be seriously limited if new land or new buildings have to
be acquired.

Finally, there will be some reserve capacity on the organizational and administrative
level. The administrative staff will be hired at such numbers as to allow some
increase in the operations of the firm.

A B

O XA XB X
Fig.15

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Micro Economics I, Econ 111 4. Theory of Costs

In summary, the businessman will not necessarily choose the plant which will give
him today the lowest cost, but rather that equipment which will allow him the greatest
possible flexibility, for minor alternations of his product or his technique.

Under these conditions the AFC curve will be as in fig.15. The firm has some largest-
capacity units of machinery which set an absolute limit to the short-run expansion of
output (boundary b in fig. 15). The firm has also small-unit machinery, which sets a
limit to expansion (boundary A in fig. 15). this is not an absolute boundary, because
the firm can increase its output in the short run(until the absolute limit B is
encountered), either by paying overtime to direct labor for working longer hours (in
this case AFC shown by the dotted line in fig.15), or by buying some additional small-
unit types of machinery (in this case the AFC curve shifts upwards, and starts falling
again as shown by the line ab in fig.15).

The Average variable cost

As in the traditional theory, the average variable cost of modern microeconomics
includes the cost of:
(a) direct labor which varies with output,
(b) raw materials,
(c) running expenses of machinery.
The SAVC in modern theory has a saucer-type shape that is broadly shaped but has a
flat stretch over a range of output (fig.16). The flat stretch corresponds to the built-in
the plant reserve capacity. Over this stretch the SAVC is equal to the MC, both being
constant per unit of output. To the left of the flat stretch the MC lies below the SAVC,
while to the right of the flat stretch the MC rises above the SAVC. The falling part of
the SAVC shows the reduction in costs due to the better utilization of the fixed factor
and the consequent increase in skills and productivity of the variable factor (labor)
with better skills the wastes in raw materials are also being reduced and a better
utilization of the whole plant is reached.

C
MC
SAVC

MC

O X Fig. 16
The increasing part of the SAVC reflects reduction in labor productivity due to the
longer hours of work, the increasing cost of labor due to overtime payment (which is
higher than the current wage), the wastes in materials and the more frequent break
down of machinery as the firm operates with overtime or with more shifts.

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Micro Economics I, Econ 111 4. Theory of Costs

The innovation of modern microeconomics in this field is the theoretical

establishment of a short-run SAVC curve with a flat stretch over a certain range of
output (fig.18). It should be clear that this reserve capacity is planned in order to give
the maximum flexibility in the operation of the firm. It is completely different from
the excess capacity which arises with the U-shaped costs of the traditional theory for
the firm. The traditional theory assumes that each plant is designed without any
flexibility: it is designed to produce optimally only a single level of output (X M in fig.
17). If the firm produces an output X smaller than XM there is excess (unplanned)
capacity, equal to the difference XM – X. This excess capacity is obviously
undesirable because it leads to higher unit costs.

In the modern theory of costs the range of output X1, X2 in fig. 18 reflects the
planned reserve capacity which does not lead to increases in costs. The firm
anticipates using its plant sometimes closer to X1 and at others closer to X2. On the
average the entrepreneur expects to operate his plant within the X1X2 range. Usually
firms consider that the ‘normal’ level of utilization of their plant is somewhere
between two-thirds and three-quarters of their capacity, that is, at a point closer to X2
than X1. The level of utilization of the plant which firms consider as ‘normal’ is
called ‘the load factor’ of the plant.
C C SAVC
SAVC

Reserve
Capacity
excess capacity

O X XM X O X1 X2 X
Fig. 17 Fig. 18

The Average Total Cost

The average total cost is obtained by adding the average fixed (inclusive of normal
profit) and the average variable costs at each level of output. The ATC is shown in
fig.19. The ATC curves falls continuously up to the level of output (X2) at which the
reserve capacity is exhausted. Beyond that level ATC will start rising. The MC will
intersect the average total-cost curve at its minimum point (which occurs to the right
of the level of output XA at which the flat stretch of the AVC ends).
MC SATC
C
SAVC

O Fig. 19 XA X

AFC
MC
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Micro Economics I, Econ 111 4. Theory of Costs

Mathematically the cost-output relation may be written in the form

C = b0 + b1X
TC = TFC + TVC The TC is a straight line with a positive slope over the range
of reserve capacity (fig. 20).

TC
C C

TVC
SAC
SAVC=MC
TFC
AFC
O
O Fig. 20 X X X
range of reserve capacity
Fig. 21

The AFC is a rectangular hyperbola

AFC = bo
X

The AVC is a straight line parallel to the output axis

(b1 X )
AFC   b1
X
The ATC is falling over the range of reserve capacity

b0
ATC   b1
X
C
The MC is a straight line which coincides with the AVC  b1
X

Thus the range of reserve capacity we have MC=AVC=b1, while ATC falls
continuously over this range (fig. 21). Note that the above total cost function does not
extend to the increasing part of costs, that is it does not apply to ranges of output
beyond the reserve capacity of the firm.

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Micro Economics I, Econ 111 4. Theory of Costs

LONG-RUN COSTS

Long-run Costs of the Traditional Theory: The Envelope Curve

In the long – run all factors are assumed to become variable. It is known that the
long-run cost curve is a planning curve, in the sense that it is a guide to the
entrepreneur in his decision to plan the future expansion of his output.

The long run average cost curve is derived from short-run cost curves. Each point on
the LAC corresponds to a point on a short-run cost curve, which is tangent to the LAC
at that point. Let us examine in detail how the LAC is derived from the SAC curves.

Assume, as a first approximation, that the available technology to the first at a

particular point of time includes three methods of production, each with a different
plant size: a small plant, medium plant and large plant. The small plant operates with
costs denoted by the curve SAC1, the medium – size plant operates with the costs on
SAC2 and the large – size plant gives rise to the costs shown on SAC3 (fig.1).

SATC1
C1
C| 1 SATC2
SATC3
|
C2
C2
C3

0 X1 X|1 X||1 X2 X|2 X3 X

Fig. 1
If the firm plans to produce output X1 it will choose the small plant. If it plants to
produce X2 it will choose medium size plant. If it wishes to produce X 3 it will choose
the large size plant. If the firm starts with the small plant and its demand gradually
increases, it will produce at lower costs (up to level x1). Beyond that point costs start
increasing. If its demand reaches the level X”1 the firm can either continue to produce
with the small plant or it can install the medium size plant. The decision at this point
depends on not on costs but on the firm’s expectations about its future demand. If the
firm expects that the demand will expand further thatnX” 1 it will install the medium
plant because with this plant outputs larger than X”1 are produced with a lower cost.
Similar considerations hold for the decision of the firm when it reaches the level X”2.
If it expects its demand to stay constant at this level, the firm will not install the large
plant, given that it involves a larger investment which is profitable only if demand
expands beyondX”2. For example, the level of output X 3 is produced at a cost C3 with
the large plant, while it costs C’3 if produced with medium size plant (C’2 >C3).

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Micro Economics I, Econ 111 4. Theory of Costs

Now if we relax the assumption of the existence of only three plants and assume that
the available technology includes many plant sizes, each suitable for a certain level of
output, the points of intersection of consecutive plants are more numerous. In the
limit, if we assume that there are a very large number of plants, we obtain a
continuous curve, which is the planning LAC curve of the firm. Each point of this
curve shows the minimum (optimal) cost for producing the corresponding level of
output. The LAC curve is the locus of points denoting the least cost of producing the
corresponding output. It is a planning curve because on the basis of this curve the firm
decides what plant to set up in order to produce optimally the expected level of
output. The firm chooses the short-run plant which allows it to produce the
anticipated output at the least possible cost. In the traditional theory of the firm the
LAC curve is U-shaped and it is often called the ‘envelope curve’ because it
envelopes the SRC curves Fig. 2

LAC

O Fig. 2 XM X

Let us examine the U shape of the LAC. This shape reflects the laws of returns to
scale. According to these laws the unit costs of production decreases as plant size
increases, due to the economies of scale which the larger plant size make possible.
The traditional theory of the firm assumes that economies of scale exist only up to a
certain size of plant, which is known as the optimum plant size, because with this
plant size all possible economies of scale are fully exploited. If the plant increases
further than this optimum size there are diseconomies of scale, arising from
managerial inefficiencies. It is argued that management becomes highly complex,
managers are overworked and the decision making process becomes less efficient.
The turning-up of the LAC curve is due to managerial diseconomies of scale, since
the technical diseconomies can be avoided by duplicating the optimum technical plant
size.

A serious assumption of the traditional U-shaped cost curves is that each plant size is
designed to produce optimally a single level of output (e.g. 1000 units of X). Any
departure from that X no matter how small (e.g., an increase by 1 unit of X) leads to
increased costs. The plant is completely inflexible. There is no reserve capacity, not
even to meet seasonal variations in demand. As a consequence of this assumption the

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Micro Economics I, Econ 111 4. Theory of Costs

LAC curve ‘envelopes’ the SRAC. Each point of the LAC is a point of tangency with
the corresponding SRAC curve. The point of tangency occurs to the falling part of
the SRAC curves for points lying to the left of the minimum point of the LAC: since
the slope of LAC is negative up to M the slope of the SRAC curves must also be
negative, since at the point of their tangency the two curves have the same slope. The
point of tangency for outputs larger than XM occurs to the rising part of the SRAC
curves: since the LAC rises, the SAC must rise at the point of their tangency with the
LAC. Only at the minimum point M of the LAC is the corresponding SAC also at a
minimum. Thus at the falling pat of the LAC the plants are not worked to full
capacity to the rising part of the LAC the plants are overworked; only at the minimum
point A is the (short-run) plant optimally employed.

We stress once more the optimality implied by the LAC planning curve: each point
represents the least unit-cost for producing the corresponding level of output. Any
point above the LAC is inefficient in that it shows a higher cost for producing the
corresponding level of output. Any point below the LAC is economically desirable
because it implies a lower unit-cost, but it is not attainable in the current state of
technology and with the prevailing market prices of factors of production.

The long-run marginal cost is derived from the SRMC curves, but does not envelope
them. The LRMC is formed from the points of intersection of the SRMC curve with
vertical lines (to the x-axis) drawn from the points of tangency of the corresponding
SAC curves and the LRA cost curve (fig. 3).
LMC
C

a
SMCM
SMC1
SMC2 LAC

0 X|1 X1 X||1 X2 XM X
Fig. 3

The LMC must be equal to the SMC for the output at which the corresponding SAC is
tangent to LAC. For levels of X to the left of tangency a the SAC>LAC . At the
point of tangency SAC=LAC. As we move from a position of inequality of SRAC
and LRAC to a position of equality. Hence the change in total cost (i.e. the MC) must
be smaller for the short-run curve than for the long-run curve. Thus LMC>SMC to the
left of a. For an increase in output beyond X1 (e.g.X ||1) the SAC>SMC. That is we
move from the position a of equality of the two costs to the position b where SAC is

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Micro Economics I, Econ 111 4. Theory of Costs

greater than LAC. Hence the addition to total cost (= MC) must be larger for the short
run curve than for the long run curve. Thus LMC<SMC to the right of a.

Since to the left of a, LMC>SMC, and to the right of a, LMC<SMC, it follows that a,
LMC = SMC. If we draw a vertical line from a to the X – axis the point at which it
intersects the SMC (point A for SAC1) is a point of the LMC.

If we repeat this procedure for all points of tangency of SRAC and LAC curves to the
left of the minimum point of the LAC, we obtain points of the section of the LMC
which lies below the LAC. At the minimum point M the LMC intersects the LAC.
To the right of M the LMC lies above the LAC curve. At point M we have

SACM = SMCM = LAC = LMC

There are various mathematical forms which give rise to U-shaped unit cost curves.
The simplest total cost function which would incorporate the law of variable
proportions is the cubic polynomial

C = b0 + b1X – b1X2 + b3X3

TC = TFC + TVC

The AVC is
TVC
AVC =  b1  b2 X  b3 X 2
X

The MC is
C
MC =  b1  2b2 X  3b3 X 2
X

The ATC is
C b0
  b1  b2 X  b3 X 2
X X

The TC curve is roughly S-shaped, while the ATC, the AVC and the MC are all U-
shaped; the MC curve intersects the other two curves at their minimum points.

LONG RUN COSTS IN MODERN MICRO ECONOMIC THEORY:

The L – Shaped scale Curve.

These are distinguished into production costs and managerial costs. All costs are
variable in the long run and they give rise to a long-run cost curve which is roughly L-
shaped. The production costs fall continuously with increases in output. At very
large scales of output managerial costs may rise. But the fall in production costs more

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Micro Economics I, Econ 111 4. Theory of Costs

than offsets the increase in the managerial costs, so that the total LAC falls with
increases in scale.

Production costs
Production costs fall steeply to begin with and then gradually as the scale of
production increases. The L-shape of the production cost curve is explained by the
technical economies of large-scale production. Initially these economies are
substantial, but after a certain level of output is reached all or most of these economies
are attained and the firm is said to have reached the minimum optimal scale, given the
technology of the industry. If new techniques are invented for larger scales of output,
they must be cheaper to operate. But even with the existing known techniques some
economies can always be achieved at larger outputs:

(a) economies from further decentralization and improvement in skills;

(b) lower repairs costs may be attained if the firm reaches a certain size;
(c) the firm, especially if it is multiproduct, may well undertake itself the
production of some of the materials or equipment which it needs instead of
buying them from other firms.

Managerial Costs
In the modern management science for each plant size there is a corresponding
organizational administrative set-up appropriate for the smooth operating of that
plant. There are various levels of management, each with its appropriate kind of
management technique. Each management technique is applicable to a range of
output. There are small-scale as well as large-scale organizational techniques. The
costs of different techniques of management first fall up to a certain plant size. At
very large scales of output managerial costs may rise, but very slowly.

In summary: Production costs fall smoothly at very large scales, while managerial
costs may rise only slowly at very large scales. Modern theorists seems to accept that
the fall in technical costs more than offsets the probable rise of managerial costs, so
that the LRAC curve falls smoothly or remains constant atv very large scales of
output.

We may draw the LAC implied by the modern theory of costs as follows. For each
short-run period we obtain the SRAC which includes production costs, administration
costs. Other fixed costs and an allowance for normal profit. Assume that we have a
technology with four plant sizes, with costs falling as size increases. We said that in
business practice it is customary to consider that a plant is used normally when it
operates at a level between two-thirds and three-quarters of capacity.

Following this procedure, and assuming that the typical load factor of each plant is
two-thirds of its full capacity (limit capacity), we may draw the LAC curve by joining
the points on the SATC curves corresponding to the two-thirds of the full capacity of
each plant sizes the LAC curve will be continuous (fig.4).

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Micro Economics I, Econ 111 4. Theory of Costs

SATC1
C
Cost SATC2
SATC3
SATC4
2/3

2/3
LAC
2/3
2/3

0 Fig. 4 X Output

The characteristic of this LAC curve is that (a) it does not turn up at very large scales
of output; (b) it is not the envelope of the SATC curves, but rather intersects them (at
the level of output defined by the typical load factor of each plant). If, LAC falls
continuously (though smoothly at very large scales of output), the LMC will lie below
the LAC at all scales (fig. 5).
C C

LAC = LMC

LAC
LMC

0 Fig. 5 X 0 Fig. 6 x X
Minimum optimal scale

If there is a minimum optimal scale of plant (x in fig. 6) at which all possible scale
economies are reaped, beyond that scale the LAC remains constant. In this case the
LMC lies below the LAC until the minimum optimal scale is reached, and coincides
with the LAC beyond the U-shaped costs of traditional theory.

DYNAMIC CHANGES IN COSTS – THE LEARNING CURVE

It is believed that a large firm may have long-run average cost than a small firm:
increasing returns to scale in production. So it is convincing to conclude that firms
which enjoy lower average cost over time are growing firms with increasing returns to
scale. But this need not be true. In some firms, long-run cost may decline over time
because workers and managers absorb new technological information as they become
more experienced at their jobs.

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Micro Economics I, Econ 111 4. Theory of Costs

As management and labor gain experience with production, the firm’s marginal and
average costs of producing a given level of output fall for four reasons:

1. Workers often take longer to accomplish a given task the first few times they
do it. As they become more adept, their speed increases.
2. Managers learn to schedule the production process more effectively, from the
flow of materials to the organization of the manufacturing itself.
3. Engineers who are initially cautious in their product designs may gain enough
experience to be able to allow for tolerances in design that save cost without
increasing defects. Better and more specialized tools and plant organization
may also lower cost.
4. Suppliers of materials may learn how to process materials required more
effectively and may pass on some of this advantage in the form of lower
materials cost.

As a consequence, a firm “learns” over time as cumulative output increases. Managers

can use this learning process to help plan production and forecast future costs. Fg. 1
illustrates this process in the form of a learning curve – a curve that describes the
relationship between a firm’s cumulative output and the amount of inputs needed to
produce each unit of output.
Hours of labor / machine Lot

10 20 30 40 50
Cumulative Number of Machine Lots Produced

The Learning Curve (Fig. 1): A firm’s production cost may fall over time as managers and
workers become more experienced and more effective at using the available plant and
equipment. The learning curve shows the extent to which hours of labor needed per unit of
output fall as the cumulative output increases.

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Micro Economics I, Econ 111 4. Theory of Costs

Graphing the Learning Curve

Fig.1 shows a learning curve for the production of machine tools. The horizontal axis
measures the cumulative number of lots of machine tools (groups of approximately
40) that the firm has produced. The vertical axis shows the number of hours of labor
needed produce each lot. Labor input per unit of output directly affects the production
cost because the fewer the hours of labor needed the lower the marginal and average
cost of production.

The learning curve in fig.1 is based on the relationship L = A + BN-β

Where N is the cumulative units of output produced and L the labor input per unit of
output. A, B, and β are constants, with A and B positive, and β between 0 and 1.
When N is equal to 1, L is equal to A + B, so that A + B measures the labor input
required to produce the first unit of output. When β equals 0, labor input per unit of
output remains the same as the cumulative level of output increases; there is no
learning. When β is positive and N gets larger and larger, L becomes arbitrarily close
to A. A, therefore represents the minimum labor input per unit of output after all
learning has taken place.

The larger is β, the more important is the learning effect. With β equals to 0.5, for
example, the labor input per unit of output falls proportionally to the square root of
the cumulative output. This degree of learning can substantially reduce the firm’s
production costs as the firm becomes more experienced.

In this machine tool example, the value of β is 0.31. for this particular learning curve,
every doubling in cumulative output causes the input requirement (less the minimum
attainable input requirement) to fall by about 20% (because (L - N) = BN -31, we can
check that 0.8 (L – A) is approximately equal to B(2N)-31). As fig.1 shows, the
learning curve drops sharply as the cumulative number of lots increases to about 20.
Beyond an output of 20 lots, the cost savings are relatively small.

Learning versus Economies of Scale

Once the firm has produced 20 or more machine lots, the entire effect of the learning
curve would be complete, and we could use the usual analysis of cost. If, the
production process were relatively new, relatively high cost at low levels of output
(and relatively low cost at higher levels) would indicate learning effects, not
economies of scale. With learning, the cost of production for a mature firm is
relatively low regardless of the scale of the firm’s operation. If a firm that produces
machine tools in the lots knows that it enjoys economies of scale, it should produce its
machine in very large lots to take advantage of the lower cost associated with size. If
there is a learning curve, the firm can lower its cost by scheduling the production of
many lots regardless of the individual lot size.

Fig. 2 shows this phenomenon. AC1 represents the long-run average cost of
production of a firm that enjoys economies of scale in production. Thus the change in

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Micro Economics I, Econ 111 4. Theory of Costs

production from A to B along AC1 leads to lower cost due to economies of scale.
However, the move from A on AC 1 to C on AC2 leads to lower cost due to learning,
which shifts the average cost curve downward.

Cost (Birrs / unit of

output)

A Economies of Scale

AC1
Learning C
AC2

Output
Economies of Scale versus Learning Fig. 2 : A firm’s average cost of
production can decline over time because of growth of sales when
increasing returns are present ( a move from A to B on curve AC 1), or it can
decline because there is a learning curve ( a move from A on curve AC 1 to c
on curve AC2.

The learning curve is crucial for a firm that wants to predict the cost of producing a
new product. For example, a firm producing machine tools knows that its labor
requirement A is equal to zero, and b is approximately equal to 0.32. Table 1
calculates the total labor requirement for producing 80 machines.

Because there is a learning curve, the per-unit labor requirement falls with increased
production. As a result, the total labor requirement for producing more and more
output increases in smaller and smaller increments. Therefore, a firm looking only at
the high initial labor requirement will obtain an overtly pessimistic view of the
business. Suppose the firm plans to be in business for a long time, reducing 10 units
per year. Suppose the total labor requirement for the first year of production, the
firm’s cost will be high as it learns the business. But once the learning effect has
taken place, production costs will fall. After 8 years, the labor required to produce 10
units will be only 5.1, and per-unit cost will be roughly half what it was in the first
year of production. Thus the learning curve can be important for a firm deciding
whether it is profitable to enter an industry.

Cumulative Output (N) Per-unit labor Total Labor

requirement for each 10 Requirement
units of output (L)*
10 1.00 10.0
20 0.80 18.0 (10.0+8.0)
30 0.70 25.0 (18.0+7.0)
40 0.64 31.4 (25.0+6.4)
50 0.60 37.4 (31.4+6.0)
20
60 0.56 43.0 (37.4+5.6)
70 0.53 48.3 (43.0+5.3)
80 0.51 53.4 (48.3+5.1)
Micro Economics I, Econ 111 4. Theory of Costs

Predicting the Labor Requirements of Producing a given output.

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