This document discusses theories of costs in the short run and long run for firms. It defines fixed costs as expenses that do not change with output, and variable costs as expenses that change proportionally with output. In the short run, total costs are the sum of fixed and variable costs. In the long run, when all costs are variable, the long run average cost curve is derived from the minimum points of multiple short run average cost curves and can exhibit economies or diseconomies of scale.

1. THEORY OF COSTS
Short Run

2. Decision making in different time
periods
 Short run for the firms and very short run for
the industry.
 Long run for the firms and short run for the
industry.
 Very long run for the firms and long run for the
industry.

3. Theory of costs
• Costs of a firm is incurred to establish the
production unit and to purchase different
factors of production.
• Cost of a firm (TC) is classified into two
broad categories - Fixed cost (TFC) and
Variable cost (TVC).
i.e. TC = TFC + TVC
• However, nothing is fixed in the long run.

4. Theory of costs
Fixed costs
Fixed costs are expenses that does not
change in proportion to the activity of a
business.
Fixed costs include overheads (rent,
insurance-premium, interests), and also
direct costs such as payroll (particularly
salaries).

5. Theory of costs
Fixed cost does not change with the
volume of production.
TFC
Q
costs
100
O

6. Theory of costs
Variable costs
Variable costs change in direct
proportion to the activity of a business
such as sales or production volume. In
retail, the cost of goods is almost entirely
variable. In manufacturing, direct material
costs, wages, fuel costs are examples of
variable costs.

7. Theory of costs
For example, a manufacturing firm pays for
raw materials. When activity is decreased,
less raw material is used, and so the
spending for raw materials falls. When
activity is increased, more raw material is
used and spending therefore rises.
Although tax usually varies with profit, which
in turn varies with sales volume, it is not
normally considered a variable cost.

8. fig
100
80
60
40
20
0
Total costs for firm X
TFC
Output
(Q)
01234567
TFC
(£)
12
12
12
12
12
12
12
12
0 1 2 3 4 5 6 7 8

9. fig
100
80
60
40
20
0
Total costs for firm X
TFC
Output
(Q)
01234567
TFC
(£)
12
12
12
12
12
12
12
12
TVC
(£)
0
10
16
21
28
40
60
91
0 1 2 3 4 5 6 7 8

10. fig
100
80
60
40
20
0
Total costs for firm X
TVC
Output
(Q)
01234567
TFC
(£)
12
12
12
12
12
12
12
12
TVC
(£)
0
10
16
21
28
40
60
91
TFC
0 1 2 3 4 5 6 7 8

11. fig
100
80
60
40
20
0
Total costs for firm X
TVC
TFC
Diminishing marginal
returns set in here
0 1 2 3 4 5 6 7 8

12. fig
100
80
60
40
20
0
Total costs for firm X
TVC
Output
(Q)
01234567
TFC
(£)
12
12
12
12
12
12
12
12
TVC
(£)
0
10
16
21
28
40
60
91
TFC
0 1 2 3 4 5 6 7 8

13. fig
100
80
60
40
20
0
Total costs for firm X
TVC
TFC
Output
(Q)
01234567
TFC
(£)
12
12
12
12
12
12
12
12
TVC
(£)
0
10
16
21
28
40
60
91
TC
(£)
12
22
28
33
40
52
72
103
0 1 2 3 4 5 6 7 8

14. fig
100
80
60
40
20
0
Total costs for firm X
TC
Output
(Q)
01234567
TFC
(£)
12
12
12
12
12
12
12
12
TVC
(£)
0
10
16
21
28
40
60
91
TC
(£)
12
22
28
33
40
52
72
103
TVC
TFC
0 1 2 3 4 5 6 7 8

15. fig
100
80
60
40
20
0
Total costs for firm X
TC
TVC
TFC
Diminishing marginal
returns set in here
0 1 2 3 4 5 6 7 8

16. Average fixed cost
Average fixed cost (AFC) = TFC/Q
where TFC = fixed cost, Q = total number of
units produced.
Unit fixed costs decline along with volume,
following a rectangular hyperbola. As a
result, the total unit cost of a product will
decline as volume increases.

17. Average Fixed costs
Q
Costs
AFC
O

18. Average variable cost
Average variable cost (AVC) is the TVC of a firm
divided by the total units of output (Q).
AVC = TVC/Q
Q
costs
Y
AVC
O

19. Average cost
Average cost (AC) is the TC of a firm divided by
the total units of output (Q).
AC = TC/Q = AFC + AVC
Q
costs
Z
AC
O

20. Marginal Cost
The additional cost incurred to produce one
additional unit of output is called the
Marginal Cost (MC).
MC = dC/dQ

21. MC
The marginal cost curve is U-shaped.
Marginal cost is relatively high at small
quantities of output - then as production
increases, it declines - then reaches a
minimum value - then rises.
This shape of the marginal cost curve is
directly attributable to increasing, then
decreasing marginal returns (the law of
diminishing marginal returns).

22. Diminishing marginal
returns set in here
fig Output (Q) Costs (£)
MC
x
MMaarrggiinnaall ccoossttss

23. Numerical Example
Q TFC TVC TC AFC AVC AC MC
0 100 0 100
1 100 20 120 100 20 120 20
2 100 37 137 50 18.5 68.5 17
3 100 52 152 33.33 17.33 50.67 15
4 100 80 180 25 20 45 28
5 100 120 220 20 24 44 40
6 100 165 265 16.67 27.5 44.17 45

24. Average and marginal costs
fig Output (Q) Costs (£)
AVC
AFC
MC
x
AC
z
y

25. LONG RUN

26. Long run cost curves
The Long run average cost (LRAC or LAC)
curve illustrates - for a given quantity of
production - the average cost per unit
which a firm faces in the long run (i.e.
when no factors of production is fixed).

27. LRAC
LRAC curve is derived from a series of short
run average cost curves.
It is also called the ‘Envelope curve' since it
envelops all the short run average cost
curve.
The curve is created as an envelope of an
infinite number of short-run average total
cost curves.

28. LAC
The LRAC curve is U-shaped, reflecting
economies of scale when it is negatively-sloped
and diseconomies of scale when it
is positively sloped.
In perfect competition, the LRAC curve is
flat at the point of equilibrium – in this
stage the firm is enjoying constant returns
to scale.

29. LAC
In some industries, the LRAC is L-shaped,
and economies of scale increase
indefinitely. This means that the largest
firm tends to have a cost advantage, and
the industry tends naturally to become a
monopoly, and hence is called a natural
monopoly. Natural monopolies tend to
exist in industries with high capital costs in
relation to variable costs, such as water
supply and electricity supply.

30. Long-run average cost curves
Output OCosts
fig
LRAC
Economies of Scale

31. long-run average cost curves
fig Output OCosts
LRAC
Diseconomies of Scale

32. long-run average cost curves
fig Output OCosts
LRAC
Constant costs

33. Long-run Costs
• Long-run average costs
– assumptions behind the curve
• factor prices are give
• state of technology and factor quality are given
• firms choose least-cost combination of factors

34. A typical long-run average cost curve
Output OCosts
fig
LRAC

35. A typical long-run average cost curve
Economies Constant
LRAC
of scale
costs
fig Output OCosts
Diseconomies
of scale

36. Long-run Costs
• Long-run average costs
– assumptions behind the curve
• factor prices are give
• state of technology and factor quality are given
• firms choose least-cost combination of factors
– shape of the LRAC curve
– a typical LRAC curve
– long-run average and marginal cost curves

37. Long-run average and marginal costs
Output OCosts
fig
LRAC
LRMC
Economies of Scale

38. Long-run average and marginal costs
fig Output OCosts
LRMC
LRAC
Diseconomies of Scale

39. Long-run average and marginal costs
fig Output OCosts
LRAC = LRMC
Constant costs

40. Long-run average and marginal costs
fig Output OCosts
LRMC
LRAC
Initial economies of scale,
then diseconomies of scale

41. Long-run Costs
• Long-run average costs
– assumptions behind the curve
• factor prices are given.
• state of technology and factor quality are
given.
• firms choose least-cost combination of
factors.

42. Envelope Curve
The envelope curve is based on the point of
each short-run ATC curve that provides
the lowest possible average cost for each
quantity of output.

43. Deriving long-run average cost curves: plants of fixed size
fig
SRAC3
1 factory
Costs Output
O
SRAC5
SRAC4
5 factories
4 factories
3 factories
2 factories
SRAC1 SRAC2

44. Deriving long-run average cost curves: factories of fixed size
SRAC1
fig
SRAC2 SRAC4
SRAC3
SRAC5
LRAC
Costs Output
O

45. Deriving a long-run average cost curve: choice of factory size
Costs Output
fig
O
Examples of short-run
average cost curves

46. Deriving a long-run average cost curve: choice of factory size
fig
LRAC
Costs Output
O