Theory of Cost

The Production and sales of goods and services are always profit-motivated. However, production depends on certain factors like the law of diminishing marginal returns and marginal productivity. In this chapter, we will study how cost and profit affect market behavior.

Cost – refers to actual or real expenses incurred in the production of goods and services.

In analyzing cost, we will identify fixed input as Total Fixed Cost (TFC) and variable input as Total Total Variable Cost (TVC).

Total Fixed Cost – are cost or expense in the production of inputs that do not change as the output increases.

Examples:

• Rent

 

Total Variable Cost – are cost or expense in the production of inputs that change as the output increases.

Examples:

• Labor Cost
• Raw Materials

 

Total Cost (TC) is the sum of all the cost or expenses or simply put TC=TFC+TVC. TC is the overall production cost of an output.

Average Total Cost (ATC) is the sum of the Average Fixed Cost (AFC) and Average Variable Cost (AVC) or ATC=AFC+AVC or ATC=TC/Q. ATC is the average cost in producing a unit or quantity of output.

Average Fixed Cost is the overall fixed cost distributed to the total Quantity (Q) products or simply AFC = TFC/Q.

Average Variable Cost is the overall variable cost distributed to the total Quantity (Q) products or simply AFC = TVC/Q.

Marginal Cost (MC) is the change in the Total Cost over the change in Quantity or simply MC= change in TC/change in Q

 Revenue is the amount of money received by firms from selling goods and services.

Total Revenue (TR) is the product of the Price (P) multiplied by the Quantity (Q) or TR=P x Q

Profit is the difference between Total Revenue (TR) and Total Cost (TC) or simply Total Profit (TP) = TR – TC.

 Marginal Revenue is the Change in the Total Revenue (TR) over the Change in Quantity (Q) or simply MR= Change in TR/Change in Q

 For a firm to maximize profit in competitive market, marginal revenue and marginal cost must be balanced with the price. At the point when total revenue is only equal to total cost, no profit is made. However, there is also no loss at this instance. This means that the firm has a break-even in its production.

Break-Even Point refers to a situation where a firm’s gain from its economic activity equals the costs it incurred.

Q	TFC	TVC	TC	MC	AFC	AVC	ATC	TR	MR	TP
1	100	10.0	110.0		100.0	10.0	110.0	25.0		-85.0
2	100	14.0	114.0	4	50.0	7.0	57.0	50.0	25	-64.0
3	100	17.5	117.5	3.5	33.3	5.8	39.2	75.0	25	-42.5
4	100	21.7	121.7	4.2	25.0	5.4	30.4	100.0	25	-21.7
5	100	26.2	126.2	4.5	20.0	5.2	25.2	125.0	25	-1.2
6	100	31.2	131.2	5	16.7	5.2	21.9	150.0	25	18.8
7	100	37.7	137.7	6.5	14.3	5.4	19.7	175.0	25	37.3
8	100	46.7	146.7	9	12.5	5.8	18.3	200.0	25	53.3
9	100	59.0	159.0	12.3	11.1	6.6	17.7	225.0	25	66.0
10	100	75.0	175.0	16	10.0	7.5	17.5	250.0	25	75.0
11	100	95.0	195.0	20	9.1	8.6	17.7	275.0	25	80.0
12	100	121.0	221.0	26	8.3	10.1	18.4	300.0	25	79.0
13	100	165.0	265.0	44	7.7	12.7	20.4	325.0	25	60.0
14	100	220.0	320.0	55	7.1	15.7	22.9	350.0	25	30.0
15	100	290.0	390.0	70	6.7	19.3	26.0	375.0	25	-15.0
16	100	390.0	490.0	100	6.3	24.4	30.6	400.0	25	-90.0

TC, TFC, TVC

AFC, AVC, ATC