Cost Theory in Economics

Business colleagues going over business economics
Business colleagues going over business economics (Image: altrendo images/Stockbyte/Getty Images)

A central economic concept is that getting something requires giving up something else. For example, earning more money may require working more hours, which costs more leisure time. Economists use cost theory to provide a framework for understanding how individuals and firms allocate resources in such a way that keeps costs low and benefits high.

Understanding the Costs

Economists view costs as what an individual or firm must give up to get something else. Opening a manufacturing plant to produce goods requires an outlay of money, and once a plant owner spends money to manufacture goods, that money is no longer available for something else. Production facilities, machinery used in the production process and plant workers are all examples of costs. Cost theory offers an approach to understanding the costs of production that allows firms to determine the level of output that reaps the greatest level of profit at the least cost.

Fixed Vs. Variable

Cost theory contains various measures of costs, both fixed and variable. The former do not vary with the quantity of goods produced. Rent on a facility is an example of a fixed cost. Variable costs change with the quantity produced. If increased production requires more workers, for example, those workers’ wages are variable costs. The sum of fixed and variable costs is a firm’s total costs.

Additional Measures

Cost theory derives two additional cost measures. Average total cost is the total cost divided by the number of goods produced. Marginal cost is the increase in total cost that results from increasing production by one unit of output. Marginals -- including marginal costs and marginal revenue -- are key concepts in mainstream economic thought.

Falling and Rising Costs

Economists often use graphs, similar to supply-and-demand charts, to illustrate cost theory and firms’ decisions about production. An average total cost curve is a U-shaped curve on an economic diagram that illustrates how average total costs decline as output rises and then rise as marginal costs increase. Average total costs decline at first because as production rises, average costs are distributed over a larger number of units of output. Eventually, marginal costs of increasing output rise, which increases average total costs.

Maximizing Profits

Economic theory holds that the goal of a firm is to maximize profit, which equals total revenue minus total cost. Determining a level of production that generates the greatest level of profit is an important consideration, one that means paying attention to marginal costs, as well as marginal revenue, which is the increase in revenue arising from an increase in output. Under cost theory, as long as marginal revenue exceeds marginal cost, increasing production will raise profit.

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  • Principles of Economics, 3rd Edition; N. Gregory Mankiw
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