Cost Analysis

Introduction

Knowledge of cost functions is essential for understanding various topics such as profit maximisation, individual firms’ supply choices, market structures, pricing strategies, and regulation and policy analysis.

What are cost functions?

A cost function in economics describes the relationship between the quantity of output produced and the costs of producing that output. They are mathematical representations of how the costs of production vary with different levels of output. More precisely, a cost function is the result of minimising the cost of production given an explicit specification of technology (production function). Key points to understand include:

• Total Cost (TC): The minimal cost of producing different levels of output with a given specification of technology. Total cost can be split into fixed cost and variable cost.
• Fixed Costs (FC): Costs that do not change with the level of output. Common examples include rent or salaries of permanent staff. Fixed costs also occur if the firm produces zero output.
• Variable Costs (VC): Costs that vary directly with the level of output. Common examples include raw materials and hourly labour wages.
• Average Total Cost (ATC): Total cost divided by the number of units produced, revealing the per-unit cost.
• Marginal Cost (MC): The additional cost incurred by producing an additional unit of output.

General objectives of this section

The visualisations in this section pursue two key objectives:

• Clarify firms’ cost minimisation problem from given alternative specifications of technology (coming soon).
• Clarify total cost, fixed cost, variable cost, average total cost, average fixed cost, average variable cost, and marginal cost given explicit specifications of cost functions commonly used in economics.