Cost: Concepts

Cost of production:
Cost involved in a production process is called the cost of production.
These costs are associated with the price paid for employing different factors of production in
a production process.
A Firm changes its output by varying its variable factors like labour, raw materials in short run
production process and it changes its output by varying its fixed as well as variable factors in
long run production process.
Short Run and Long Run Costs

Long run costs have no fixed factors of production, while short run costs have fixed factors and
variables that impact production.

Cost Concepts
1. Nominal Cost and Real costs
Nominal Cost
Nominal cost is the money cost of production. It is also called expenses of production. These
expenses are important from the point of view of the producer. These expenses are paid out by
him to the factors he employs or for the raw materials he uses in production.
Real cost
The real cost of production has been variously interpreted. Adam Smith regarded pains and
sacrifices of labour as real cost of production. Marshall included under it the “real cost of efforts
of various qualities”, and “real cost of waiting.” This Marshall called as the social cost of
production. Some economists define real cost as the next best alternative sacrificed in order to
obtain a commodity. It is also called opportunity cost or displacement cost
2. Explicit and Implicit costs
Explicit costs
Explicit costs are also called paid-out costs. These costs the entrepreneur has to pay to those
persons from whom he has obtained factors of production or services.
Implicit costs
Implicit costs, on the other hand, are costs which have not to be paid out to others but the costs
which the entrepreneur pays to himself, as it were.
3. Opportunity cost:
The cost of any activity measured in terms of the value of the next best alternative forgone (that
is not chosen).
 4. Production costs
Production costs refer to the total amount of money spent in the production of goods. They
include the cost of raw materials and freight thereon, the costs of manufacture, i.e., the wages
of workers engaged in the manufacture of the commodity and salaries of the manager etc. They
also include other overheads like rent, interest on capital, taxes, insurance and other incidental
expenses like costs of repairs and replacements. They include both prime costs and
supplementary costs.

5. Selling Costs:
Selling costs are the costs of marketing, advertisement and salesmanship. These costs are
incurred to attract customers, expand market and capture more business and retain the existing
business. These costs are essential costs of the competitive economy. They are especially
important in the case of imperfect competition in which goods are not identical but substitutes.

Cost of production

1. Total Cost: In economics, the total cost (TC) is the total economic cost of production.
It consists of variable costs and fixed costs.

2. Fixed costs or Supplementary costs are the costs in a production process associated
with factors of production which are considered to be fixed in the short run (eg: rent
paid on land). Fixed costs exist even when production is stopped.

3. Variable costs or Prime costs are the costs which are associated in a production
process associated with factors of production which vary in short run as well as long
run (eg: wages paid to labour). All fixed costs become variable costs in long run.
However, a variable cost exists only when production is in progress.
Difference between fixed and variable costs
Economic Cost

The economic cost of a decision that a firm makes depends on the cost of the alternative chosen
and the benefit that the best alternative would have provided if chosen. Economic cost is the
sum of all the variable and fixed costs (also called accounting cost) plus opportunity costs.

Components of Economic Costs

Economic cost takes into account costs attributed to the alternative chosen and costs specific
to the forgone opportunity. Before making economic decisions, there are a series of
components of economic costs that a firm will take into consideration. These components
include:

 Total cost (TC): total cost equals total fixed cost plus total variable costs (TC = TFC +
TVC).
 Variable cost (VC): the cost paid to the variable input. Inputs include labor, capital,
materials, power, land, and buildings. Variable input is traditionally assumed to be labor.
 Total variable cost (TVC): same as variable costs.
 Fixed cost (FC): the costs of the fixed assets (those that do not vary with production).
 Total fixed cost (TFC): same as fixed cost.
 Average cost (AC): total costs divided by output (AC = TFC/q + TVC/q).
 Average fixed cost (AFC): the fixed costs divided by output (AFC = TFC/q). The average
fixed cost function continuously declines as production increases.
 Average variable cost (AVC): variable costs divided by output (AVC = TVC/q). The
average variable cost curve is normally U-shaped. It lies below the average cost curve,
starting to the right of the y axis.
 Marginal cost (MC): the change in the total cost when the quantity produced changes by
one unit.
 Cost curves: a graph of the costs of production as a function of total quantity produced.
In a free market economy, firms use cost curves to find the optimal point of production
(to minimize cost). Maximizing firms use the curves to decide output quantities to
achieve production goals.

Average and Marginal Cost

Marginal cost is the change in total cost when another unit is produced; average cost is the total
cost divided by the number of goods produced.

Relationship Between Average and Marginal Cost

Average cost and marginal cost impact one another as production fluctuate:
 When the average cost declines, the marginal cost is less than the average cost.
 When the average cost increases, the marginal cost is greater than the average cost.
 When the average cost stays the same (is at a minimum or maximum), the marginal cost
equals the average cost.

Short Run Costs

TC
In Short run, as output increases
Cost

TFC Remains constant TVC

Increases at increasing rate initially TFC

TVC and later increases at decreasing rate and
again increases at increasing rate
Increases at increasing rate initially
Output
TC and later increases at decreasing rate and
again increases at increasing rate MC
AFC
AC
AFC Decreases

AVC Decreases initially and then increases

Cost

AC Decreases initially and then increases AVC

MC Decreases initially and then increases

Output
 Relation between MC, AC and AVC
• MC curve cuts AC and AVC curve at their lowest point
• MC curve rises more steeply than AC and AVC

AFC MC
AC
Cost

Shapes of the cost curves

AVC
AC U shaped curve
AVC saucer shaped curve

AFC Rectangular hyperbola

Output
MC U shaped curve

Formulas of costs
1. TC = TVC + TFC
2. AFC = TFC/ Q
3. AVC = TVC/ Q
4. AC = TC/Q
5. AC = AFC + AVC
6. MC = ΔTC/ΔQ