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6 - Cost

Cost refers to the total expenditure incurred in producing a commodity, including explicit costs (actual payments) and implicit costs (imputed value of self-owned inputs). There are three types of costs: fixed costs that do not vary with output, variable costs that do vary with output, and total costs which are the sum of fixed and variable costs. Total, average, and marginal costs are important cost concepts, with total cost being the sum spent and average and marginal costs referring to per-unit costs. These various cost curves typically take U-shapes over different ranges of output as costs behave differently in the short run due to laws of variable proportions.

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39 views

6 - Cost

Cost refers to the total expenditure incurred in producing a commodity, including explicit costs (actual payments) and implicit costs (imputed value of self-owned inputs). There are three types of costs: fixed costs that do not vary with output, variable costs that do vary with output, and total costs which are the sum of fixed and variable costs. Total, average, and marginal costs are important cost concepts, with total cost being the sum spent and average and marginal costs referring to per-unit costs. These various cost curves typically take U-shapes over different ranges of output as costs behave differently in the short run due to laws of variable proportions.

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nai
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter - 6

Cost
 Meaning of Cost:
 Refers to the total expenditure incurred in producing a commodity
 It is the total sum of actual expenditure (explicit cost) and the imputed value of the inputs supplied by
the owners(implicit cost)
 Explicit cost and Implicit cost:
 Explicit cost : It is the payment made to outsiders for hiring factor services. It is the actual money
expenditure on buying and hiring inputs.
 Example: payment of wages, rent , raw materials, etc.
 Implicit cost: It is the cost of self occupied factors.
 It is the estimated value of the inputs supplied by the owners.
 It involves imputed value of factors owned by the firm. There is no money payment involved.
 Example: interest on own capital, rent of own land, salary for the services of entrepreneur.
 Cost Function: Refers to the functional relation between cost and input.
 C = f(q), C = cost of production, q = quantity of output, f = functional relationship.
 Types of Costs:
1. Fixed Cost/ Total fixed cost: Refers to those cost which do not vary directly with the level of output.
 It cannot be changed in the short run.
 It can never be zero even if there is no production.
 It is incurred on fixed factors liked land building etc.
 TFC curve is a horizontal straight line parallel to the x axis as fixed cost remains the same at all
level of output.
 It is also known as Supplementary cost, Overhead cost, Indirect cost, General cost or Unavoidable
cost.
 Example: salary of permanent staff, Building rent, telephone rent, etc.
2. Variable cost/ Total variable cost: Refers to those cost which vary directly with the level of output.
 It can be changed in the short run.
 It is zero when there is no production.
 It is incurred on variable factors like labour, raw material, etc.
 TVC curve is inversely S shaped as variable cost increases initially at a decreasing rate( because of
better utilisation of fixed factor and increase in efficiency of variable factor) and later at an
increasing rate ( because of fall in efficiency of variable factors due to limitation of variable factors).
As it operates on law of variable proportion.
 It is also known as Prime cost, Direct cost or Avoidable cost.
3. Total Cost: Refers to the total expenditure incurred by the firm on the factors of production required
for the production of a commodity.
 TC= TFC+ TVC It is the sum total of total fixed cost and total variable cost at various levels of
output.
 TC curve is inversely S shaped as it derives its shape from TVC and because of law of variable
proportion.
 The change in TC curve is entirely due to TVC, as TFC remains constant. By adding TFC and TVC
curve we get TC curve.
 Vertical distance between TC and TVC always remains the same due to constant TFC.
 TC = TFC at zero level of output.
 Relationship between TC, TFC and TVC:
 TFC is a horizontal straight line parallel to x-axis as it is constant.
 TC and TVC curves are inversely S-shaped due to Law of Variable Proportions.
 At zero output, TC is equal to TFC and both starts at the same point which is above the origin.
 The vertical distance between TFC and the TC curve is equal to the TVC.
 The vertical distance between TVC and TC is equal to TFC. Also TVC and TC curves are parallel to each other.

 Average Cost / Per Unit Cost:


 Average Fixed Cost/AFC is per unit fixed cost of production. AFC=TFC/Q
 AFC falls with rise in output as TFC is constant.
 AFC curve slopes downwards as it falls with increase in output and is a rectangular hyperbola (i.e. area under the
curve remains same at all places)it can never become zero.
 AFC can never touch the x-axis as TFC can never be zero and it can never touch y-axis as TFC is positive at zero
output. (Refer table no. 6.4 and fig. no.6.4)

 Average Variable Cost/AVC:


 Is per unit variable cost of production. ATC=TVC/Q
 AVC initially decrease with increase in output, then becomes constant and starts increasing when the output
reaches the optimum level
 AVC is a U-shaped curve due to the three phases of law of variable proportions.(Refer table no. 6.5 and fig. no.
 Average total cost or Average cost (ATC or AC) is the per unit total cost of production.
ATC=AFC+AVC or AC=TC/Q
 ATC also falls initially, reaches its minimum point becomes constant and then starts rising, due to
law of variable proportion.
 ATC is also a U-shaped curve as it takes the shape of the AVC.

 Important observations from AC, AVC and AFC:


 AC curve always lie above the AVC curve as it includes AVC and AFC at all levels of output.
 AVC reaches its minimum (point A) at a level of output lower than that of AC (point B) because when
AVC is at its minimum, AC is still falling due to falling AFC.
 As the output increases, the gap between AC and AVC curves decreases, never intersect each other as
AFC can never be zero.
Output TFC (₹) TVC (₹) TC AFC(₹) AVC (₹) ATC
in units =TFC+TV = = =AFC+AV
(Q) C (₹) TFC/Q TVC/Q C (₹)
0 12 0 12 - - -
1 12 6 18 12 6 18
2 12 10 22 6 5 11
3 12 15 27 4 5 9
4 12 24 36 3 6 9
5 12 35 47 2.4 7 9.4
.

 Marginal Cost: Refers to the addition to total cost when one more unit of output is produced. MC =
TCn – TCn-1, or MC = Change in TC/Change in Q or MC= TVCn – TVCn-1.
 MC initially falls till it reaches its minimum point and thereafter it starts rising.
 MC curve is a U shaped curve due to Law of variable proportion.
 Relationship between short run cost curves :
 Relationship between AC & MC:
 When MC is less than AC, AC falls with increase in output.
 When MC becomes equal to AC, AC becomes minimum & constant.
 When MC is more than AC, AC rises with increase in output.
 MC increases at a faster rate than AC and becomes steeper than AC curve.
 Relationship between AVC & MC:
 When MC is less than AVC, AVC falls with increase in output.
 When MC becomes equal to AVC, AVC becomes minimum & constant.
 When MC is more than AVC, AVC rises with increase in output.
 MC increases at a faster rate than AC and becomes steeper than AC curve.
 Relationship between AC & AVC:
 AC is greater than AVC by the amount of AFC.
 The vertical distance between AC and AVC falls due to fall in the AFC.
 AC and AVC can never intersect each other as AFC can never be zero.
 Both AC and AVC are U-shaped due to law of variable proportions.
 MC cuts AC and AVC at their minimum points.
 The minimum point of AC lies to the right of the minimum point of AVC.

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