Concepts of cost.

Learning Objectives:
1) To explain the concept of cost.
2) To analyze the short run costs of production.
a) Fixed and Variable costs- Behavior of Fixed cost , Variable Cost and Total Cost.
b) Average Cost- Fixed and variable components of Average Cost.
c) Marginal Cost- Estimation and behavior of MC
3) To examine the relation between Average, Marginal and Total Cost.
 Concept of Cost
Cost refers to the expenditure incurred by a producer (explicitly or implicitly )
on the factor as well as non-factor inputs for a given output of a commodity.

Explicit and Implicit Cost:

Expenditure incurred by the producer on the purchase of inputs from the

market is called explicit Cost.

Estimated expenditure on the use of self -owned inputs is called implicit cost.

Total Cost= Explicit cost + Implicit cost.

Distinguish between Explicit and
implicit Cost.
Explicit Cost Implicit Cost
1) It is the opportunity cost of 1) It is the opportunity cost of
purchasing inputs from the using self –owned inputs.
market .
2) It is measured in terms of
2) It is measured in terms of cash imputed costs (or estimated
payments that a firm makes to costs) of the self –owned and
others for the purchase of inputs. self –employed resources.

Eg: Wages paid to the workers , Eg: Estimated rent on

payment of electricity bill . entrepreneur’s own building,
estimated Interest on
entrepreneur’s own capital.
 Opportunity cost refers to the total sacrifice made (in
terms of explicit or implicit cost) for producing a given
level of output.s
Selling Cost.
It refers to the expenditure incurred by the producer to promote sale of the
commodity. Eg: Expenditure on advertisement.

Production Cost:
It refers to the expenditure incurred by a producer on the inputs for producing
a given level of out put.
 Short run Costs of production
Short run is a period of time during which some factors are fixed and
some are variable.
Short period costs are divided into two components
1) Fixed costs , referring to expenditure on fixed factors.
2) Variable costs, referring to expenditure on variable factors .

TC= TFC+ TVC

TC= Total Cost.
TFC= Total Fixed Cost.
TVC= Total Variable Cost.
 Fixed Costs
Fixed costs are the sum total of expenditure incurred by the producer on the
purchase or hiring of fixed factors of production.
Fixed costs are the costs related to the use of fixed factors of production
These are also called supplementary costs or overhead costs or indirect costs.
These costs do not change with the change in output. Fixed costs are incurred
even when output is zero.
Principal Components of
Fixed Costs .
1) Expenditure on machine and plant.
2) Expenditure on land and building
3) Licence fee
4) Wages and salaries of permanent staff
 Total Fixed Cost.
Units Total Fixed Cost (Rs)
of
output
0 10
1 10
2 10
3 10
4 10
5 10
6 10

TFC is horizontal straight line ,showing that TFC is constant at all levels of
output. It is= Rs 10 , even when output is zero.

Fixed costs do not change with increase or decrease in output. These are
constant costs . These are incurred even when output is zero.
 Variable costs
Variable costs are the expenditure incurred by the producer on the use of
variable factors of production.

When output changes, these costs also change. As the output increases,
these costs also increase, and as the output decreases, these costs also
decrease.

When output is zero, these costs are also zero. These costs are called
Prime Costs or Direct Costs.
Principal Components of Variable
Costs
1) Cost of raw material.
2) Wages of casual workers.
3) Expenses on electricity.
4) Wear and tear expense.
 Total Variable Costs
Units of out Total Variable Cost
put
0 0
1 10
2 18
3 24
4 28
5 32
6 38
TVC increases with increase in output. Between O---A, TVC increases at a decreasing rate.
TVC increases
Beyond point A,with
TVC increase
increasesinatoutput. Between
an increasing O---A, TVC increases at a decreasing rate.
rate.
- Beyond
Initiallypoint A, TVC increases
TVC increases at an increasing
at a diminishing rate.
rate .(till point A) – This is because of
- Initially TVC
increasing increases
returns at a diminishing
to a factor. ( MP of the rate .(tillfactor
variable point A) – This
tends to is because
rise or MC of the
increasing
variable returns
factor tendstotoa fall.)
factor. ( MP of the variable factor tends to rise or MC of the
- variable
Eventually factor
TVCtends to fall.)
increases at an increasing rate. (beyond point A) – This is the situation
of- Eventually
diminishingTVC increases
returns at an increasing
to a factor. (MP of therate. (beyond
variable factorpoint A) – This
is falling is the
or MC situation
of the
of diminishing
variable factor isreturns
rising) to a factor. (MP of the variable factor is falling or MC of the
variable factor is rising) TVC curve is inversely S-shaped.
 Distinguish between Fixed Costs
and Variable Costs.
Fixed Costs Variable Costs

1) Fixed costs are the costs incurred on 1) Variable costs are the costs
the fixed factors of production. incurred on the variable factors of
production
2) Fixed costs do not change with
increase or decrease in output. 2) Variable costs increase with increase
in output and decrease with decrease
in out put.
3) Fixed costs remain constant even
when out put is zero. 3) Variable costs are zero when output
is zero.
4) Fixed Costs are incurred even before
output actually starts. 4) Variable costs are incurred only
when output actually starts.
 Behavior of FC, VC and TC
Out Put(Units Fixed Costs Variable Cost Total Costs
) (Rs) (Rs) (Rs)
0 10 0 10
1 10 10 20
2 10 18 28
3 10 24 34
4 10 28 38
5 10 32 42
6 10 38 48

TC= TFC+TVC
TFC is constant at all levels of output.
TVC increases as output increases
TC is parallel to TVC. It Shows that the difference between TC and TVC
(=TFC) is constant.
TC= TFC+TVC
TFC is constant at all levels of output.
TVC increases as output increases
TC is parallel to TVC. It Shows that the difference between TC and
TVC (=TFC) is constant.
TFC shows total fixed cost ,TVC shows total variable cost and TC
shows total cost .TC is the aggregates of TFC and TVC curves.
TC curve begins from 10 (on the Y –axis) .This is because at zero level
of output ,TFC=10 while TVC=0 so that TFC +TVC =10.
The difference between TC and TVC is constant, because of which TC
and TVC are parallel to each other.
The difference between TC and TVC is equal to TFC which is constant.
Average Cost.(AC)
Average cost is the cost per unit of out put produced. It is
also called unit cost of production.
AC= TC/Q

TC= Total Cost

Q= Quantity of output
 Fixed and variable components of AC

AC is the sum total of AFC (Average Fixed Cost) and AVC( Average Variable
Cost) .

1) Average Fixed Cost(AFC).

It is the fixed cost per unit of output.
AFC= TFC/Q
TFC= Total Fixed Cost.
Q= Quantity of Output.
Average Fixed Cost.

Out put (Units ) TFC ( Rs) AFC (Rs)

1 10 10
2 10 5
3 10 3.3
4 10 2.5
5 10 2
6 10 1.67
7 10 1.43
8 10 1.25
 AFC

AFC is a rectangular hyperbola. It shows that

1) AFC decreases as output increases
2) AFC x Q at any level of output is the same. Because
AFCx Q = TFC
Which is constant at all levels of output.
 Average Variable Cost

It is the variable cost per unit of output.

AVC=TVC/Q

TVC= Total Variable Cost

Q= Quantity of output.
AVC

Out Put (Units ) TVC (Rs) AVC (Rs)

1 10 10
2 18 9
3 24 8
4 28 7
5 32 6.4
6 38 6.3
7 46 6.6
8 62 7.7
AVC

AVC is U shaped .This is in accordance with the law of variable

proportions .
It falls so long as returns to a factor are increasing. It rises when returns to
a factor are decreasing .
AC curve is a vertical summation of AFC and AVC curves .

AC is the vertical summation of AVC and AFC at different levels of

output.
 Marginal Cost .(MC)
MC is the change in total cost when an additional unit of output is
produced.
MCn = TCn- TCn-1

Or
MC = Change in TC/ Change in Output.
 Estimation and behavior of MC
Out put (Units ) TFC(Rs) TVC(Rs) TC(Rs) MC(Rs)

0 10 0 10 -----
1 10 10 20 10
2 10 18 28 8
3 10 24 34 6
4 10 28 38 4
5 10 32 42 4
6 10 38 48 6
7 10 46 56 8
8 10 62 72 16
MC is U shaped in accordance with the law of variable proportions.
Initially, MC is falling. It is because MP tends to rise when there are
increasing returns to a factor. Subsequently, MC tends to rise. It is
because MP tends to fall when there are diminishing returns to a
factor.
MC is variable cost only.

MC is an additional cost. Additional cost by definition

can not be fixed cost. It can only be variable cost.
Therefore MC can be estimated in either of the
following ways.
MCn = TCn-TCn-1
Or
MCn= TVCn – TVCn-1

∑MC= TVC
 At OL level of output, area under MC curve
=OLSK. This is equal to TVC. This is because
TVC =∑ MC.
TVC is the sum total of marginal cost for each
unit of a given output.
 Relation between AC and MC
Out put (Units ) TC (Rs) AC (Rs) MC(Rs)

0 10 ∞ ----
1 20 20 10
2 28 14 8

3 34 11.3 6
4 38 9.5 4
5 42 8.4 4
6 48 8 6
7 56 8 8
8 72 9 16
1) When AC is falling , MC < AC
2) When AC is rising , MC > AC
3) When AC is constant( as at point E), MC=AC
4) MC is always to the left of AC, and cuts AC from its lowest point.
1)When AC falls, MC is lower than AC:-
When average cost falls, marginal cost is less than AC. AC is falling till it
becomes ₹ 8, and MC remains less than ₹ 8.
AC is falling till point E, and MC continues to be lower than AC.
2) When AC rises, MC is greater than AC:-
When average cost starts rising, marginal cost is greater than average cost.
When AC rises from ₹ 8 to ₹ 9 , MC rises from ₹ 8 to ₹ 16.
AC starts rising from point E. And, beyond E, MC is higher than AC.
3) When AC does not change, MC is equal to AC:-
When average cost does not change, then MC= AC. It happens when falling AC
reaches its lowest point. At the 7th unit, average cost does not change. It sticks
to its minimum level of ₹ 8 .Here, marginal cost is also ₹ 8.Thus MC curve is
intersecting AC curve at its minimum point.
Relationship between AVC
and MC
The relationship between AVC and MC is similar to
the relationship between AC and MC.

1) When AVC falls, MC <AVC

2) When AVC rises, MC>AVC
3) When AVC is constant , MC= AVC
(it is the lowest point of AVC)
 Relation between TC and MC
1) MC is estimated as the difference between TC of two successive units of output.
MCn= TCn-TCn-1
2) When MC is diminishing , TC increases at a diminishing rate .
3) When MC is rising , TC increases as an increasing rate .
4) When MC reaches its lowest point , TC stops increasing at a decreasing rate .

Up to point Q* , TC is increasing at a decreasing

rate , because MC is decreasing .
Beyond point Q*, TC is increasing at an
increasing rate , because MC is increasing .
At point Q*, TC stops increasing at a decreasing
rate, because MC touches its lowest point.

Note: The relation between TVC and MC

will be the same as between TC and MC,
because the difference between TC and
AC, AVC, AFC and MC in one diagram.
When AC declines, MC declines
faster than AC. So that MC
curve remains below AC curve.

When AC increases, MC
increasers faster than AC. So
that MC curve is above AC
curve,

Since MC declines faster than

AC, it reaches its lowest point
earlier than AC. So that MC
starts rising even when AC is
falling.
MC must cut AC from its lowest
point.
Form the data, calculate 1) AFC 2) AVC 3)MC

Out Put (Kg) TC (Rs)

0 40

1 100

2 120

3 130

4 150

5 190
Complete the following table

Output TC (₹) AVC (₹) MC (₹) AFC (₹)

(Units)

0 30 -- -- --
1 -- -- 20 --
2 68 -- -- --
3 84 18 -- --
4 -- -- 18 --
5 125 19 -- 6
Complete the following table

Output TVC (₹) AVC (₹) MC (₹)

(Units)

1 10 -- --
-- -- 8 6
3 27 -- --
-- -- 10 13
Complete the following table

Output (Units) AFC(₹) MC (₹) AVC (₹) A C (₹)

1 60 20 -- --

2 -- -- 19 --

3 20 -- 18 --

4 -- 18 -- --

5 12 -- -- 31