COSTS

Q) What are money costs? A) Money costs of production refer to the expenditure on hiring or buying of inputs for
producing a given output. Thus, the money spent on payment of wages and salaries of employees of the firm; payment for raw materials that go into the production of the commodity including power, lighting, fuel and transportation; payment of interest on capital employed; depreciation of machinery in the process of production; payments for insurance against risks, are all parts of the firms money costs of production.

Q) What are Real Costs? A) Real costs refer to the toil, pain, discomfort and sacrifice involved in supplying the
factors of production by their owners and also sacrifices involved in saving the capital. Since elements like pain, discomfort and sacrifice are subjective, it is difficult to measure real costs.

Q) What are Explicit Costs? A) Explicit costs of production refer to money expenses incurred on both hired factor
inputs as well as purchased non-factor inputs. These include wages, rent, interest and payments made for raw materials, payment for the use of power, payment for insurance, advertising, transportation etc.

Q) What are Implicit Costs? A) The costs of self-owned resources employed in the production of a commodity are
known as implicit costs. These include payment for self-owned premises (imputed rent), self-invested capital (imputed interest) and wages of self-labour. These imputed payments are, generally, overlooked while calculating the expenses by a producer. The total cost of production of a commodity consists of explicit costs and implicit costs.

Q) What is Opportunity Cost? A) Economic resources are limited and they have alternative uses. A particular factor can
be put to one use at a time. It cannot be put to different uses simultaneously. For instance a piece of land may be used either for cultivation or for residential flats or for commercial centre or for school building etc. Scarcity of resources having alternative uses has given birth the notion of opportunity cost in Economics. Opportunity cost of a commodity is the next best alternative sacrificed in order to produce that commodity. For instance if a piece of land which is equally fit for production of wheat and rice, yields Rs. 1,000/- from cultivation of wheat, this sum will be the opportunity cost of cultivating rice. It is also defined as the Cost of foregone alternatives or alternative cost or transfer earnings.

Q) What is private cost?

A) Private costs refer to the costs incurred by a firm in producing a commodity. It is

actually the money cost which a firm incurs on hiring and purchasing the services of factors of production for producing a commodity. This cost has nothing to do with the society.

Q) What are social costs? A) Social costs refer to the costs of producing a commodity to the society as a whole. It
does not take into account money cost but something like real costs which are borne by the society directly or indirectly. For example, when trees of a forest are felled indiscriminately by a private contractor, the community incurs social costs in the form of floods, soil erosion, loss of sanctuary for animals, etc. When factories pollute the atmosphere, the social cost to the community takes the form of additional medical bills, additional washing bills for clothes etc. Social cost is not included while working out the cost of producing a commodity by a firm.

Q) What are Total Fixed Costs (TFC) / Supplementary Costs / Overhead Costs? A) Fixed costs are the costs which do not change with the change in size of output during
short-period. These are a part of total costs of a firm. These are incurred primarily on fixed factors like machines, buildings, top-management, insurance, etc. whose supply remains fixed in the short-period. An increase or decrease in production does not affect fixed costs. Production may come down to zero or be doubled, fixed costs remain the same. These are also known as Over-head costs. The concept of fixed cost is explained with the help of a schedule and figure below. Since fixed cost remains fixed TFC curve is always parallel to OX-axes. TFC are present only in the short-run and not in the long-run because all costs become variable in the long-run. Output TFC (Rs.) 0 10 1 10 2 10 3 10 4 10 5 10

Q) What is Average Fixed Cost (AFC)? A) AFC is the per unit fixed cost of producing a commodity. AFC is derived by dividing
the total fixed cost by the number of units of commodity produced. For instance if total fixed cost of producing 10 pens is Rs. 100, then AFC will be Rs. 10. AFC = TFC / No. of units produced. Total fixed costs remains fixed at different level of output. Consequently, when units of output increase, AFC falls. The concept of AFC is shown with the help of a table and diagram. Output TFC (Rs.) AFC

0 1 2 3 4 5

10 10 10 10 10 10

10 5 3.3 2.5 2

Graphically, AFC curve will be a downward sloping curve. This curve will never touch the OX-axis because AFC cannot be zero, however, large the level of output may be. Similarly, AFC curve never touches the OY axis. It is so, because TFC is positive value at zero output and positive value divided by zero will provide infinite value. AFC curve is a rectangular hyberbola. The AFC curve continuously decreases as output increases, because the numerator of the ratio TFC/Output is constant while the denominator increases.

Q) What are Total Variable Costs (TVC) / Direct Costs / Prime Costs? A) Variable costs are costs which vary directly with changes in the size of output. These
refer to that part of total costs which are incurred on variable factors of production like labour, raw materials, power, fuel, wear and tear of machines etc. The supply of variable factors can be changed according to the level of output. Such costs increase when output increases and decrease when output falls. That is why they are called direct costs because they change directly with the change in the level of output. When the production stops variable costs become zero. TVC are also called Prime Costs. TVC are shown in the below table and diagram. The TVC curve moves upward with the increase in output. Output TVC (Rs.) 0 1 2 3 4 5 0 10 12 15 24 50

Q) What are Average Variable Costs (AVC)? A) Average Variable Cost is the per unit variable cost of producing a commodity. This is
calculated by dividing TVC by number of units produced. For example, if TVC of manufacturing 10 pens is Rs. 100, then AVC will be Rs. 10. AVC = TVC / No. of Units produced. The concept of AVC is explained with the help of a schedule and diagram. Output TVC (Rs.) AVC (Rs.) 1 10 10

2 3 4 5

12 15 24 50

6 5 6 10

In the beginning AVC decreases but after reaching the stage of minimum cost, it starts increasing. Consequently, AVC becomes usually U-shaped because of Law of Diminishing Returns. When the firm experiences increasing returns it has diminishing cost and vice-versa. Initially, the firm requires less number of variable factors and later more as output increases.

Q) Bring out the difference between Fixed Costs and Variable Costs.
1. Fixed Costs Fixed costs are incurred on the fixed factors of production like machines, buildings, insurance, top-management etc. TFC do not increase or decrease with the level of output. TFC are related with fixed factors which can not be changed during shortperiod. Fixed costs are never zero even when production is stopped. Production even at the loss of TFC may continue. TFC curve is parallel to OX-axis. It always begin at a point above the zero axis. Variable Costs 1. Variable costs are incurred on variable factors of production like labour, raw materials, electricity, transport, etc. 2. TVC changes with changes in the level of output. 3. TVC are related with variable factors capable of being changed during shortperiod. 4. Variable costs become zero when production is stopped. 5. A firm continues production only when TVC are met. 6. TVC curve rises upwards. It starts from zero axis because at zero level of output TVC = O.

2. 3. 4. 5. 6. 7.

Q) What is Total Cost (TC)? OR Show relationship between TFC, TVC and TC.

A) Total cost is the total expenditure incurred by the firm on procuring factor inputs and
non-factor inputs required for production of a commodity. It is the sum total of total fixed costs and total variable costs. Symbolically, TC = TFC + TVC. TC is explained with the help of schedule and figure. Output TFC TVC TC 0 10 0 10 1 10 12 22 2 10 15 23 3 10 24 34 4 10 50 60 From the above table and diagram, we can infer that (i) During short-period since TFC remains constant irrespective of size of output, changes in total costs is entirely due to change in TVC. As a result TC curve and TVC curve have similar shapes except that TVC curve starts from zero level of output whereas TC curve starts on OY axis from a point having distance equal to TFC. (ii) As the distance between TC curve and TVC curve remains the same (i.e., equal to TFC), the two curves remain parallel to each other. They never intersect because TFC can never be zero. (iii) By definition, the TC is the vertical summation of TFC and TVC curves. (iv) Notice that, at zero level of output, TC = TFC, because TVC = zero when output is zero.

Q) What is Average Cost (AC) / Average Total Cost (ATC)? A) AC/ATC is the per unit cost of production of a commodity. It is calculated by dividing
the total cost of the number of units of a commodity produced. AC/ATC : TC / No. of Units produced. Suppose TC of production of 10 pens is Rs. 100. In this case, cost per pen or AC is Rs. 10. Alternatively AC can also be got by adding AFC and AVC. Symbolically, AC = AFC + AVC. Average cost is also termed as average total cost (ATC). Average cost is explained with the help of a schedule and a diagram. Output AC / ATC 1 20 2 18 3 16 4 14 5 14 6 16 AC curve is generally U shaped curve because of Law of Diminishing returns. When the firm experiences increasing returns it has diminishing cost and vice-versa. We can also explain the reason for U-shape of the AC curve on the basis of AVC and AFC. Initially, as the output increases AVC and AFC both fall. Since AC = AFC + AVC, AC also declines. Then at higher levels of output AVC rises and AFC becomes negligible. The AVC overshadows AFC and hence it pulls up the AC curve. Hence AC takes U-shape.

Q) Why is Average Cost Curve U-shaped? A) Average Cost Curve in short-run and long-run is U-shaped. It means that at first this
curve falls and after reaching the minimum point it begins to rise. The following are the main causes of the U-shape of AC curve. (i) Basis of AFC and AVC : AC is the summation of AFC and AVC. With every increase in output AFC continues to fall. AVC continues to fall in the beginning till it reaches its minimum point. Then it begins to rise. Thus, AC tends to decrease initially, stabilize subsequently and rises finally. It finally rises because at later stages of output AFC is over-shadowed by AVC. (ii) Basis of Laws of Variable Proportions : Initially when variable factors are combined with a fixed factor, then the fixed factor is more efficiently used. Consequently AC begins to diminish. After the fixed factors have been optimally used, production increases at a diminishing rate. This signifies the operation of Law of Diminishing Returns to a factor or Law of Increasing Costs. That is why AC curve begins to rise. (iii) Basis of Internal Economies & Diseconomies of Scale : When a firm in the long-run increases its production then it enjoys several types of economies like technical economies, marketing economies etc. As a result of it AC begins to fall and AC curve slopes downwards. However after a given limit of production, the firm experiences diseconomies of scale. Consequently, AC begins to rise and AC curve begins to move upwards.

Q) What is Marginal Cost (MC)? Define Marginal Cost. A) Marginal Cost is addition to the total cost when an additional unit of a commodity is
produced or when output is increased by one unit. For example, if the TC of producing 10 pens is Rs. 100 and if it goes up to Rs. 108 by producing 11 pens, in this case MC is Rs. 8 (Rs. 108 Rs. 100) which is an addition to the TC (Rs. 100) when an additional unit (11 pen) is produced. MC is related to TVC and not to TFB since TFC remains the same in the short-period. Hence MC can be defined as the increase in TVC when one extra unit is produced. Moreover, TVC is equal to the sum of MC(MC = TVCn TVCn1) (TVC = MC1 + MC2 + MC3 + MCn). Output MC 1 8 2 5 3 3 4 4 5 6 6 9 MC curve is initially decreasing as output increases and then it is increasing, i.e., it is U-shaped. The reason behind the U-shape of the MC curve is the law of diminishing returns. This law states that as other inputs are kept unchanged, an increase in any given input leads first to an increase in its MPP, and, then, after certain point, leads

to a decrease in its MPP. Hence, as more and more output is produced initially, the rate of increase in the requirement of the variable input will be less and less, and, after a certain point, it will be more and more. This implies that, initially, the rate of increase in TVC which is same as MC will be less and less as output increases, and then, it will be more and more when output increases further. This explains the U-shape of MC curve or (when the firm experiences increasing returns, the cost per unit will decline and when the firm experiences diminishing returns, cost per unit will increase).

Q) How is TVC derived from MC curve? A) TVC is the sum of the marginal costs.
TVC is equal to the area under the marginal cost curve. For eg. at OQ level of output, the TVC is equal to the area OABQ.

Q) Explain the relationship between MC, AC (ATC), AVC & MC. A) Define MC, AVC, AC/ATC and AFC as
given in earlier questions. The relationship between different costs is explained with the help of a graph. AFC curve is continuously falling downwards because as production increases TFC is getting divided with more number of units produced. Since TFC is constant at all levels of output AFC falls. Initially, it falls sharply, later the rate of fall shows down. I. Relationship between AC / ATC and MC : (i) Both are U-shaped curves because of Law of Diminishing Returns. (ii) When MC declined AC also declines but the fall MC is more. Hence MC curve is below AC curve. (iii) MC reaches it minimum point before AC reaches its minimum point. Hence MC starts rising even though AC is declining. (iv) MC = AC / ATC when AC is at its lowest point called Point of Optimum Capacity. MC curve cuts AC curve from below at its lowest point. (v) After the point of optimum capacity when MC rises AC also rises but the rise in MC is fast (or (i) As long as AC > MC, AC falls. Hence, MC curve is below AC curve (ii) AC = MC when AC is at its lowest. Hence, MC curve cuts AC curve from below (iii) when MC > AC, AC rises. Hence MC curve is above AC curve). II. (i) (ii) Relationship between MC and AVC : Both the curves (AVC & MC) are U-shaped curves because of Law of Diminishing Returns. When MC declines AVC also declines

but the fall in MC is steeper. Hence, MC curve is below AVC curve. (iii) MC reaches its minimum point before AVC reaches its minimum point. Hence MC starts rising before AVC. (iv) MC = AVC when AVC is at its minimum. MC curve cuts AVC from below at its lowest point. [OR (i) when AVC > MC, AVC falls. Hence MC curve is below AVC curve. (ii) AVC = MC when AVC is at TC lowest (iii) When MC > AVC, AVC rises. MC curve will be above AVC curve] Relationship between AVC and AC/ATC : Both AC & AVC are U-shaped curves because of Law of Diminishing Returns. (ii) AC is obtained by dividing TC with output and AVC is obtained by dividing TVC with output. AC/ATC is the summation of AFC and AVC. (iii) Since TFC remains constant at levels of output AC is influenced by AVC. (iv) When AVC declines AC also declines. AVC curve is below the curve since AC = AFC + AVC. (v) AVC reaches its minimum point before AC reaches its lowest Point because AC = AFC + AVC. (vi) When AVC rises AC also rises. Hence both the curves have U-shaped. (vii) Initially there is a big gap between AC and AVC because of large AFC and the gap narrows down with the increase in output because of fall in AFC (since TFC remains constant). AVC curve comes closer to AC/ATC curve but never touches it because AFC can never be zero. III. (i)

Q) Do fixed costs affect marginal costs? A) Fixed costs do not affect marginal costs. Marginal cost is the additional cost of
producing an additional unit of the commodity. And this additional cost is in fact variable cost because fixed cost remains constant irrespective of units of the commodity produced. Therefore, fixed costs do not affect marginal costs. It is variable costs which influence marginal costs. (MC = TVCn TVCn1) (TVC = MC1 + MC2 + MC3 + MCn).

Q) Can MC rise when AC is falling? A) It is not necessary that when AC declines, MC should also decline necessarily and
when AC increases, MC should also necessarily increase. When AC is falling MC may fall or may not. In other words, it is possible that AC is declining and MC is rising. In the diagram, upto OQ, level of output, AC and MC both are declining. After OQ level of output, MC and AC both are increasing. However, from OQ, level of output, AC is declining and MC is increasing. According to the diagram, the lowest point of MC is before

the lowest point of AC.

Q) Why does MC curve intersect AVC and AC curves at their lowest point? A) We know that as long as MC is less than AVC or AC, the two curves cannot rise. The
AVC curve falls till the point B in the diagram because MC lies below it. At the point of intersection AVC = MC but after point B. MC rises and becomes greater than AVC and therefore AVC gets pulled up making automatically the minimum point of AVC curve. Similarly, till point C we find MC < AC, therefore, AC keeps falling but beyond this point MC > AC pulling AC upwards and making point C its minimum point. Therefore MC always intersects AVC and AC/ATC at their minimum points.

Q) Show the relationship between Total Cost and MC. A) (i) TC is the summation of TFC and TVC. MC is the addition to the TC by producing
an additional unit (MC = TCn TCn1). (ii) When the TC rises at diminishing rate MC declines. (iii) When the rate of increase in the stops diminishing, the MC is at its minimum. (iv) When the rate of increase in TC starts rising, the MC is increasing.

Q) Classify the following into fixed costs or variable costs. A) (a) Rent for a shed. F.C.
(b) (c) (d) (e) (f) (g) (h) Minimum telephone bill Cost of raw materials Wages to permanent staff. Interest on capital Transportation charges Telephone charges beyond minimum Daily Wages F.C. V.C. F.C. F.C. V.C. V.C. V.C.

Q) What is the relationship between MC and AVC?

A) Both MC and AVC curves are U-shaped but the rate of rise and fall of MC curve is
higher than that of AVC curve. MC curve intersects AVC curve at its lowest point.

Q) How does TFC changes when output changes? A) TFC does not change when output changes as it remains fixed irrespective of the level
of output (in the short-run).

Q) How is TVC derived from MC schedule? A) TVC is the sum of MCs. TVC = MC1 + MC2 + MCn. Q) How can one obtain TVC from MC curve? A) TVC is equal to the area under the MC curve as TVC is the sum of MCs. Q) What is the general shape of the AFC curve? A) The general shape of AFC curve is of rectangular hyperbola showing at all points the
magnitude of TFC is same.

Q) What are the general shapes of AC and MC curves? A) AC and MC curves are generally U-shaped because of law of diminishing returns. Q) What will happen to ATC when MC > ATC? A) When MC > ATC, ATC is increasing beyond the range of output corresponding to the
minimum point of ATC.

Q) With increase in output, the AVC and the ATC curves come closer and closer. Why? Can they meet? Give reasons in support of your answer. Or do ATC and AVC curve intersect? Give reason for your reason. A) AFC is the fixed cost per unit of output since TFC is a constant quantity, AFC will
steadily fall as output increases and slopes downward. When output becomes very large, AFC approaches the OX axis, but never touches it because AFC cant be zero. AVC is the TVC divided by the number of units of output. AVC curve will fall initially because of the occurrence of increasing returns but beyond the normal capacity output, TVC would increase because of diminishing returns. AFC keeps on becoming smaller and smaller. Therefore, the vertical distance between ATC and AVC keeps on becoming less and less, then AFC approaches zero, ATC approaches AVC, and ATC seems to be coming closer and closer to AVC. These two curves would seem to meet but they would never meet (ATC = AVC + AFC) because AFC can never be zero. Though it may become extremely small when output becomes quite large.

Q) What is the relationship between TC, TVC and TFC? A) TC of a firm is the sum of its TVC and TFC. TC = TFC + TVC. Fixed costs are costs
which do not vary with output and cannot be altered in the short-run. TFC remains constant when the output is increased. Therefore, TFC curve is a straight line parallel to the OXaxes. TVC vary with the level of output. TVC is zero when nothing is being produced. It is positively sloped starting from zero. In the initial stages of rises at diminishing rate and then it starts rising at an increasing rate. TC curve can be attained by adding vertically TFC + TVC. TC is the sum of TFC and TVC. The shape of the TC curve is exactly the same as that of TVC.