Ch 06 Cost

Contents

 Introduction
 Concepts of Cost
 Short Run Costs
 Average Costs
 Marginal Cost
 Relationship between Short Run cost curves

Introduction
A firm uses various inputs to produce goods and services. Firm has to make payments from such inputs as they
do not come free. The expenditure incurred on these inputs is known as cost of production.

Concepts of Cost
1) Real Cost
It refers to sacrifice, mental and physical efforts spent to produce a commodity. This cost cannot be
measured in terms of money as it is subjective.
2) Social Cost
Social costs are the costs which the society has to bear on account of production processes in the
economy. It occurs due to environmental pollution such as noise pollution, air pollution and water
pollution.
3) Implicit Cost
Implicit costs are the costs of self-owned and self-employed resources by the firm including estimated
normal profits. For example, rent on entrepreneur’s own land, interest on its own capital and wages of
his own labour. These costs are difficult to measure because these costs do not involve cash payments.
These costs are imputed (estimated) value of self owned factors of production. It is also known as
indirect/non-expenditure costs.
4) Explicit Cost
Explicit costs are the cash payments made by the firms to outsiders for the purchase or hire of goods
and services, e.g. wages paid to labour, rent to landlord, and interest on loans taken. These costs are
also known as direct costs/ expenditure costs.
Total cost is the sum of actual money expenditure on inputs (explicit cost) and estimated value of the
inputs supplied by the owners (implicit cost).
5) Opportunity Cost
It is the value of a factor in its next best alternative use. It is also known as alternative cost.

Short Run Costs

1) Fixed Cost
Fixed costs are those costs which do not change with the change in the level of output. Production may
be maximum or zero, fixed cost remains the same. The expenses incurred on the fixed factors of
 production remain unchanged at all the levels of output. These include expenditure on rent,
depreciation, interest, salary of permanent staff, etc.
Output 0 1 2 3 4
(units)
Fixed Cost 20 20 20 20 20
(Rs)

Fixed cost is represented as a straight line parallel to X-axis. It

remains constant at all levels of output and it is positive at 0
output.

2) Variable Cost/Total Variable Cost

Variable costs are the costs which vary directly with the level of output. For example, payment of raw
material, power, fuel, and wages of daily labour, etc. variable cost are incurred on variable factors. If
output falls to zero, these costs also fall to zero.

Output TVC

0 0

1 10

2 18

3 24

4 28

5 32

6 38

7 46

8 58

 TVC is inversely S-shaped curve due to the Law of Variable Proportions.

 It increases with the increase in output. Initially it increases at a falling rate (1-4 units of output). It is
because efficiency of variable factor and better utilization of fixed factor.
 Then it increases at a constant rate (4th and 5th)
 Finally, it rises at rising rate (5th to 8th). It is because of fall in efficiency of the variable factor and over
utilization of the fixed factor.

No. Basis Fixed Cost Variable Cost

1. Meaning Fixed Cost are those cost which do not Variable Cost are those cost which
change with the change in level of changes with the change in level of
output. These remain same. output.

2. Factors These are payments made to the fixed These are payments made to the
factors of production. variable factors of production.

3. Zero level of These costs occur even the level of These costs become zero when the
output output is zero. output is zero.

4. Diagrammatic FC curve is horizontal straight line VC curve is an inverse S-shaped curve.

presentation parallel to X-axis.

5. Alternate These costs are also known as These costs are also known as prime
names supplementary costs or indirect costs. costs or direct costs.

6. Effect on Business may continue even if these Business may not continue if these
business costs are not recovered in short run. costs are not recovered.

7. Examples Insurance premium, rent Wages to casual labour, Raw materials.

3) Total Cost
Total Cost is the total expenditure incurred by the firm on the factors of production required for the
production of a commodity.
It is the sum of total fixed cost (TFC) and total variable cost (TVC) at various levels of output.

Output 0 1 2 3 4 5 6 7 8

TFC 20 20 20 20 20 20 20 20 20

TVC 0 10 18 24 28 32 38 46 58

TC 20 30 38 44 48 52 58 66 78

TC = TFC + TVC
  Total cost can never be zero, even when the level
of output is zero, because fixed cost is positive and
constant at zero level of output.
 As the level of output increases, total cost also
increases due to increase in variable cost.
 TC and TVC curves are parallel to each other, but
can never meet at any level of output, because the
difference between two is TFC and is always positive
and constant.
 TFC is constant and hence a horizontal straight line
parallel to X-axis while TC and TVC curves are inverse ‘S’
shaped curves.

Average Cost

1) Average Fixed Cost

It is per unit fixed cost of producing the commodity. Or it refers to the ratio of total fixed cost to total
output.
𝑇𝐹𝐶
AFC = 𝑄

Output TFC AFC

(units) (Rs) (Rs)

1 20 20

2 20 10

3 20 6.6

4 20 5

5 20 4

6 20 3.3

7 20 2.9

8 20 2.5

As output increases, AFC goes on falling and forms a downward sloping curve but never touches X-axis
as fixed cost can never be zero. TFC remains fixed at all level of output, with the rise in output, AFC fall.
Since TFC is never 0, AFC curve does not touch X Axis and it does not touch Y axis because at zero level
of output, TFC is positive. Thus, the shape of AFC curve is rectangular hyperbola.

2) Average Variable Cost

 It is per unit variable cost of producing the commodity. Or it refers to the ratio of total variable cost to
total output.
𝑇𝑉𝐶
AVC = 𝑄
Output (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 6.5

8 58 7.25

9 72 8

10 100 10

AVC curve is ‘U’ shaped curve; it is because of the application of law of variable proportions.
 As the output increases, the AVC begins to fall because of law of decreasing cost.
 Then AVC reaches its minimum point
 AVC starts increasing with every increase in output due to the law of increasing costs
3) Average Cost
Average cost refers to the per unit total cost of production. It is calculated by dividing TC by total
output.
𝑇𝐶
AC = 𝑄
Average cost is also defined as the sum of average fixed cost (AFC) and average variable cost (AVC).

AC = AFC + AVC.
Output 1 2 3 4 5 6 7 8 9 10

AFC 20 10 6.6 5 4 3.3 2.9 2.5 2.2 2

AVC 10 9 8 7 6.4 6.2 6.6 7.25 8 10

AC 30 19 14.6 12 10.4 9.5 9.5 9.75 10.2 12

 Like AVC curve, AC curve is also ‘U’
shaped curve.It is due to;
1) Basis of AFC and AVC.
AC is the sum total of AFC and AVC and
thus when initially both AFC and AVC are
falling. AC curve also slopes downwards
and reaches its minimum point. After that
the AVC starts rising and so does the AC
curve, thus giving the AC curve ‘U’ shape.

2) Due to Law of Variable Proportions

1. Initially AC falls due to better utilization of the fixed and variable factor.
2. Then AC reaches its minimum point i.e. the point of the optimum capacity of the firm or lowest per
unit of production.
3. Then AC begins to rise due to application of law of diminishing returns. This happens due to over
utilization of the fixed factor and imperfect substitution of the variable factor.

Relation among AFC, AVC and AC

Output (units) AFC (Rs) AVC (Rs) AC (Rs)

1 20 10 30

2 10 9 19

3 6.6 8 14.6

4 5 7 12

5 4 6.4 10.4

6 3.3 6.2 9.5

7 2.9 6.6 9.5

8 2.5 7.25 9.75

9 2.2 8 10.2

10 2 10 12

1. AC will always lie above the AVC curve because AC, at all levels of output includes both AVC and
AFC.
 2. Minimum point of AC curve lies to the right of the minimum point of AVC curve. In other words
AVC becomes minimum at lower output level compared to AC. It is because AFC is continuously
decreasing.
3. As the output increases, the gap between AC and AVC curves decreases, but, they never intersect
each other. It happens because the vertical distance between them is AFC, which can never be
zero.

Marginal Cost

Marginal Cost refers to addition to total cost when one more unit of output is produced. For example, If TC of
producing 2 units is Rs 200 and TC of producing 3 units is Rs 240, then MC = 240 – 200 = Rs 40.

MCn = TCn – TCn-1

When change in units produced is more than one, then MC can also be calculated as: MC =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 ∆ 𝑇𝐶
= .
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑂𝑢𝑡𝑝𝑢𝑡 ∆𝑄

Marginal Cost is directly affected by the Total Variable Cost. It is because MC is the rate of change in TC. And
TC = TFC + TVC. TFC being constant MC changes due to change in TVC only.

MCn = TVCn – TVCn-1

Output TFC TVC TC (TFC + MC

(units) TVC)

0 20 0 20 --

1 20 10 30 10

2 20 18 38 8

3 20 24 44 6

4 20 28 48 4

5 20 32 52 4

6 20 38 58 6

7 20 46 66 8

8 20 58 78 12
 In the diagram, MC curve is ‘U-shaped’, due to the operation of
laws of return to a factor. Initially MC curve falls due to increasing
returns (or decreasing costs), because of better coordination
between fixed and variable factor from point A to point B.

MC may remain constant due to application of law of constant

returns from point B to point C.

Then MC curve starts rising due to diminishing returns (or

increasing costs), because of defective ratio between the fixed
factor and variable factor from point C to point F.

Relationship between AC and MC

Both AC and MC are derived from TC. AC refers to TC per unit of output and MC refers to addition to TC when
one more unit of output is produced.

Output TC AC MC Phase

0 12 -- -- I (MC < AC)

1 18 18 6

2 22 11 4

3 27 9 5

4 36 9 9 II (MC = AC)

5 47 9.40 11 III (MC > AC)

1) When MC is less than AC, AC falls with increase in output.

2) When MC is equal to AC, AC is constant and at its minimum point.
3) When MC is more than AC, AC rises with increase in output.
4) MC and AC both rises, but MC rises faster than AC. As a result MC
curve is more steeper than AC curve.

Output TFC TVC TC AFC AVC AC MC

 0 12 12

1 12 18

2 12 22

3 12 27

4 12 36

5 12 47

Relationship between AVC and MC

Both AVC and MC are derived from total variable cost (TVC). AVC refers to TVC per unit of output and MC is
the addition to TVC.

Output TVC AVC MC Phase

0 0 -- -- I (MC < AVC)

1 6 6 6

2 10 5 4

3 15 5 5 II (MC = AVC)

4 24 6 9 III (MC > AVC)

5 35 7 11

1. When MC is less than AVC, AVC falls.

2. When MC is equal to AVC, AVC is constant and at its minimum
point.
3. When MC is more than AVC, AVC rises with increase in output.
4. MC increases at faster rate than AVC, as a result MC curve is
steeper than AVC curve.

Relationship between AC, AVC and MC

Output TVC AC AVC MC

0 0 -- -- --

1 6 15 6 6

2 10 11 5 4

3 15 9 5 5

4 24 9 6 9

5 35 9.40 7 11

1. When MC is less than AC and AVC, both of them falls.

2. When MC becomes equal to AC and AVC, they become constant
and both the curves are at its minimum points.
3. When MC is more than AC and AVC, both rise with increase in
output.
4. AC is greater than AVC by the amount of AFC.
5. The gap between AC and AVC continuous to fall because AFC falls
with the rise in output.
6. AC and AVC can never intersect with each other because AFC can
never be zero.
7. MC curve cuts AVC and AC curves at their minimum points.

Output TFC TVC TC AFC AVC AC MC

0 12 0 12 -- -- -- --

1 12 6 18 12 6 18 6

2 12 10 22 6 5 11 4

3 12 15 27 4 5 9 5

4 12 24 36 3 6 9 9

5 12 35 47 2.4 7 9.4 11