Module ± 6


Cost of Production
Cost of Production refers to the total money expenses(both explicit and implicit) incurred by the producers in the process of transforming inputs into outputs. Cost is analyzed from the producers point of view .Cost estimates are always made in terms of money.

Cost Concepts
A. Money Cost and Real Cost When cost of production is expressed in terms of money, it is called as money cost. If the cost is expressed in terms of physical efforts or mental efforts put in by various people in the production of a commodity, it is called as real cost.

Continued «..
B. Explicit Cost and Implicit Cost

Explicit cost refer to the actual money outlay or out of pocket expenditure of the firm to buy or hire the productive resources it needs in the process of production. The following items of a firms expenditure are explicit money costs. 1. Cost of raw materials 2. Wages and Salaries

Power charges 4. 3. Rent of Factory Premises 5. . Insurance premium 7. Miscellaneous Business expenses like Marketing and Advertising expenses. License Fee etc 8. Interest Payment on Capital 6. Property Tax.

3. Rent for his own building used in production Profits of enterpreneur Depreciation . 2. The implicit money costs are as follows: Wages for labour rendered by the entrepreneur himself Interest on capital supplied by him. Such costs arise when the entrepreneur supplies certain factors owned by himself. 5.1. Implicit costs are payments which are not actually paid by the firm. 4.

Opportunity cost of the given economic resources is the foregone benefits from the next best alternative use of that resource. Payment of wages. . cost of raw materials.Continued «. machines. Outlay Costs and Opportunity costs Outlay cost is the actual financial expenditure of the firm.. C. etc. interest. It is recorded in the firm¶s books of account. For example.

etc vary.. machinery. D.Continued «. costs can be classified into short run costs and long run costs. Long run costs are the costs which vary with output when all inputs including plant. . etc remain fixed. Short run and Long run Costs On the basis of span of time in production . Short run costs are the costs which vary with output in the short period when plant. machinery.

The relationship between cost and output is described as the ³ cost function´.Quantity of output produced . TC = f(Q) Where TC --.Cost± Output Relationship Cost-output relationship refers to the relationship between output and costs and the behaviour of costs in relation to the change in output.Total cost of production Q --.

.Cost Function The cost function depends on the three independent variables: Production function Market prices of inputs Period of time 1. 2. 3.

They are: Short run cost function Long run cost function Cost output relationships or cost behaviour is discussed for the short period and the long period separately. . In economic theory there are mainly 2 types of cost functions. 2.Types of Cost Functions 1. When this relationship is represented with the help of diagram we get the short and long run cost curves.

The total no of firms in an industry will remain the same. management. etc remain constant. .Meaning Of Short Run Short run is a period of time in which only the variable factors can be varied. While the fixed factors like plant. machinery.

Cost²Output Relationship And The Behaviour Of Cost Curves In The Short Run Cost Schedule: A Cost Schedule is a list or statement showing variations in costs resulting from variations in the levels of output. . On the basis of the cost schedule we can analyse the relationship between changes in the level of output and cost of production. It shows the response of cost to changes in output.

A Hypothetical Cost Schedule Output units TFC 300 300 300 300 300 300 300 TVC --100 180 240 300 450 660 TC 300 400 480 540 600 750 960 AFC --300 150 100 75 60 50 AVC --100 90 80 75 90 110 AC --400 240 180 150 150 160 MC --100 80 60 60 150 210 0 1 2 3 4 5 6 .

They are the costs a firm has to incur even when the output is zero. tools and equipments in the short run. They are fixed in nature. TFC = TC ± TVC where TVC = Total Variable Cost TC = Total Cost . machinery . Mathematically. Total Fixed Cost (TFC) Total Fixed Costs refers to the total money expenses incurred on fixed inputs like Plant.1.

Diagrammatic Representation Of TFC Curve .

etc in the short run. The variable cost vary directly with the output. advertisement.2. transportation. Total Variable Cost (TVC) Total Variable Cost refers to the total money expenses incurred on variable factor inputs like raw materials. electricity. TVC = TC ± TFC . fuel.

Diagrammatic Representation Of TVC Curve .

Mathematically.3. Total Cost (TC) Total cost refers to the aggregate money expenditure incurred by a firm to produce a given quantity of output. The behaviour of TFC. TC = f(Q) which means that total cost varies with level of output. TC varies in the same proportion as in TVC. . TC = TCF + TVC. TVC & TC are shown in the following diagram.

The Behaviour Of TFC. TVC and TC Curve .

of units of output produced. Average Fixed Cost (AFC) is the fixed cost per unit of output produced. The greater the output the smaller will be the average fixed cost. AFC = TFC Q Where µQ¶ represents output.4. It is found out by dividing the total fixed cost by total output. . An important character of AFC is that it goes on decreasing as output increases since the amount of total fixed cost is being divided by larger no.

Diagrammatic Representation of AFC Curve .

Average variable cost (AVC) is the variable cost per unit of output. An important character of AVC is that it will decline in the beginning as output increase. It is found out by dividing the total variable cost by the total output. .5. This is the stage when the stage has reached its full capacity of production. but when a certain stage is reached it stops declining. AVC = TVC Q where µQ¶ represents the total output.

AVC Curve ± U shaped Curve .

= AFC + the cost per unit of the output. Since the total cost consists of fixed cost & variable cost. AC = TC / Q = TC / Total output. 6. the average cost will be equal to the sum of average fixed cost & average variable cost. Average cost (AC) . = FC + VC / Total output. This is found out by dividing the total cost by the total output. = TFC + TVC / Q Where µQ¶ stands for the total output.

Diagrammatic Representation Of AC Curve .

AVC and AC In the short run the AC curve tends to be U-shaped.The Behaviour of AFC. The combined influence of AFC and AVC curves will shape the nature of AC curve. AFC begins to fall with an increase in output. . AVC comes down upto a particular level and then rises.

AVC and AC Curves .The Behaviour Of AFC.

It implies additional cost incurred to produce an additional unit.7. Or MC = TCn ² TCn-1 . MC = change in TC change in TQ Where TC = Total cost TQ = Total output. Marginal Cost (MC) Marginal costs may be defined as the net addition to the total cost as one more unit of output is produced.

Diagrammatic Representation OF MC Curve .

Output 0 1 2 3 4 5 6 7 8 9 10 5 TC (Rs) -80 140 185 220 245 276 322 384 468 570 MC (Rs) 75 60 45 35 25 31 46 62 84 100 AC (Rs) -80 70 61 55 49 46 46 48 52 57 .

Relationship Between MC and AC .

When AC is falling . when both the costs are rising . MC is also falling. When Ac is minimum. the MC=AC.Relationship between MC and AC 1. . 3. 2. When AC and MC curves are falling MC curve is lies below the AC curve. Once MC=AC. MC curve will always lie above the AC curve.

If the demand for the product declines . a firm can cut down its production capacity. In the long run a firm is not tied upto a particular plant capacity. it can expand output by enlarging its plant capacity.Cost±Output Relationship in the Long Run Long period is a period during which the quantities of all factors variable as well as fixed factors can be varied according to the requirements. . If the demand increases. Hence production cost comes down to a great extent in the long run.

the total of these costs is the total cost of production. In the long run only average cost is important and considered in taking long term output decisions. .Continued« As all costs are variable in the long run . Long run average cost= TC Output It is the per unit cost of production at different levels of output by changing the size of the plant.

The long run cost curve is influenced by the Laws of Returns To Scale. The long run cost curve explains how costs will change when the scale of production varies.Continued« The long run cost output relationship is explained by drawing a long run cost curve through short run cost curves. .

Diagrammatic Representation of Long Run Cost Curve .

Tangent Curve Envelope Curve Planning Curve Flatter U Shaped Curve . 2.Important Features of LAC Curve 1. 3. 4.

. LMC tends to decline. indicating that initially as output expands in the long run with the increasing scale of production . The LMC curve also has a flatter U. At a certain stage however LMC tends to increase.Long Run Marginal Cost Curve The long run marginal cost curve is derived from long run total cost curve at the various points relating to the given level of output at each time.shape.

Diagrammatic Representation Of Relation between LMC and LAC .

The revenue concepts commonly used in economics are 1. Total revenue 2.REVENUE CONCEPTS The amount of money which a firm receives by the sale of its output in the market is known as its revenue. Average revenue 3. Marginal revenue .

The TR can be calculated by following formula: TR = Q x P where TR = Total revenue Q = Quantity of output P = Price per unit of the Commodity . Total Revenue Total revenue refers to the total amount of money that the firm receives from the sale of its products.1.

The price paid by the consumer is the revenue realised by the producer. . Average Revenue Average revenue can be obtained by dividing the total revenue by the number of units sold. AR = TR Q where AR is the revenue earned per unit of commodity sold. AR is the price of the commodity.2.

Mathematically.3. MR = TRn ± TRn-1 Or MR = change in TR change in Q . Marginal Revenue Marginal revenue refers to the additional revenue earned by selling the additional unit of output by the seller.

Relationship between TR. Of units sold 1 2 3 4 5 6 7 TR (Rs) 10 18 24 28 30 30 28 AR (Rs) 10 9 8 7 6 5 4 MR (Rs) 10 8 6 4 2 0 -2 . AR and MR: No .

Diagrammatic Representation .

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