COST CONCEPT

TYPES OF COSTS
I. Direct costs or explicit costs
II. Indirect costs or implicit costs
III. Private Costs
IV. Social Costs
V. Fixed costs
VI. Variable costs
VII. Accounting costs
VIII. Economic costs
IX. Marginal Costs
EXPLICIT COSTS VS. IMPLICIT COSTS
 An explicit cost is a cost that is directly incurred by the
firm, company or organization during the production.
The explicit cost is kept on record by the accountant of
the firm. Salaries, wages, rent, raw material are few
example of the explicit cost.

 Implicit costs are those costs which the firm lets go or

sacrifices in order to hire an alternative factor of
production. These costs are opportunity costs of the
factors of production. Implicit cost is also called as
imputed cost.
PRIVATE COSTS VS. SOCIAL COSTS
 While producing a commodity a firm has to pay for raw
material; it has to pay wages of workers; it has to pay
rent of building. These are private costs for the firms.
Thus private costs are the expenditure of an individual
firm in producing a commodity.

 Factories emit large amount of smoke from their

chimneys into the atmosphere. This may not figure in the
calculation of costs in their records. But the cost to the
community may be in the form of additional washing
bills for clothes and the money spent by the community
on medical bills etc. These costs are social costs.
ACCOUNTING COSTS
 Accounting Costs are those Costs which are actually
incurred & recorded in the Books of Accounts by the
Firm in Payment for Various Factors of Production.
 For Example, Wages to workers employed; Rent for the
Building he hires; Prices of the Raw Materials; Fuel &
Power, etc.
 Also Called as Explicit Cost.
ECONOMIC COSTS
 The Normal Return on Money Capital invested by the
Entrepreneur himself in his own Business. (Implicit
Cost)
 The Wages & Salary not Paid to the Entrepreneur but
could have been Earned if the Services had been Sold
somewhere else.
 Economic Cost = Accounting Cost + Implicit Cost
THEORY OF COST
 The cost function of a firm shows a relationship between
output produced and the associated cost of producing it.
Hence, costs are nothing but input prices. There are four
major inputs as discussed; land, labour, capital and
entrepreneurship. The costs attached with each are; rent,
wages, interest and profits respectively.
 Like production, costs of a firm may also be analyzed in
the context of time period as follows:
 – Short Run Costs

 – Long Run Costs

SHORT RUN COSTS
 There are two categories of costs in short run: Fixed cost
and Variable cost.
 The firm needs to incur few fixed costs initially in short
period irrespective of the level of output.
 All these expenditures are not related to the level of
output and are required to incur before production
actually starts.
 A firm then needs to incur variable cost which is the
expenditure on variable factors i.e. factors which vary
with the level of output, for example, raw material, labor
etc.
 It is obvious that total cost (TC) is the summation of
total fixed costs (TFC) and total variable costs (TVC).
CONCEPTS OF TOTAL COST OF A FIRM
 X axis shows levels of
output and Y axis shows
costs.
 TC is Total Cost Curve

 TVC is Total Variable

Cost Curve
 TFC is Total Fixed Cost
Curve
 Total Cost Curves: Graphically, if quantity of output is
measured along X-axis and costs are measured along
Yaxis, then the Total Fixed Cost Curve (TFC) runs parallel
to X-axis.
 In contrast, total variable cost and total output are
positively related. They move together. With zero output,
the variable costs of the firm are also zero.
 The total variable cost (TVC) curve, therefore, starts from
the point of origin. If we add the two curves vertically, we
get a corresponding curve which represents total cost (TC).
 Its starting point on Y-axis coincides with that of TFC
curve.
AVERAGE AND MARGINAL COST OF A
FIRM
 X axis shows levels of
output and Y axis shows
costs.
 MC is Marginal Cost
Curve
 ATC is Average Total
Cost Curve
 AVC is Average Variable
Cost Curve
 AFC is Average Fixed
Cost Curve
 Average Fixed Cost (AFC) Curve: Since total fixed
costs do not change with level of output, therefore,
average fixed cost (AFC) declines with increase in the
level of output and tends to infinity when output reaches
zero.
 For first unit of output, AFC equals TFC. The AFC
curve, therefore, is a rectangular hyperbola.
• AFC= TFC/ Q
 Average Variable Cost (AVC) Curve: As output
increases total variable cost also increases. But the rate
of increase of TVC would depend on whether the law of
eventual diminishing returns operates or not.
 When it is not operating TVC increases (slowly) less
than proportionately to product (Q).
 As a result, AVC decreases.

 However, once the law starts to operate, TVC increases

(steadily) more than proportionately to product implying
increase in AVC. Consequently, the shape of the average
cost curve is U-shaped. It first falls then rises.
 AVC= TVC/ Q
 As output increases AFC is declining throughout.
However, AVC is declining up to a point and later starts
to rise.
 Therefore, AC is declining rapidly when both AFC and
AVC are declining; whereas it starts rising as AFC
continues to decline and AVC rises.
 Graphically, it is obtained by vertical addition of the
AFC and AVC curves. AC curve lies above AVC curve
 At each point, its vertical distance from AVC curve is
exactly equal to the distance of AFC curve from X-axis.
Therefore, AC curve is U-shaped and with increasing
output, its vertical distance from AVC keeps declining.
 Marginal Cost (MC) Curve: Marginal cost is addition
to total cost on account of the production of an additional
unit. It is ratio of change in total cost to change in total
output.
 Since, TFC does not change in short run, MC depends upon
only TVC
 For this reason, MC curve is related to only AVC curve.
Therefore, MC curve is also a U shaped curve. When
AVC is decreasing, MC is less than it and MC curve lies
below AVC curve.
 However, when the rate of fall of AVC slows down, MC
curve reaches its lowest value and starts increasing and
cuts AVC from below at its lowest point. In other words,
when AVC is minimum, MC is equal to it. In the next
phase, when AVC curve slopes upwards, MC curve rises
faster than the former and lies above it.
SHAPES OF LONG-RUN AVERAGE COST CURVES

 While in the short run firms are limited to operating on a

single average cost curve (corresponding to the level of
fixed costs they have chosen), in the long run when all
costs are variable, they can choose to operate on any
average cost curve.
 Thus, the long-run average cost (LRAC) curve is
actually based on a group of short-run average cost
(SRAC) curves, each of which represents one specific
level of fixed costs.
  For example, you can imagine SRAC1 as a small
factory, SRAC2 as a medium factory, SRAC3 as a large
factory, and SRAC4 and SRAC5 as very large and ultra-
large. Although this diagram shows only five SRAC
curves, presumably there are an infinite number of other
SRAC curves between the ones that are shown. This
family of short-run average cost curves can be thought of
as representing different choices for a firm that is
planning its level of investment in fixed cost physical
capital—knowing that different choices about capital
investment in the present will cause it to end up with
different short-run average cost curves in the future.
 From Short-Run Average Cost Curves to Long-Run Average Cost
Curves. The five different short-run average cost (SRAC) curves
each represents a different level of fixed costs, from the low level of
fixed costs at SRAC1 to the high level of fixed costs at SRAC5. Other
SRAC curves, not shown in the diagram, lie between the ones that
are shown here. The long-run average cost (LRAC) curve shows the
lowest cost for producing each quantity of output when fixed costs
can vary, and so it is formed by the bottom edge of the family of
SRAC curves. If a firm wished to produce quantity Q3, it would
choose the fixed costs associated with SRAC3.
 The long-run average cost curve shows the cost of producing
each quantity in the long run, when the firm can choose its
level of fixed costs and thus choose which short-run average
costs it desires.
 If the firm plans to produce in the long run at an output of Q 3,

it should make the set of investments that will lead it to locate

on SRAC3, which allows producing q3 at the lowest cost.
 A firm that intends to produce Q3 would be foolish to choose
the level of fixed costs at SRAC2 or SRAC4.
At SRAC2 the level of fixed costs is too low for producing
Q3 at lowest possible cost, and producing q3 would require
adding a very high level of variable costs and make the
average cost very high.
 At SRAC4, the level of fixed costs is too high for producing

q3 at lowest possible cost, and again average costs would be

very high as a result.
 The left-hand portion of the long-run average cost curve,
where it is downward- sloping from output levels Q1 to
Q2 to Q3, illustrates the case of economies of scale. In
this portion of the long-run average cost curve, larger
scale leads to lower average costs.
 In the middle portion of the long-run average cost curve,
the flat portion of the curve around Q3, economies of
scale have been exhausted. In this situation, allowing all
inputs to expand does not much change the average cost
of production, and it is called constant returns to scale.
 Finally, the right-hand portion of the long-run average
cost curve, running from output level Q4 to Q5, shows a
situation where, as the level of output and the scale rises,
average costs rise as well. This situation is
called diseconomies of scale.