COST
What is cost of production?
In order to produce a good, every firm makes use of factor of production. The amount spend on the
factor of production is called cost of production. Cost of production mainly depends upon the quantity
of production. Cost of production increase with the increase in output. It can therefore be said that cost
of production is the function of output.
C = f (Q)
C = cost of production
Q= output
F= function
COST FUNCTION:
Cost function studies the’’ FUNCTIONAL RELATIONSHIP’’ between cost and output.
TYPES OF COST:
SELLING COST: selling cost refer to the cost incurred by the producer to promote sale of the
commodity such as ADVERTISEMENT COST, DISCOUNT ALLOWED, OFFERING GIFT ETC.
PRODUCTION COST: Production cost refers to that cost incurred by the producer on the
production of goods and services. Production cost includes the cost of factor input as well as non- factor
input.
What is money cost?
To produce or sell a commodity, the amount spend in the term of money, is called money cost. In
ordinarily language the term cost is used for monetary cost. Economists include following in cost:
1) Cost of raw material Production cost
2) Interest Production cost
Cost which engaged in
3) Rent paid Production cost
production of the commodity is
4) Wages paid Production cost
called production cost. Cost
which engaged to push the sale
of the commodity is called
selling cost of sale of sale.
5) Expenses of electricity Production cost
6) Depreciation Production cost
7) Expenses on publicity Selling cost
8) Insurance charges
9) Packing charges
MONETARY COST
EXPLICIT COST IMPLICIT COST
EXPLICIT COST
: All those expenses that a firm incurs to make payment to other are called explicit cost. In simple words
EXPLICIT COST are those cash Payments which firm makes to outsiders for their services and goods. It is
also called ‘’outlay cost’’ or ‘’ absolute cost’’.
IMPLICIT COST
These are the cost of an entrepreneur’s own factors or resources. These arise when a firm makes use of
its own resources, e.g. its own land, own building, own capital.
TOTAL COST = EXPLICIT COST + IMPLICIT COST
OPPORTUNITY COST:
INTRODUCTION: Opportunity cost refers to value of a factor in its best alternatives.
DEFINITION: In the words of leftwitch, opportunity cost of a particular product is the value of the
foregone alternative product.
INVENTOR: This concept was firstly introduced by D.I.GREEN. in his article ‘’ pain cost and
opportunity cost’’ published in 1894. But credit for making it goes to prof. knight.
ASSUMPTIONS:
1) It is applicable in short period.
2) Only two goods are produced i.e., X and Y can be produced in an economy.
3) There is a perfect competition in the market.
DIAGREMATIC PRESENTATION:
Y
A
Y Commodity G C Opportunity cost = GH for MN.
H k D
O M N B
X Commodity
In this figure line AB represent different combinations of ‘X’ and ‘Y’ which can be produced in the
economy with the given resource and technology.
AT POINT ‘C’: Point C represent OF units of good X and OG units of good Y. if we want to produce more
units of good X we will have to reduce the units of Y. for example if firm want to increase the production
of ‘X’ from OF to OK, then he has to reduce the production of ‘Y’ from OG to OH. Here CE is the
opportunity cost of ED.
SHORT TIME COST
TOTAL COST AVERAGE COST MARGINAL COST
TOTAL FIXED AVERAGE FIXED IT DERIVED
TTT
COST COST FROM VARIABLE
COST
TOTAL VARIABLE AVERAGE
COST VARIABLE COST
TOTAL COST: The cost incurred to produce a particular level of output is called TOTAL
COST. For example,’’
FIXED COST + VARIABLECOST
TOTAL COST= TOTAL COST = FIXED COST (IF OUTPUT ZERO)
AVERAGE COST OUTPUT
TOTAL COST
FIXED COST VARIABLE COST
FIXED COST
INTRODUCTION – 1) the costs of fixed inputs are called fixed cost. 2) The cost which do
not change with the change in output. 3) The cost which remain same at every level of output
4) fixed cost is the concept of short run. It do not applicable under long run because in long run
all factors are variable.
EXAMPLES - Rent paid salary to permanent staff, license fee, depreciation and
maintenance, interest on fixed capital etc.
ANOTHER NAME: fixed cost is also called SUPPLEMENTARY COST.
RELATION WITH OUTPUT: Fixed cost is the cost which does not change with the change
of output. In simple words, these costs not vary as the level of output varies. Production may be
maximum, increase, decrease, or zero, fixed costs remain the same.
METHOD TO CALCULATE IT: It is calculated by multiplying UNITS OF FACTOR INPUT with
PRICE OF THE FACTOR.
FIXED COST = UNITS OF FACTOR INPUT X PRICE OF THE FACTOR.
MAIN POINT REGARDING FIXED COST: Fixed cost is the concept of short period because
in short period there are two factors named fixed factor and variable factor are used to produce
goods and services. It is not the concept of long time because in long time all the factors of
production are variables.
FIXED COST SCHEDULE: Fixed cost explained with the help of following table.
OUTPUT FIXED COST DISCRIPTION
0 10
1 10 FIXED COST DOES
2 10 NOT CHANGE
3 10 WITH CHANGE IN
4 10 OUTPUT.IT IS
5 10 REMAIN SAME
6 10 AS OUTPUT
7 10 CHANGED.
The above table indicates the change in quantity in output causes no change in fixed cost.
When output ZERO, OUTPUT 2, OUTPUT 5, OUTPUT 7, the fixed remain 10.
AT ZERO PRODUCTION, TOTAL COST AND FIXED COST ARE EQUAL TO EACH OTHER.
Fixed cost curve: A curve that graphically represents the relation between total fixed cost incurred
by a firm in the short-run with output of the firm.
In this curve output are shown at OX-AXIS and Fixed cost are shown at OY-AXIS, FC line
Represent fixed cost. It is parallel to OX-AXIS Which indicate cost remains fixed whether output
is more or less, even output zero.
VARIABLE COST:
INTRODUCTION: 1) The costs of VARIABLE INPUT are called fixed cost. 2) Variable cost is the
cost which changed with the change of output.
EXAMPLES: Expenses on raw material, wages paid to the worker, electricity expenses.
ANOTHER MANE: PRIME COST OR AVIDABLE COST.
RELATION WITH OUTPUT: Variable cost is the cost which changed with the change of
output. In simple words, these costs are varies as the level of output varies. If output Falls these
costs also fall and if the output raises these cost also rises. If output zero these cost also zero.
METHOD TO CALCULE IT:
VARIABLE COST = TOTAL COST – FIXED COST OR
AVERAGE VARIABLE COST OUTPUT
MAIN POINT REGARDING VARIABLE COST: Variable cost is the concept of short time as
well as long time because variable factor are used in short time as well as long time.
VARIABLE COST SCHEDULE: It is a table which shows direct relationship between variable cost
and output.
Output Variable cost Variable cost is directly
positive related with
0 0 output. Means Variable
1 10
cost rises as output rises
2 18 and vice versa.
3 24
4 28
5 32
6 38
7 48
The above table indicates that variable cost rises with the rises in output. It is zero when
output zero.
CURVE:
SPEED OF VARIABLE COST:
1) INITIALLY, it increases at decreasing rate.(in increasing rate of return)
2) Increasing at increasing rate. (in decreasing rate of return)
DIFFERENCE BETWEEN FIXED COST AND VARIABLE COST
BASIS FIXED COST VARIABLE COST
MEANING it is not change with the it is changed with the
change in output. change in output
RELATION it is remain same whether variable cost is zero when
WITH OUTPUT Output is zero or maximum. Output zero, and increase
When output increase.
EXAMPLE Rent, salary of permanent material expences, labour
Employee, license fee, etc. cost etc.
TIME It is the short time concept it is the short as well as long
Term concept.
MARGINAL COST:
INTRODUCTION: Marginal cost is the change in total cost as a result of a
unit change in output. In simple words, it is a cost of producing an
additional unit of output.
How it is calculate: it is calculate by using following formula
MC = TCN – TCN-1
OR
MC = Change in total cost/ change in output
MAIN POINT REGARDING VARIABLE COST:
AVERAGE COST (AC)
INTRODUCTION: Per product cost is called average cost.
EXAMPLE: total cost of producing 6 units is Rs 48. Accordingly average cost will be 48/6=8
METHODS TO CALCULATE AVRAGE COST:
AVERAGE COST = TC/OUTPUT
OR
AVERAGE FIXED COST + AVERAGE VARIABLE COST
Table 6.average total cost
OUTPUT TOTAL COST AVERAGE COST
0 10 INFINITE
1 18 18
2 24 12
3 28 9.3
4 32 8
5 38 7.6
6 46 7.6
7 60 8.5
CURVE:
AC has U shaped in short run: short run AC curve is U- shaped. It means that at first, this curve tends to
fall and after reaching the minimum point, it begins to rise. It is happened due to law of variable
proportion. In law of variable proportion there are three stages exist. In first stage MP goes up or AC
goes down (because there is negative relationship between MP and AC). And in second and third stages
MP goes to fall or AC goes to rises.
DERIVATION OF AVERAGE COST
AC = TOTAL COST/ OUTPUT
OR
AC = FC + VC / OUTPUT
OR
AC = FC/OUTPUT + VC/ OUTPUT
OR
AC = AFC + AVC
Average cost
Average fixed Average variable
cost cost
AFC: Per unit fix cost is called average fix cost. It is calculate by dividing total fixed cost by output.
AFC = TOTAL FIXED COST/ OUTPUT
Average fixed cost can be explained with of following table and curve;
Output fixed cost average fixed cost
1 2 3 = 2/1
1 10 10
2 10 5
3 10 3.3
4 10 2.5
5 10 2
6 10 1.7
The above table shows that when one unit is produced, the AVERAGE FIXED COST IS Rs. 10. When 5
units are produced, the average fixed cost is Rs.2. so average fixed cost goes on diminishing as output
increased.
CURVE:
In the above curve AFC is a AVERAGE FIXED COST CURVE. This curve slopes downwards to the right.
Downward slope of AFC shows that AFC decrease as output increase. In this curve AFC IS RECTANGULAR
HYPERBOLA. It shows:
1) That AFC decreases as output increase.
2) AFC X OUTPUT at any level of output is the same because AFC X OUTPUT = FIXED COST.
AVERAGE VARIABLE COST: Per unit variable cost is called average variable cost. It is calculate by
dividing TOTAL VARIABLE COST WITH OUTPUT.
AVERAGE VARIABLE COST = TOTAL VARIABLE COST/ OUTPUT
AVERAGE VARIABLE COST IS SHOWN BY FOLLOWING TABLE AND CURVE.
OUTPUT VARIABLE COST AVERAGE VARIABLE COST
1 10 10
2 18 9
3 24 8
4 28 7
5 32 6.4
6 38 6.3
7 46 6.5
RELATIONSHIP BETWEEN AVERAGER COST AND MARGINAL COST
There are some Following relationship between AC and MC
1) When AC falling, AC > MC
2) When AC constant, AC=MC
3) When AC is rising, AC < MC
4) MC curves cuts AC curve at its lowest point
5) Both AC and MC are U Shaped.
RELATIONSHIP BETWEEN TOTAL COST AND MARGINAL COST
1) When MC decreasing, TC increases at a constant rate
2) When MC increasing, TC increasing at increasing rate
3) When MC constant, TC increases at constant rate
4) MC is the rate of TC.