chapter 6.pdf

Cost
Meaning
In simple terms- total expenditure incurred in producing a commodity.
In economics, cost can be defined as a monetary valuation of efforts,
material, resources, time and utilities consumed, risks incurred, and
opportunity forgone in the production of a good or service.

Cost is the sum of…
Explicit cost+ Implicit cost

Explicit cost
• Explicit cost : it is the actual money expenditure on inputs or
payments made to outsiders for hiring their factor services
For example,
Wages
Rent
Raw material, etc.

• Implicit cost : it is the estimated value of the inputs supplied by the
owners including ‘Normal profit’.
For example,
Estimated interested on own capital
Estimated Rent of own land
Imputed services of entrepreneur, etc.

• Economic cost of production includes not only accounting cost
(explicit cost) but also implicit cost.
• Total cost of production= explicit cost + implicit cost

Basis Explicit cost Implicit cost
Meaning Payment to outsiders for hiring
factors services
It is the cost of self supplied
factors
Money payment It is involves actual money payment on
buying and hiring inputs
There is no money payment. It
involves imputed value of
factors owned by the firm.
Example Payment of wages
Rent
Insurance premium etc
Interest on capital
Rent of own land
Salary for entrepreneur of his
services

Opportunity cost
It is the estimate of the substitute opportunities forgone in the choice
of one commodity or pursuit over others . This basic cost is normally
mentioned as the opportunity cost
OC is income that would have been received if input had been used in
its most profitable alternative use

General example of opportunity cost
when you choose between two brands of bread at the grocery
store.
If you buy one loaf that costs seven rupees more than another,
that difference of seven rupees is the opportunity cost of buying
your preferred bread.
At a savings of just seven rupees, it may not be worth choosing
the less expensive brand over your preferred brand.

• Opportunity cost = Cost of alternative output - cost of
chosen output
• Another example
• a farmer producing rice or wheat
• Suppose producing rice 40 quintals – 100000
wheat 50 quintals -200000
OC= 200000 – 100000 =100000

Short run costs and long run costs
• Short-run = time period when one or more inputs are fixed
• Long-run = time period when all inputs can be changed (none are fixed)

Fixed Costs
• Costs associated with owning a fixed input or resource
• Do not change as level of production changes (large, small or even
zero)
• Incurred even if not input is used
• Not under control of the manager in the short-run
• Example
rent of premises
Interest on loans
Salary of permanent employee

Total fixed cost schedule
Output (in units) TFC(Rs.)
0 12
1 12
2 12
3 12
4 12
5 12

0
2
4
6
8
10
12
14
0 1 2 3 4 5 6
Fixed
cost
in
Rs.
Output in units
Total fixed cost curve
Y-Values

• Variable Costs
• Those costs that the manager has control over in a given period of time
• Can be increased or decreased at the manager’s discretion

• Direct Materials Direct materials is considered the most purely
variable cost of all, these are the raw materials that go into a
product.
• Piece Rate Labor ...
• Production Supplies ...
• Billable Staff Wages ...
• Commissions ...
• Credit Card Fees ...
• Freight Out ...

Total variable cost schedule
Output (in units) TVC(Rs.)
0 0
1 6
2 10
3 15
4 24
5 35

0
5
10
15
20
25
30
35
40
0 1 2 3 4 5 6 7
Variable
cost
in
R.s
Output in units
Total variable cost curve

Total cost refers to the overall cost of production, which includes both
fixed and variable components of the cost. In economics, the total
cost is described as the cost that is required to produce a product.

Total Cost Table
Output (in units) TFC(Rs.) TVC(Rs.) TC(Rs.)
0 12 0 12
1 12 6 18
2 12 10 22
3 12 15 27
4 12 24 36
5 12 35 47

Total cost= total fixed cost+ total variable cost
0
5
10
15
20
25
30
35
40
45
50
0 1 2 3 4 5 6
Output
in
units
Cost in Rs.
Total Cost curve
TFC (output in units)
TVC(Rs.)
TC(Rs.)

Relationship between TFC,TVC and TC

Average Fixed Cost
• In economics, average fixed cost (AFC) is the fixed cost per unit
of output. Fixed costs are such costs which do not vary with
change in output.
• AFC is calculated by dividing total fixed cost by the output level.

Marginal Cost
The marginal cost is the change in total production cost that
comes from ma
The purpose of analyzing marginal cost is to determine at what
point an organization can achieve economies of scale* to
optimize production and overall operations.
If the marginal cost of producing one additional unit is lower than
the per-unit price, the producer has the potential to gain a profit.
*Economies of scale are cost advantages reaped by companies when production becomes efficient.

• The marginal cost curve is a U-shaped curve “(due to law of
variable proportion).
• It indicates that initially when the production starts, the marginal
cost is comparatively high as it reflects the total cost including
fixed and variable costs.
• In the initial stage, the cost of production is high as it includes
the cost of machines, setting up a factory, and other expenses.
That is why the marginal cost curve (MC curve) starts with a
higher value.
• Then it shows a decline as with the same fixed cost, many units
are produced, keeping the cost of production low.
• After it reaches the minimum level or point, it again starts rising
to show a rise in the cost of production.
• It is because of the exhaustion of resources or the overuse of
resources (diminishing returns creep in).

Relationship between short run costs curves
• Average Cost (AC) and Marginal Cost(MC)
• Average average Cost (AVC) and Marginal Cost(MC)
• Average Cost (AC) and Average average Cost (AVC) and Marginal
Cost(MC)
• Average Cost (AC) and Average average Cost (AVC)
• Total Cost (TC) and Marginal Cost(MC)
• Total Variable Cost (TC) and Marginal Cost(MC)

Relationship Average Cost (AC) and Marginal Cost(MC)
• Both AC and MC can be calculated from TC
• Both are ‘U ‘ shaped (law of variable proportions)

Relationship Average Cost (AC) and Marginal
Cost(MC)

Relationship Average Variable Cost (AVC) and Marginal
Cost(MC)
• Both AVC and MVC curves are U-shaped due to law of variable
proportion

Relationship Average Variable Cost (AVC) and Marginal
Cost(MC)

Average Cost (AC) and Average average Cost (AVC) and
Marginal Cost(MC)
When MC is less than AC and AVC, both of them fall with increase in the output.
When MC becomes equal to AC and AVC , they become constant. MC curve cuts AC curve (A) and AVC curve (B) at their minimum
points.
When MC is more than AC and AVC, both rise with increases in output.

Average Cost (AC) and Average average Cost (AVC) and
Marginal Cost(MC)

Relationship Between AC and AVC

Relationship between TC and MC

Relationship between TVC and MC

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