Concepts Of Cost

What Is Cost ?Cost refers to the expenditure

incurred by a producer ( Explicitly or Implicitly ) on the factor as well as non – factor inputs for a given amount of output of a commodity .

Explicit Cost and Implicit Cost

In Economics , total cost is estimated considering its two elements , viz. , explicit cost and implicit cost.

Total Cost = Explicit Cost + Implicit Cost Explicit Cost – Those cash payments which firms makes to the outsiders from

their goods and services . ( Tangible in nature. ) For examples – 1. Procurement of raw material

2. Payment of salary and wages 3. Transportation expenses

4. Rent

Implicit Cost – These are the cost of self owned and self employed in the process of production . It does not involve any cash payment . ( Intangible in nature. )

For example – 1. Imputed rent of the building

2. Imputed salaries of the owner

3. Imputed interest on money invested by the owner

Opportunity CostIt refers to the total sacrifice

made ( explicits or implicits ) for availing an opportunity ( or producing a given level of output ) .

Selling Cost And Production Cost

Selling Cost – It refers to the expenditure incurred by the producer to promote sale of the commodity . Example – expenditure on advertisement .

Production Cost – It refers to the expenditure incurred by a producer ( explicitly or implicitly ) on the inputs for producing a given level of output .

Short Run Costs Short run is a period of time during which some factors are fixed and some

are variable .Short run costs have two components , viz. , Fixed costs and Variable costs .

TC ( Total Cost ) = TFC ( Total Fixed Cost ) + TVC ( Total Variable Cost )1. Fixed Costs – Fixed costs are the costs related to the use of fixed factors of

production ( land , machine and plant ) . Schedule :

TFC is a horizontal straight line parallel to X – axis , showing that total fixed cost is constant at all levels of output .

2. Variable costs – Variable costs refer to the expenditure incurred by the producer on the use of variable factors of production ( raw material , wages of casual labour , power and fuel ) . Schedule :

TVC increases with increase in output . It is = Rs 10 , when output = 1 unit , and is = Rs 38 , when output = 6 units . Between 0-A , TVC increases at a decreasing rate . Beyond point A , TVC increases at an increasing rate .

CONTRASTFixed Costs

Fixed costs do not change with change in quantity of output .

They remain the same whether output is zero or maximum .

Examples : rent , wages of permanent staff , license fee , cost of plant and machinery .

Variable Costs Variable costs change with

change in quantity of output . They are zero when output is

zero. These costs increase when output increases and decrease when output decreases .

Examples : cost of raw material , wages of casual labour , expenses on electricity .

Behaviour Of Fixed Cost , Variable Cost and Total Cost

Schedule :

TFC is constant at all levels of output . TVC increases as output increases . TC is parallel to TVC . It shows that the difference

between TC and TVC ( = TFC ) is constant .

Average Cost – It is the cost per unit of output produced . AC = TC / Q AC = Average Cost , TC = Total Cost , Q = Quantity of output AC = AFC + AVC

Schedule :

Average Fixed Cost : It is the fixed cost per unit of output . AFC = TFC / Q

Schedule :

AFC Curve is rectangular hyperbola . If we take any point on AFC curve and multiply AFC at that point with the corresponding level of output , the product shall always be the same . This shows that total fixed cost remains constant at all levels of output .1. AFC decreases as output increases .2. AFC x Q at any level of output is the same . Because , AFC x Q = TFC which is constant at all levels of output . Thus : 4 x 2.5 = 10 8 x 1.25 = 10

Average Variable Cost – It is the variable cost per unit of output . AVC = TVC / Q

Schedule :

AVC curve is U – shaped . This is in accordance with the law of variable proportions . It falls so long as returns to a factor are increasing . It rises when returns to a factor are decreasing .

AC as the Summation of AFC and AVC

Marginal Cost – It is the change in total cost when an additional unit of output is produced .

MCn = TCn – TCn-1

Schedule :

MC is U – shaped in accordance with the law of variable proportions . Initially , MC is falling . It is because MP tends to rise when there are increasing returns to a factor .subsequently , MC tends to rise . It is because MP tends to fall when there are diminishing returns to a factor .

The sum total of marginal cost corresponding to different units of output is TVC .

∑MC = TVC

At OL level of output , area under MC Curve = OLSK .

This is equal to TVC . This is because TVC = ∑MC . Total variable cost is

the sum total of marginal cost for each unit of a given output .

Relation between Average Cost and Marginal Cost

Output ( units )

Total Cost ( Rs )

Average CostAC = TC/Q

( Rs )

Marginal Cost MC = TCn – TCn-1 ( Rs )

0 10 ∞ -1 20 20 102 28 14 83 34 11.3 64 38 9.5 45 42 8.4 46 48 8 67 56 8 88 72 9 16

When AC is falling , MC < AC . When AC is rising , MC > AC . When AC is constant ( as at point E ) , MC = AC . MC is always to the left of AC and cuts AC from its lowest point .

Relation between AVC and MC

When AVC falls , MC < AVC .

When AVC rises , MC > AVC .

When AVC is constant , MC =AVC ( it is the lowest point of AVC ) .

Relation between Total Cost and Marginal Cost

Up to point Q* , TC is increasing at a decreasing rate , because MC is decreasing .

Beyond point Q* , TC is increasing at an increasing rate , because MC is increasing .

At point Q* , TC stops increasing at a decreasing rate , because MC touches its lowest point .

AC , AVC , AFC and MC in one Diagram

When AC declines , MC declines faster than AC . So that MC curve remains below AC curve .

When AC increases , MC increases faster than AC . So that MC curve is above AC curve .

Since MC declines faster than AC , it reaches its lowest point earlier than AC . So that MC starts rising even when AC is falling .

MC must cut AC from its lowest point .

LIST OF FORMULAE Cost = Explicit Cost + Implicit Cost TC = TFC + TVC AC = AFC + AVC AC=TC/Q => AC x Q = TC AFC = TFC/Q => AFC x Q = TFC AVC = TVC/Q => AVC x Q = TVC MC = TVCn – TVCn-1 ∑MC = TVC

Short Questions Q 1 . What does cost mean in Economics ?Ans. Cost is the expenditure incurred by the producer ( explicitly and implicitly ) on factor as well as non – factor inputs for a given amount of output of a commodity .Q 2 . What is meant by explicit and implicit costs ?Ans. Explicit costs are those cash payments which a firm makes to others for the purchase of inputs . Implicit costs are imputed ( estimated ) costs of self – owned and self – employed resources .Q 3 . Define opportunity cost ?Ans. It is the total sacrifice made for availing an opportunity or producing a given level of output .Q 4 . What are selling costs ?Ans. Selling costs refer to the expenditure incurred by the producer in order to promote the sale of the commodity .

Q 5 . Define production cost .Ans. Production cost refers to the expenditure incurred by the producer on the inputs for producing a given level of output .Q 6 . What is meant by fixed cost ?Ans. It is the cost incurred on the purchase of fixed inputs of production , like plant and machinery .Q 7 . What is meant by variable cost ?Ans. It is the cost incurred on the purchase of variable inputs of production , like raw material .Q 8 . Define total cost .Ans. It refers to all expenses incurred by the producer to produce a given quantity of output .Q 9 . The cost of zero level of output is equal to which cost ?Ans. It is equal to fixed cost .Q 10 . Why is total fixed cost curve parallel to X-axis ?Ans. It is because total fixed cost remains constant at all levels of output .Q 11 . What is the general shape of MC curve ?Ans. ‘U’ shaped .

Q 12 . If the total cost of producing 5 units of a commodity is Rs 20 and that of producing 4 units is Rs 15 , what will be the marginal cost ?Ans. MC = TCn – TCn-1 = Rs 20 – Rs 15 = Rs 5

Q 13 . Find out TC , given the following information on MC for a firm which has spent Rs 50 thousand on its establishment even when output was zero ?

Output (Units)

1 2 3 4 5 6 7

MC (Rs thousand

)

7 6 5 4 3 2 1

Output (units) MC TVC TC = TFC + TVC ( TFC = Rs 50

thousand )1 7 7 50 + 7 = 572 6 13 50 + 13 = 633 5 18 50 + 18 = 684 4 22 50 + 22 = 725 3 25 50 + 25 = 756 2 27 50 + 27 = 777 1 28 50 + 28 = 78

Ans.

MADE BY SANJANA IN THE GUIDANCE OF MRS. VIDYUT SHIKHA MAM .CLASS – XII - C