CONCEPT OF COST

PRESENTED BY

RAJA RAM SHARMA

MEANING OF COST

Cost of producing a good is the sum of actual money expenditure on purchase of inputs and estimated expenditure on inputs supplied by the firm itself.

Cost = Explicit cost + Implicit Cost

Explicit Cost and Implicit Cost

Explicit Cost – The actual money spent by a firm on buying or hiring of factors of inputs and non-factor inputs is called money cost or explicit cost.

Implicit Cost – It is the estimated value of inputs supplied by the owner of the firm himself.

Cost Function

The functional relationship between output and cost is called Cost Function.

C =

where C = Cost

f = Function

Q = Units of Output

In short, cost function studies the relationship between the cost of inputs and level of output.

SHORT RUN COSTS

1. Total Cost (TC)

TC = TFC + TVC

2. Average Cost (AC)

AC = AFC + AVC

3. Marginal Cost (MC)

MC = TCn – TCn-1

DISTINGUISH BETWEEN FIXED COSTS AND VARIABLE COSTS

FIXED COSTS (FC) 1. Fc do not increase or decrease with

increase or decrease in level of output.

2. FC are costs of fixed factors which cannot be changed during short period.

3. FC can never be zero even when production is stopped.

4. Production may continue even at the loss of FC during short period.

5. FC curve is parallel to X-axis.

VARIABLE COSTS (VC) 1. VC change with changes in the level of

output.

2. VC are costs of variable factors capable of being changed during short period.

3. VC is zero when production is stopped.

4. A firm continues production only when VC are met.

5. VC curve moves up from left to the right.

Schedule of Costs

Output

TFC TVC TC AFC AVC AC MC

0 100 0 100 - - - -

1 100 50 150 100 50 150 50

2 100 70 170 50 35 85 20

3 100 80 180 33.34 26.67 60 10

4 100 105 205 25 26.25 51.25 25

5 100 135 235 20 27 47 30

6 100 170 270 16.67 28.34 45 35

RELATIONSHIP BETWEEN MC & AC

RELATIONSHIP BETWEEN MC & AC

1. When Ac falls, MC ‹ AC.

2. When AC is constant MC = AC.

3. When AC rises, MC › AC.

Rising Portion of MC Curve is the Supply Curve

EXPLANATION

In the figure, MC is U-shaped and P1 is the price line under perfect competition. At price P1 , the price line cuts MC curve at two points – at Q1

a and Q1b , i.e., it satisfies profit maximizing

condition P =MC at two places. But total profit at output level of Q1

b is higher. Therefore, at price P1, the firm produces the amount Q1

b. It means that if price is OP1 , the firm will supply Q1b

level of output. Similarly if price is OP2, the firm would supply OQ2 level of output and at price OP3, it would supply OQ3 level of output and so on. We see clearly that all price-output combinations are simply the points on the rising portion of MC curve. Hence, it is concluded that the rising portion of MC curve is the supply curve.