Unit Three

Cost Curves
Cost
Cost refers to the expenditure made by a firm to produce
goods and services.
Types of Cost
1. Explicit Cost
2. Implicit Cost
3. Fixed Cost
4. Variable Cost
5. Money Cost
6. Real Cost
7. Opportunity Cost
8. Actual Cost
9. Accounting Cost
10. Economic Cost
1. Explicit Cost:
Explicit cost is the amount paid for the use of the
factors of production that the producer obtain from others.
These are the direct, out-of-pocket expenses. Examples
include wages, rent, utility bills, raw materials, and other
tangible expenses that require a monetary payment.
2. Implicit Cost:
Implicit cost refers to the value of the inputs owned and
used by the firm in its own production process. In other
words, Implicit costs are the opportunity costs of using
resources owned by the business or individual instead of
selling or renting them out. These costs represent the potential
benefits that are foregone when resources are used in a
specific endeavor instead of their next best alternative.
3. Fixed Cost:
Fixed costs are expenses that do not vary with the
level of production or sales volume. They remain
constant within a certain production or time period.
Examples include rent, insurance, and salaries of
permanent employees.
4. Variable Cost:
Variable costs are expenses that change in
proportion to the level of production or sales volume. As
production increases, variable costs increase, and vice
versa. Examples include raw materials, direct labor, and
sales commissions.
5. Money Cost:
Monetary cost is the payment made for the
different factors of production in terms of money. In
other words, Money costs refer to the actual expenses
paid in monetary terms for various inputs, services, or
goods required in production or any economic activity.

6. Real Cost:
Real cost is the pain, inconvenience and obstacles
borne by the producers while producing the goods and
services.
7. Opportunity Cost:
Opportunity cost is the price of any other product which
can be produced by the same factors of production but which is
not produced. In other words, Opportunity cost is the cost of
choosing one option over the next best alternative
forgone. It is the value of the best alternative that is
sacrificed when a particular choice is made.

8. Actual Cost:
Actual costs are the real expenses incurred during
a specific period or for a particular project or activity. In
other words, the expense incurred in the use of land,
labour, capital and raw material is known as actual cost.
9. Accounting Cost:
Accounting costs are the explicit costs that are
recorded and reported in a company's financial
statements. These costs are typically measured in
monetary terms.

10. Economic Cost:

Economic costs refers to the cost which includes
both explicit and implicit costs. They represent the total
cost of an economic activity, including the opportunity
costs associated with the resources used.
 Each type of cost serves a different purpose and is
essential in analyzing the financial and economic aspects
of businesses and decision-making. Understanding these
cost concepts helps individuals and organizations make
informed choices about resource allocation and
profitability.
Short Run Cost
It refers to the payment made for such factor as
labour, raw materials that can be changed in the short
period of time.
Long run Cost
It refers to the expenses incurred in such factor
as land, labour, capital, organization, technology etc
that can be changed in the long period of time as per
requirement.
Types of short run total cost
a. Total fixed cost (TFC)
It refers to the expenditure made by a firm in fixed
factors during production process. It remains fixed
whether the level of output is increased or decreased
or becomes zero.
Symbolically,
TFC = Rent of building + Interest on capital
+ Salaries of permanent employees +
Depreciation cost + Insurance premium
b. Total variable cost (TVC)
Total variable cost refers to the expenditure
made by a firm in variable factors during production
process. It may increase or decrease or becomes zero
with the change in output level.
Symbolically,
TFC = f(Q) = AVC * Q
Where,
TVC = Total variable cost
AVC = Average variable cost
Q = Output produced
c. Total Cost (TC)
It refers to the cost incurred on both fixed and
variable factors.
Symbolically,
TC = TFC + TVC
Where,
TC = Total Cost
TFC = Total fixed cost
TVC = Total variable cost
Relationship between TFC, TVC and TC
The relationship between TFC, TVC and TC can
be illustrated with the help of following table and
figureQuantity
: TFC TVC TC
0 30 0 30
1 30 20 50
2 30 28 58
3 30 39 69
4 30 58 88
5 30 84 114
6 30 112 142
7 30 144 174
 In the above table, initially total variable cost
increases at decreasing rate and then increases at faster
rate. Total fixed cost (TFC) remains constant whatever
be the level of output. It is incurred even output is zero.
Total cost (TC) is derived by the summation of
total fixed cost (TFC) and total variable cost (TVC).
The nature and direction of total cost is determined by
the nature and direction of Total variable cost (TVC). It
means TC increases at decreasing rate in the beginning
and increases at increasing rate as output is increased.
We can also illustrate or explain the nature and shape of Total
fixed cost (TFC), Total variable cost (TVC) and Total Cost
(TC) with the help of figure as below:
 In the above figure, Quantity produced and cost are
represented in x-axis and y-axis respectively. Here, Total
fixed cost (TFC) is constant at RS. 30 even in 0 level of
output but variable cost is zero at zero level of output. When
1st unit of good is produced, Total variable cost is incurred
Rs. 20. By summing TFC and TVC, total cost is calculated
to be Rs. 50. When 2 units of goods are produced, variable
cost increases by Rs. 8 (increased to Rs. 28 from Rs. 20)
and TC increases to Rs. 58 from Rs. 50. TC increases at a
decreasing rate till 2nd unit of output. But, TC increases
rapidly from 3rd units of production. Since, TVC increased
at a decreasing rate at initial stage and increases at an
increasing rate. The TVC and TC curves are inversed S-
shaped due to the operation of law of variable proportions.
Total Cost Curves in Smooth Lines.
Types of Short Run Average Cost
The types of short run average cost are as follows:
1. Average Fixed Cost (AFC)

The average fixed cost is defined as total fixed cost

divided by the level of output produced. As output
increases, AFC falls continuously. Average fixed cost can
never be zero and negative because total fixed cost is not
zero. Symbolically,
AFC= TFC
Q
Where,
AFC= Average fixed cost, TFC = Total Fixed cost
Q = Output produced.
It can be explained with the help of following table
 In above table, as total fixed cost remains fixed i.e. Rs 50, dividing it by an
increasing output would gradually reduce the average fixed cost. This would give a
downward sloping average fixed cost curve. It can be explained by the help of
following graph;
 In above graph, AFC shows average fixed cost curve. This curve slopes
downwards to the right. Downward slope of AFC shows that it decreases continuously
as output increases but never zero and negative. Its shape is rectangular hyperbola as
shown in above figure.

[Link] Variable Cost (AVC)

Average variable cost is defined as the total
variable cost divided by the level of output produced.
AVC decreases at first, reach minimum and then start to
increase along with the increase in output. Symbolically,
AVC = TVC
Q
Where, AVC= Average Variable Cost
TVC= Total Variable Cost
Q = Quantity Produced.
It can be explained with the help of following table
 The above table shows that initially AVC
decreases and reaches minimum to Rs. 13.7 And then
start to increase thereafter with the increase in output
produced. Here, initially AVC falls due to the operation
of increasing return in production and after a 4th unit of
output, AVC increases continuously due to operation of
diminishing return in production.
It can be explained with the help of following Figure
 In above figure, AVC represents the average
variable cost curve. It slopes downward in the beginning
reaches the minimum point and rises upward thereafter.
The AVC curve is 'U' shaped.
3. Average Cost (AC)
Average cost is the cost per unit of
output. It is obtained by dividing total cost by
quantity of output. It may also be obtained by adding
average fixed cost (AFC) and average variable cost
(AVC). It is also called Average Total Cost (ATC).
Symbolically,
AC = TC
Q
Where, AC = Average cost , TC = Total Cost
Q = Unit of output produced
It can be explained with the help of following table
 In above table, AC is outcome of
summation of AFC and AVC or it is obtained dividing
total cost by quantity of output produced. It decreases at
first up to 4 unit of output are produced, reaches
minimum point when 5 unit of output are produced and
starts to rise with the increase in output. Here, initially
AC falls due to the operation of increasing return in
production and after a certain level it increases
continuously due to operation of diminishing returns in
production.
It can be explained with the help of following Figure
 AC curve is the summation of AVC and
AFC. Both AVC and AFC fall in the beginning as
shown in the figure. AC also falls in the initial stage,
reaches the minimum point and starts rising. AC curve
is also „U‟ shaped because it takes its shape from the
AVC curve, with the upturn reflecting the onset of
diminishing returns to the variable factor.
4. Marginal Cost (MC)
Marginal cost is addition to the total cost caused by producing
one more unit of output. It is the extra cost of producing one more unit of
output. It is also defined as the change in total cost due to the change in output.
According to Ferguson, “Marginal cost is the addition to total cost due
to the addition of one unit of output” . Symbolically,
MC = TC
Q
Similarly, MCn = TCn – TCn-1
Where MC = Marginal cost
TC = Change in total cost
Q = Change in output.
Note:
The marginal cost of second unit of output is obtained by subtracting the
total cost of one unit of output from two unit of output produced.
Symbolically,
MC2 = TC2 – TC1
It can be explained with the help of following table
 In the above table, marginal cost decreases from Rs 30 to Rs
10 with the increase in output i.e., 1 unit to 2 unit respectively, then
it reaches minimum i.e., Rs 5 and then starts to rise with every
increase in quantity produced. This can be explained with the help of
following figure:
 In the above figure, the marginal cost first
falls, reaches the minimum point and increase
thereafter along with every increase in quantity
produced. Thus, MC curve also first slopes downward,
reaches the minimum and rises thereafter. The shape of
MC curve is also U-shaped.
Marginal Cost Curve in Smooth Lines.
 Relation of AC, AVC and MC
Relation of AC and AVC
Average cost is the sum of AVC and AFC.
So, AVC is only a part of AC. Both AC and AVC curves
are U-shaped due to the operation of law of variable
proportions in production. However, the minimum
point of AC lies to the right minimum point of AVC.
This happens due to continuous fall in AFC with every
increase in output. AC falls continuously even if AVC
rises at beyond minimum point because AFC is falling
continuously. When AVC rises at higher rate than the
falling rate of AFC, AC begins to rise.
This law can be explained with the help of following figure:
 In the above figure, output and cost are
measured on ‘X’ and ‘Y’ axis respectively. In the initial
stage both AVC and AC are falling but AVC lies below
AC. When AVC reaches to minimum point, AC
remains falling and minimum point of AC lies
rightwards above minimum point of AVC. AVC starts
to increase at a faster rate than falling rate of AFC
beyond minimum point of AVC. Due to this reason, AC
also begins to increase as more and more units are
produced, AC and AVC get nearer. In case of AFC, it
falls down continuously from left to right. However, it
never touches X-axis.
Relationship between AC and MC
Average cost is the cost per unit of output
produced. Marginal cost is the change in total cost
resulted by one more unit of output produced. Initially,
both AC and MC falls continuously, reaches to the
minimum point, then rises due to law of variable
proportions. The relationship between AC and MC is
clearly explained in the figure below:
 In the above figure both AC and MC curves are
U-shaped. It is clear that when both AC and MC curves
are falling, MC lies below AC because AC includes
both variable and fixed cost. On the other hand, MC is
the addition made to the variable cost only. So, MC lies
below AC and falls at a higher rate than AC. MC curve
reaches its minimum before the AC is minimum. (i.e.
MC intersects AC from below). When AC starts to rise,
MC rises more rapidly than AC.
Summary of Relationship between AC and MC
1. Both AC and MC are calculated from total cost but
difference is; AC is derived from TC and Q, MC is
derived from change in TC and change in Q.
2. When AC is falling, MC curve lies below AC and
MC falls faster than AC.
3. MC cuts AC at its minimum point. (AC = MC at
minimum point of AC)
4. When AC increases, MC lies above AC curve and
MC increases rapidly.
5. Both AC and MC are U-shaped due to the operation
of law of variable proportions in production process.
Why AC curve is U-Shaped in the short-run?

The average cost falls in initial stage, reaches

minimum point and begins to rise in short run. Due to
this reason, shape of AC curve is U-shaped. The causes
of U-shaped AC curve are explained as follows:
1. Law of Variable proportion

Law of Variable proportion operates in

production process. In the initial stage of production,
when AP increases, AC decreases. When AP reaches
maximum, AC reaches minimum point. When AP
starts to decrease, AC starts to increase. Hence, AC is
U-shaped.
2. Economies of scale and diseconomies of scale.
Due to the operation of economies of scale in the initial
stage of production average cost of production declines upto
the optimum level of output. However, economies of scale
may not be long lasting in production process. Beyond the
optimum level of output, average cost begins to increase due to
the operation of diseconomies of scale. Hence, AC curve is U-
shaped.
3. Indivisibility of factors of production
Some factors of productions cannot be divided into
small parts. As a result, it is impossible to reduce machine and
managers to produce less. This results expansion of output and
hence AC declines at initial stage. But after reaching minimum
point AC starts to increase due to diminishing productivity of
indivisible factors. Hence, AC curve is U-shaped.
Notes:
 Total product is the total quantity produced by a firm

using all the factor inputs within a given period of time

under given state of technology.
 Law of variable proportion states that, As the

proportion of one factor in a combination of factors is

increased, after a certain period of time firstly the
marginal product(MP) and then the average
product(AP) and finally total product(TP) of that will
diminish.
 Economies of scale refer to the cost advantage
experienced by a firm when it increases its level of
output. The advantage arises due to the inverse
relationship between the per-unit fixed cost and the
quantity produced. The greater the quantity of output
produced, the lower the per-unit fixed cost.
 Diseconomies of scale occur when a business expands

so much that the costs per unit increase. It takes place

when economies of scale no longer function.
Numericals