Cost
In previous topic we have
discussed production as a
process of transformation of
These inputs have some
input into output. Input
price which is known as
includes land, labour,
Cost
capital, etc. as factor inputs
and intermediate goods as
non factor inputs.
Cost
Expenditure incurred on factor as well as on non factor
inputs used in the production is collectively known as
cost.
Here cost refers to production cost only, not selling
cost used incurred to promote sale of the product.
Types of Cost
• Explicit Cost: payment made by producer to an outsider
for purchasing or hiring inputs. Also known as accounting
cost.
• Example: Rent paid, wages paid, interest on loan, etc.
• Implicit Cost: not paid to an outsider but it is an imputed
charge on the self owned inputs. It is the market value of
self owned inputs in their next best alternatives use.
• Example: Imputed rent of self owned building, owner’s
salary, interest on own capital, etc.
• Economic cost = Explicit cost + Implicit Cost
Investment = 1 Cr
Suppose X Sales = 50,00,000
started Accounting Cost =(40,00,000)
business Accounting profit =10,00,000
with 1 Crore. Salary of owner
=(5,00,000)
Interest on capital =(8,00,000)
Economic Loss -
2,00,000
• Mr X is investing Rs. 20 lakh in a business out
of which he will take a loan of Rs. 12 lakh @
10% from bank?
• Exlicit Cost = 12 lakh x 10% = 1,20,000
• Implicit Cost = 8 lakh x 10% = 80,000
Short Run Cost
As discussed earlier, we have two types of inputs in
short run.
Fixed Input
Variable Input
So there will be two types of cost in short run
Total Fixed
Which does not change with the change in level of output.
Cost
Total Variable Cost: Changes directly with
the change in the output level
Total Cost (TC)
• As the Total Fixed Cost remains the same at all
output levels, the change in Total Cost
completely depends upon Total Variable Cost.
• TC = TFC + TVC OR TC – TFC = TVC
TC – TVC = TFC
• In the above graph, the TC curve is obtained by adding
TVC and TFC curves.
• As TFC remains the same at all output levels, the change
in TC is solely due to TVC.
• Therefore, the distance between the TC curve and the
TVC curve always remains the same.
• Just like the TVC curve, the TC curve is also inversely S-
shaped because of the Law of Variable Proportion
Average Fixed Cost (AFC)
• It is the cost per unit of output produced. It is also called
as unit cost of production.
• AFC = TFC/Q
• TFC = total fixed cost
• Q = total output
• As FC remain constant, with the increase in output
AFC always decreases with decreasing rate.
• AFC can never be zero so AFC curve never touches
X axis
• AFC curve is rectangular hyperbola which means
the area of all the rectangles under this curve
remains same.
• Average Variable Cost: Per unit variable cost AVC =
TVC/Q
• AVC curve is a U-shaped curve because of the Law of
Variable Proportion.
• In the beginning, the AVC curve falls (because of the
increasing returns to a factor with better utilization of fixed
factors and variable factors).
• After reaching its minimum level; i.e., optimum output level,
it starts on increasing with every additional output (because
of diminishing returns to factor).
• Average total cost (ATC) or Average Cost (AC): Per unit TC
• Another way to define Average Total Cost is by the sum of
Average Fixed Cost and Average Variable Cost; i.e., AC = AFC +
AVC.
Relationship between AC, AFC, AVC
[Link] curve will always lie above
the AVC curve (as seen in the
above graph). It is because, at
levels of output, AC includes both
AVC and AFC.
[Link] the output level increases,
the gap between AC and AVC
curves starts to decrease;
however, these curves never
intersect each other because the
vertical distance between these
two curves is AFC, which can
never be zero.
• Marginal Cost (MC) : The additional cost incurred to the total
cost or TVC when one more unit of output is produced is known
as Marginal Cost. Marginal Cost is also known as Incremental
Cost.
• Simple we can say net change in TC when one more unit is
produced.
• MCn = TCn – TCn-1 MCn = TVCn – TVCn-1
OR
• MC is a U-shaped curve because of the Law of Variable
Proportions.
• In the beginning, the units of the variable factor are employed
along with the fixed factors, yielding increasing returns to
factor and reducing MC.
• It pushes down the MC curve. Now, when more variable
factors are employed, it results in diminishing returns and
increasing MC after it reaches its minimum level.
• Therefore, the MC curve falls to its minimum level and then
increases, making the short-run MC curve, U-shaped.
Units TC TFC TVC MC
0 100
1 150
2 190
3 220
4 260
5 320
Units MC TVC AVC
1 100
2 90
3 70
4 80
5 100
Units MC TVC AVC
1 100 100 100
2 90 190 95
3 70 260 86.7
4 80 340 85
5 100 440 88