THEORY OF COST
We use the word cost in common usage. If we pay $5 per hour to
a worker whom we employ for 20 hours, then our cost is clearly $
100. this is the common usage of cost.
This type of cost is known as accounting cost.
The concept of cost in economics is somewhat different.
Opportunity cost is the concept most important in economics.
Opportunity cost is defined as the value of a resource in the next
best use. for example
Suppose that Mr. Smith quits his job making $ 50,000 per year
and instead opens his own small business. Although the
accounting cost of Mr. smith’s labor to his business is zero but
the opportunity cost is $50,000 per year.
In other words the forgone income by starting his own
business.
Sunk cost: sunk costs are costs only in the accounting sense.
Their opportunity cost is zero. For example A firm purchases
a specialized machinery with no alternative use. Once
purchased , the price of the machine is a sunk cost.
Total cost: total cost is the final cost on the production of a
product. It is represented by TC. Total cost is of two type
fixed cost and variable cost. TC= FC+VC
Marginal cost: Marginal Cost is the cost of the additional unit
of output. Its mathematical equation is MC = ∆TC/∆Q.
MC means marginal cost.
Average cost: when total cost is divided by the number of
units produced we get average cost. Or it is simply the per unit
cost of output. Mathematically it is equal to TC/Q
Outp TFC TVC TC MC AFC AVC ATC
ut
0 200 0 200
1 200 50 250 50 200 50 250.0
2 200 90 290 40 100 45 145.0
3 200 120 320 30 66.7 40 106.7
4 200 140 340 20 50.0 35 85.0
5 200 150 350 10 40.0 30 70.0
6 200 156 356 6 33.3 26 59.0
7 200 175 375 19 28.6 25 53.6
8 200 208 408 33 25.0 26 51.0
9 200 270 470 62 22.2 30 52.2
10 200 350 550 80 20.0 35 55.0
Average fixed cost (AFC): TFC/Q where is Q is output
Average variable cost (AVC): TVC/Q
Average total cost (ATC): ATC=AFC+AVC
Short run: A time period over which the quantities of some
inputs cannot be changed like land, machinery etc
Long run: A time period long enough for all inputs to be
changed.
Economies of scale: when the firm is expanding itself size
(scale) its per units cost decreases because of some factors.
These factors are known as economies. These economies are
of two types
Internal economies and external economies.
Internal economies: Internal economies are those factors which
are inside the firm. Like financial economies, marketing
economies and risk bearing economies. External economies
Financial economies: these are the economies which are related
to the acquiring of funds. Large firms can keep more
collaterals with the bank and can get more loan very easily
and at the lower cost( interest rate) than a small firm.
Marketing Economies: large firms usually buy large amount of
inputs and thus decreases its cost of production. Similarly
these large firms can advertise more than a small firm because
of having huge funds.
Risk bearing Economies: one the most important economies is
the risk bearing economies which means that a large firm can
take more risk than a small firm.
External economies: External economies can be related to any
firm irrespective of the size of the firm. If a firm is more close
to the source of raw material that firm enjoy the external
economies of scale.
Diseconomies of scale
Diseconomies of scale means disadvantages associated
with the size of the firm. If a firm is very large then that
firm can face managerial problems like late decision
making and waste of time in coordinating with various
departments inside the firm. A worker may work less
efficiently as he is far away from the center of the
decision making.