Concept

INTRODUCTION

In the previous chapter, we studied the various concepts and laws related to the behaviour of
product. A firm uses various inputs to produce goods and services. Firm has to make payments for
such inputs as they do not come free. The expenditure incurred on these inputs is known as the cost
of production.

Since production costs are important in determining a firm's output, we will understand several
aspects about a firm's costs in this chapter. This comprehensive study will lay the foundation for
understanding the supply decisions of business firms.

Concept

MEANING OF COST

Cost is the total expenditure incurred in producing a commodity. In Economics, Cost is the sum total
of:

1. Explicit Cost It is the actual money expenditure on inputs or payment made to outsiders their
factor services. For example, wages paid to the employees, rent paid for hired premises,
payment for raw materials, etc.

2. Implicit Cost: It is the estimated value of the inputs supplied by the owners including normal
profit. For example, interest on own capital, rent of own land, salary for the services of
entrepreneur, etc. Such costs are the costs of self supplied factors.

So, Cost in economics includes actual expenditure on inputs (i.e. explicit cost) and the imputed value
of the inputs supplied by the owners (i.e. implicit cost).

Economic cost of production includes not only the accounting cost (i.e. the explicit costs) but also the
implicit cost. The sum of Explicit cost and Implicit cost is the total cost of production of a commodity

Concept

How to Measure Implicit Cost?

Implicit cost is measured by determining the value of self supplied factors in terms of their market
price. For example, if a doctor has opened a clinic at his home, then imputed value of salary for his
services will be included Value of salary will be calculated on the basis of salary that he would receive
if he is employed by someone else.

Implicit cost is calculated because if such factors were not owned and used by the entrepreneur in
his firm, then he would have hired them from outsiders. So imputed value of factors, Le implicit cost
is included in the total cost of production.

Concept

Explicit Cost Vs Implicit Cost

Concept

Cost Function

The relation between cost and output is known as ‘Cost function’. Cost function refers to the
functional relationship between cost and output.

It is expressed as: C = f (q)

{Where C = Cost of production; q = Quantity of output; f = Functional relationship}

Concept

Opportunity Cost

Opportunity cost is cost of the next best alternative foregone.

The concept of opportunity cost is very important as it forms the basis of the concept of cost. When
a firm decides to produce a particular commodity, then it always considers the value of the
alternative commodity, which is not produced. The value of the alternative commodity is the
opportunity cost of the good that the firm is now producing.

For example, suppose, a farmer can produce either 50 quintals of rice or 40 quintals of wheat on his
land with the given resources. If he chooses to produce rice, then he will have to forego the
opportunity of producing 40 quintals of wheat.

Cost can be of different types:

1. Money Cost;

2. Real Cost;

3. Private Cost; and

4. Social Cost.

Refer ‘Power Booster’ for their brief discussion.

Concept

6.3 SHORT RUN COSTS

We know, in the short nun, there are some factors which are fixed, while others are Similarly, short
run costs are also divided into two kinds of costs:

 Fixed Cost

 Variable Costs
The sum total of fixed cost and variable cost is equal to total cost.

Let us discuss the short run costs in detail.

Concept

Total Fixed Cost (TFC) or Fixed Cost (FC)

Fixed Costs refer to those costs which do not vary directly with the level of output. For example, rent
of premises, interest on loan, salary of permanent staff, insurance premium, etc.

Fixed Cast is also known as:

1. Supplementary Cost; or

2. Overhead Cost or

3. Indirect Cost; or

4. General Cost; or

5. Unavoidable Cost.

Fixed cost is incurred on fixed factors like machinery, land, building, etc., which cannot be changed in
the short run. The payment to these factors remains fixed irrespective of the level of output, i.e. fixed
cost remains the same, whether output is large, small or even zero.

Example Fixed Cost

Suppose, you start a furniture business of making wooden chairs. You hire a shop at a monthly rent
of rs. 4,000 and take a loan of rs. 1,00,000 from ICICI Bank @ 1% interest per month. Now, your
monthly total fixed cost will be rs. 5,000 {rs. 4,000 as rent and rs. 1,000 as monthly interest on loan
(1% of 1,00,000)}. You will have to pay 5,000 per month irrespective of the number of chairs
produced.

The concept of fixed cost can be better explained through following schedule and diagram:

Table 6.1: Total Fixed Cost Schedule

Fixed costs are diagrammatically shown in Fig. 6.1 Units of output are measured along the X-axis and
fixed costs along the Y-axis. TFC is the fixed cost curve obtained by plotting the points shown in Table
6.1. The curve makes intercept on the Y-axis, which is equal to the fixed Cost of Rs. 12 TFC curve in a
horizontal straight line parallel to the X-axis because TTC remains same at all levels of output even if
the output is zero.

Why does Fixed Cost no vary with output?

Fixed costs like salary of a permanent manager, rent of telephone, etc. are paid irrespective of the
level of output. Buch costs are indivisible even if the fins a producing zero or small output means a
fem cannot have half a manager or half a telephone just because is operating at a low eve of output.

Concept

Total Variable Cost (TVC) or Variable Cost (VC)

Variable costs refer to those costs which very directly with the level of output. For example, payment
for raw material, power, fuel, wages of casual labour, etc. Variable costs are incurred on variable
factors like raw material, direct labour, power, etc. which changes with change in level of output. It
means, variable costs rise with increase in the output and fall with decrease in the output. Such costs
are incurred till there is production and became at zero level of output.

Variable cost is also known as ‘Prime Cost’, ‘Direct Cost’ or ‘Avoidable Cost’.

Let us discuss the concept of variable cost with the help of the following schedule and diagram:

Table 6.2: Total Variable Cost Schedule

TVC curve is inversely S-shaped as it initially increases at decreasing rate and later it increases at
increasing rate. TVC is zero at 0 level of output
In Fig. 6.2. units of output are measured along the X-axis and vantable cost along the axis TVC is the
variable coal curve obtained by plating the points shown in Table 6.2. As seen in the diagram, TVC
curve starts from the origin indicating that is zero, variable cost is also zero TVC is an inversely S-
shaped curve due to the Law of Variable when output Proportions

Concept

Differences Between Total Variable Cost and Total Fixed Cost

Concept

Total Cost (TC)

Total Cost (TC) is the total expenditure incurred by a firm on the factors of production required for
the production of a commodity.

TC is the sum of total fixed cost (TFC) and total variable cost (TVC) at various levels of output.

TC=TFC+TVC

Since TFC remains same at all levels of output, the change in TC is entirely due to TVC The concept of
total cost can be better understood through Table 63 and Fig. 6.3.

Table 6.3: Total Cost Schedule

In Table 6.3, TC = TFC = ₹12 at zero level of output because TVC is zero. At 1 unit of output, TFC
remains same at ₹12, but TVC increases to ₹6. As a result, TC becomes 12 + 6 = ₹18. Similarly, other
values of TC have been calculated.

In Fig. 6.3, TC curve is obtained by summation of TVC and TFC curve. The change in TC curve is
entirely due to TVC as TFC remains constant. By adding TFC to TVC curve, we get the TC curve. The
vertical distance between TC and TVC always remains the same due to constant TFC Like TVC curve,
TC curve is also inversely S-shaped, due to the Law of Variable Proportions.

The change in TC is entirely due to TVC as TFC is constant at all levels of output, TC = TFC at zero
output as variable cost is zero. With increase in output, TC also increases by the extent of increase in
TVC.

Concept

Relationship between TC, TFC and TVC

The various points of relationship between TC, TFC and TVC can be better explained with the help
of Table 6.3 and Fig. 6.3.

1. TFC curve is a horizontal straight fine parallel to X-axis as it remains constant at all levels of
output.
 2. TC and TVC curves are inversely S-shaped because they rise initially at a decreasing rate them
at a constant rate and finally, at an increasing rate. The reason behind their shape is the Law
of Variable Proportions.

3. At zero output, TC is equal to TFC because there is no variable cost at zero level of output. So,
TC and TFC curves start from the same point, which is above the origin.

4. The vertical distance between TFC curve and TC curve is equal to TVC. As TVC rises with
increase in the output, the distance between TFC and TC curves also goes on increasing

5. TC and TVC curves are parallel to each other and the vertical distance between them remains
the same at all levels of output because the gap between them represents TFC, which
remains constant at all levels of output.

Concept

AVERAGE COSTS

The per unit costs explain the relationship between cost and output in a more realistic manner. From
total fixed cost (TFC), total variable cost (TVC) and total cost (TC), we can obtain per unit costs. The 3
kinds of per unit costs are:

1. Average Fixed Cost (AFC)

2. Average Variable Cost (AVC)

3. Average Total Cost (ATC) or Average Cost (AC)

Concept

Average Fixed Cost (AFC)

Average fixed cost refers to the per unit fixed cost of production. It is calculated by dividing TFC by
total output.

AFC = TFC Q

{Where: AFC = Average fixed cost; TFC = Total fixed cost; Q = Quantity of output}

AFC falls with increase in output as TFC remain same at all levels of output.

Table 6.4: Average Fixed Cost

As seen in Table 6.4, AFC falls with rise in output because constant TFC is divided by increasing
output AFC curve in Fig. 6.4 is obtained by plotting the points shown in Table 6.4. AFC curve is a
rectangular hyperbola, i.e. area under AFC curve remains same at different point.

AFC does not touch any of the axes

As AFC is a rectangular hyperbola, it approaches both the axes. It gets nearer and nearer the axes,
but never touches them.

 AFC can never touch the X-axis as TFC can never be zero.

 AFC curve can never touch the Y-axis because at zero level of output. TFC is a positive value
and any positive value divided by zero will be an infinite value.

Concept

Average Variable Cost (AVC)

Average variable cost refers to the per unit variable cost of production. It is calculated by dividing TVC
by total output.

AVC = TVC Q

{Where: AVC = Average variable cost; TVC = Total Variable cost; Q = Quantity of output}

AVC initially falls with increase in output. Once the output rises till optimum level, AVC starts Rising.
It can be better understood with the help of Table 6.5 and Fig. 6.5.

Table 6.5: Average Variable Cost

Concept

Average Total Cost (ATC) or Average Cost (AC)

Average cost refers to the per unit total cost of production. It is calculated by dividing TC by total
output.

AC = TC Q

{Where: AC = Average cost; TC = Total cost; Q = Quantity of output}

Average cost is also defined as the sum of average fixed cost (AFC) and average variable cost (AVC),
i.e. AC = AFC + AVC

Like AVC, average cost also initially falls with increase in output. Once the output rises till optimum
level, AC starts rising. It can be better understood with the help of Table 6.6 and Fig. 6.6.

Table 6.6: Average Cost

As seen in Table 6.6, AC is calculated by adding AFC and AVC. As seen in Fig. 6.6, AC curve is a U-
shaped curve. It means AC initially falls (1st phase), and after reaching its minimum point (2nd phase),
it starts rising (3rd phase).
Let so understand the three phases of AC:

1st Phase: When both APC and AVC fall till the level of 2 units

of output, AC also falls Le till point A.

2nd Phase: From 2 units to 3 units, AFC continues to fall, but

AVC remains constant. So, AC falls (due to falling

AFC) till it reaches its minimum point 'B' From 3

units to 4 units, fall in AFC (by? 1) is equal to rise in

AVC (by 1), 50, AC remains constant.

3rd Phase: After 4 units of output, rise in AVC (by1) is more than

fall in AFC (by 0.60) and, therefore, AC starts rising.

Concept

Important Observations: AC, AVC and AFC

1. AC curve will always lie above the AVC curve (See Fig. 67) because AC, at all levels of output
includes both AVC and AFC.

2. AVC reaches its minimum point (point 'B') at a level of output lower than that of AC (point
'A') because when AVC is at its minimum point, AC is still falling because of falling AFC.

3. As the output increases, the gap between AC and AVC curves decreases, but, they never
intersect each other. It happens because the vertical distance between them is AFC, which
can never be zero.

Concept

MARGINAL COST

Marginal cost refers to addition to total cost when one more unit of output is produced. For example,
If TC of producing 2 units is 200 and TC of producing 3 units is 240, then

MC = 240 – 200 - ₹40.

MCn = TCn - TCn - 1

Where:

n = Number of units produced

MCn = Marginal cost of the n unit

TCn = Total cost of n units

TCn-1 = Total cost of (n-1) units.

One More way to Calculate MC

We know, MC is the change in TC when one more unit of output is produced. However, when change
in units produced is more than one, then MC can also be calculated as:

If TC of producing 2 units is ₹200 and TC of producing 5 units is ₹350, then MC will be:

MC is not affected by Fixed Costs

We know, MC is addition to TC when one more unit of output is produced. We also know, TC = TFC +
TVC. As TFC does not change with change in output. MC is independent of TFC and is affected only by
change in TVC.

This can be explained with the help of a simple mathematical derivation:

We know:

MCn = TCn – TCn-1 …. (1)

MCn = TCn – TCn-1 …. (2)

Putting the value of (2) in (1), we get

MCn = (TFCn + TVCn) – (TFCn-1 + TVCn-1)

= TFCn + TVCn – TFCn-1 – TVCn-1

= TFCn – TFCn-1 + TVCn – TVCn-1

Now, TFC is same at all levels of output, so TFCn = TFCn-1

It means, TFCn – TFCn-1 = 0

So, MCn = TVCn - TVCn-1

Let us now understand the concept of MC with the help of a schedule and diagram:

Table 6.7: Marginal Cost

As seen in Table 6.7, MC can be calculated from both TC and TVC. MC curve in Fig. 6.8 is obtained by
plotting the points shown in Table 6.7. MC is a U-shaped curve, i.e. MC initially falls till it reaches its
minimum point and thereafter, its starts rising. The reason behind its U-shape is the Law of Variable
Proportions.

Concept

RELATIONSHIP BETWEEN SHORT RUN COST CURVES

As discussed earlier, there exists a close relationship between the various types of costs. Let us
understand the relationship between the following costs:

1. Average Cost (AC) and Marginal Cost (MC)

2. Average Variable Cost (AVC) and Marginal Cost (MC)

3. Average Cost (AC) and Average Variable Cost (AVC) and Marginal Cost (MC)

4. Average Cost (AC) and Average Variable Cost (AVC)

5. Total Cost (TC) and Marginal Cost (MC) 6. Total Variable Cost (TVC) and Marginal Cost (MC)

Concept

Relationship between AC and MC

There exists a close relationship between AC and MC.

 Both AC and MC are derived from total cost (TC). AC refers to TC per unit of output and MC
refers to addition to TC when one more unit of output is produced.
  Both AC and MC curves are U-shaped due to the Law of Variable Proportions.

The relationship between them can be better illustrated through following schedule and diagram.

Table 6.8: Relationship between AC and MC

With the help of Table 6.8 and Fig. 6.9, the relationship can be summarized as under:

1. When MC is less than AC, AC falls with increase in the output, i.e. till 3 units of output.

2. When MC is equal to AC, i.e. when MC and AC curves intersect each other at point A, AC is
constant and at its minimum point.

3. When MC is more than AC, AC rises with increase in output, i.e. from 5 units of output.

4. Thereafter, both AC and MC rise, but MC increases at a faster rate as compared to AC. As a
result, MC curve is steeper as compared to AC curve.

AC depends on the nature of MC

 When MC curve lies below the AC curve, it pulls the latter downward

 When MC curve lies above AC curve, it pulls the latter upwards

 Consequently, MC and AC are equal where MC intersects AC curve

Can AC Fall, when MC is rising?

Yes AC can fall when MC is rising. How ever it is only possible when MC is less then AC. It means that
as long as MC curve is below the AC curve , AC will fall even if MC is rising. As per table 6.8, when we
move from 2 units to 3 units, MC Rises and AC Falls. It happens because during this range, MC is less
than AC.

Can AC rise, when MC is falling?

No AC cannot se, when MC is falling because when MC falls, AC will also fall

Concept

Relationship between AVC and MC

The relationship between AVC and MC curves is similar to that of AC and MC. Both AVC and MC are
derived from total variable cost (TVC). AVC refers to TVC per unit of output and MC is the addition to
TVC, when one more unit of output is produced.

Both AVC and MC curves are U-shaped due to the Law of Variable Proportions. The relationship
between AVC and MC can be better illustrated with the help of following schedule and diagram.

Table 6.9: Relationship between AVC and MC

 1. When MC is less than AVC, AVC falls with increase in the output, i.e. till 2 units of output.

2. When MC is equal to AVC, i.e. when MC and AVC curves intersect each other at point B, AVC
is constant and at its minimum point (at 3rd unit of output).

3. When MC is more than AVC, AVC rises with increase in output, i.e. from 4 units of output.

4. Thereafter, both AVC and MC rise, but MC increases at a faster rate as compared to AVC. As a
result, MC curve is steeper as compared to AVC curve.

Concept

Relationship between AC, AVC and MC

The relationship between AC, AVC and MC can be better illustrated with the help of following
schedule and diagram.

Table 6.10: Relationship between AC, AVC and MC

1. When MC is less than AC and AVC, both of them fall with increase in the output.

2. When MC becomes equal to AC and AVC, they become constant. MC curve cuts AC curve (at
'A') and AVC curve (at 'B') at their minimum points.

3. When MC is more than AC and AVC, both rise with increase in output.

Concept

Relationship between AC and AVC

The relationship between AC and AVC can be discussed with the help of Fig. 6.11. 1. AC is greater
than AVC by the amount of AFC.

1. The vertical distance between AC and AVC curves continues to fall with increase in output
because the gap between them is AFC, which continues to decline with rise in output.

2. AC and AVC curves never intersect each other as AFC can never be zero.

3. Both AC and AVC curves are U-shaped due to the Law of Variable Proportions.

4. MC curve cuts AVC and AC curves at their minimum points.

 5. The minimum point of AC curve (point A) lie always to the right of the minimum point of AVC
curve (point B).

Concept

Relationship between TC and MC

The main points of relationship between TC and MC are:

1. Marginal cost is the addition to total cost, when one more unit of output is produced. MC is
calculated as: MCn = TCn - TCn-1

2. When TC rises at a diminishing rate, MC declines.

3. When the rate of increase in TC stops diminishing, MC is at its minimum point, i.e. point E
in Fig. 6.1

4. When the rate of increase in total cost starts rising, the marginal cost is increasing.
Concept

Relationship between TVC and MC

We know, MC is addition to TVC when one more unit of output is produced. So, TVC can be obtained
as summation of MC's of all the units produced. If output is assumed to be perfectly divisible, then
total area under the MC curve will be equal to TVC.
As seen in the diagram, at OQ level of output, TVC is equal to the shaded area OPLQ in the diagram.

Solved Practical’s

Example 1. Calculate Total Fixed Cost (TFC) and Total Variable Cost (TVC).

Note : TFC = TC at 0 level of output.

Example 2. The total cost curve makes an intercept of ₹50 on the Y-axis. Calculate total fixed cost and
total variable cost.
Note : The intercept of ₹50 on the Y-axis indicates that total cost (TC) is equal to ₹50 at zero output.
It means, TFC = ₹50 as TC = TFC at zero output.

Example 3. The details about total variable cost (TVC) of a firm is given. It is also given that the
vertical distance between TVC curve and total cost (TC) curve is fixed at ₹60 at all levels of output. On
the basis of this data, calculate TC.

Note : The vertical distance between TVC curve and TC curve is equal to total fixed cost (TFC). It
means, TFC is ₹60.

Example 4. Find out the missing figure from the table given below:
Note : TFC remains the same at ₹60 at all level of output.

Example 5. Calculate total variable cost and marginal cost at each given level of output from the
following table:\

Example 6. Calculate TFC, TVC, ATC, AFC, AVC and MC:

Formulae used:

1. TVC = TC – TFC

2. ATC = TC Output

3. AFC = TFC Output

4. AVC = TVC Output

5. MC n = TC n – TCn-1

6. TC = TFC at 0 level of output

Example 7. From the following data, determine the values of TFC, TVC, AC AVC and AFC:

Formulae used:

1. TVC = TC – TFC

2. AC = TC Output

3. AVC = TVC Output

4. TFC = TC at 0 level of Output

5. AFC = TFC Output

Example 8. Following information is given about a firm:

From this information find out:

 1. Average fixed cost of producing 4 units;

2. Average variable cost of producing 5 units;

3. Least average cost level of output;

4. Marginal cost of producing the 3rd unit;

5. Total variable cost of producing 6 units;

Solution:

Formulae used:

1. TVC = TC – TFC

2. AC = TC Output

3. AVC = TVC Output

4. TFC = TC at 0 level of output

5. AFC = TFC Output

6. MCn = TCn – TCn-1

Ans. (i) ₹37.50; (ii) ₹170; (iii) Least AC is at 4 units of output; (iv) ₹180; (v) ₹1,110.