Cost

• It refers to the monetary expenditure incurred on factors of production/inputs

for producing a commodity.
• It is also known as 'nominal' or 'money' cost.
• In the short run a firm employs two types of factors of production i.e. fixed
factors and variable factors.
• Corresponding to fixed and variable factors, cost is also of two types.
Types of short run cost
FIXED COST VARIABLE COST
It is also known as overhead cost, It is also known as direct cost,
unavoidable cost or supplementary avoidable cost or prime cost.
cost.
1) This cost is related to initiation of This cost is related to initiation of
business. production.
2) It is the cost incurred on fixed It is the cost incurred on variable factors
factors of production. of production.
3) Can be incurred when output is zero. Always zero when output is zero.
4) It remains same whether output is It keeps on changing as output changes.
zero or more.
5) Eg. Rent of premises, salary to Eg. Expenditure on fuel, raw materials
permanent staff, minimum telephone wages to causal workers etc.
bill, minimum electricity bill,
insurance premium, Interest on
Capital, License fees, Normal profit
etc.
Short Run Cost Curves

Total Cost curves Average Cost curves Marginal Cost curve

(MC)

TFC TVC TC AFC AVC AC/ATC

 TOTAL COST CURVES-
Output TFC TVC TC
0 12 0 12
1 12 9 21
2 12 16 28
3 12 18 30
4 12 22 34
5 12 30 42
6 12 42 54

{AB=PQ=TFC}

1. TFC CURVE-
- In short period, total cost incurred on fixed factors is termed as total fixed cost
(TFC). This cost does not change with the change in level of output (as fixed
factor remains constant) and it incurs even when no output is produced and so
TFC curve starts above the origin. When the output is zero or maximum TFC
remains the same.
- Since TFC is constant at all levels, total fixed cost curve is a horizontal straight
line parallel to x-axis.
- TFC = AFC × output
- TFC= TC- TVC
2. TVC CURVE
- In the short run the total cost incurred on variable factors is termed as total
variable cost (TVC)
 - Total Variable cost changes directly with the level of output, rising as more is
produced and falling as less produced. When output in zero, this cost is also
zero, and so TVC curve starts from the origin.
- TVC = AVC× output
- TVC= TC-TFC
- Shape of TVC:
(i) Initially in short run, TVC increases with a diminishing rate because of law of
increasing returns.
(ii) Then after reaching a point it increases with an increasing rate because of law of
diminishing returns.

3. TC CURVE
- It refers to the total expenditure of producing any given amount of output or
summation of TFC and TVC at any given level of output.
- Thus, TC curve starts from TFC curve (at zero level of output), as TC consists
of both TFC and TVC, and TVC is zero at zero level of output.
- TC is then parallel to TVC as gap between TC and TVC curve is TFC (which
remains constant) (AB=PQ-See diagram).
- The difference between TC and TVC is TFC which is always constant. As the
difference between them is of TFC, which is constant.
- TC changes just like TVC changes as TC consists of TVC and TFC, and TFC
has no change.
- TC = AC × output
- TC = TFC + TVC
- Shape of TC:
(i) Initially in short run, TC increases with a diminishing rate because of law of
increasing returns.
(ii) Then after reaching a point it increases with an increasing rate because of law
of diminishing returns.
Relationship between TFC, TVC and TC
• TC curve can be obtained by adding TFC and TVC curve vertically at each point.
• TC and TVC curve have the similar shapes , the only difference is that TVC starts
from origin while TC starts above the origin. They have similar shape because TC
will change exactly as TVC will change because any change in TC is due to TVC,
as TFC is constant.
• At O level of output, TC is equal to TFC in short run (because there is no TVC at
zero level of output) so TC and TFC curves start from the same point which is
somewhere above the origin.
• The vertical difference between TC and TFC curves represents the TVC.
• The vertical difference between TC and TVC curve represents the TFC. TC and
TVC remain parallel all the same, as the difference between TC and TVC (which
is TFC) remains constant.

AVERAGE COST CURVES

1. AVERAGE COST/AVERAGE TOTAL COST (AC/ATC)
• Average cost (AC) is the cost per unit of output produced. AC can be
obtained by dividing the total cost by the quantity of output.
𝑻𝑪
AC =
𝑶𝒖𝒕𝒑𝒖𝒕
• Diagrammatically the vertical summation of average fixed cost (AFC and
average variable cost (AVC) gives the AC or ATC curve.
ATC or AC = AFC + AVC

(i) In short run, AC curve is U-shaped

(ii) Initially, AC diminishes because law of increasing return.
(iii) Then AC rises due to law of diminishing returns.

2. AVERAGE FIXED COST (AFC)

• Average Fixed cost is the per unit fixed cost of production. It is the per unit
expenditure on fixed factors.
• AFC can be obtained by dividing TFC by the quantity of output.
𝑻𝑭𝑪
• AFC =
𝑶𝒖𝒕𝒑𝒖𝒕
• AFC = AC-AVC (TFC = AFC X Q)
• AFC can never be zero as TFC can never be zero.
𝑇𝐹𝐶
• AFC curve is downward sloping from left to right because, AFC = ,
𝑂𝑢𝑡𝑝𝑢𝑡
TFC (numerator) remains constant and output (denominator) keeps on
increasing.
 • It never touches x & y axis as it can never be zero because TFC (numerator)
remains constant and is never zero.

• It is a rectangular hyperbola curve which means any rectangle drawn below it

will have equal area because TFC is constant.

3. AVERAGE VARIABLE COSTS (AVC)

Average variable cost is per unit cost on the variable factors of production.
• AVC can be obtained by dividing TVC by the quantity of output.
𝑇𝑉𝐶 𝑇𝑉𝐶
AVC = = (TVC = AVC X Q)
𝑂𝑢𝑡𝑝𝑢𝑡 𝑄
• AVC = AC-AFC

• In short run, AVC curve is U-shaped

• Initially, AVC diminishes because law of increasing return, when TVC
increases with diminishing rate.
• Then AVC rises due to law of diminishing returns, when TVC increases at
increasing rate.
 A. MARGINAL COST (MC)
• Marginal cost (MC) is the change in total cost by producing one more or one
less unit of output.
• In other words, MC is the addition to total cost as one more unit of output is
produced.
It is closely associated to TVC
• MC = TCn - TCn-1 or TVCn - TVCn-1
𝛥𝑇𝑉𝐶 𝛥𝑇𝐶
• MC = or
𝛥𝑄 𝛥𝑄
• ΣMC = TVC

Marginal cost is not affected by fixed cost

MC is independent of fixed cost. MC represents the change and there is no change in
total fixed cost, as it remains constant with change in output.
It is only the variable cost which changes with the change in the level of output in the
short run. In other words, a change in TC is only caused by a change in TVC and MC
measures the change in TC, which is only due to TVC.
MC can be estimated from total variable cost (TVC) also and is directly related with it.
Therefore, MC is the change in TVC as one more unit of output is produced.

- It is half u-shaped curve, as it initially falls due to increasing returns to factor

and then it rises due to diminishing returns to factor.
- The area under MC curve represents TVC.
 COMBINED DIAGRAM OF AFC, MC, ATC AND AVC.

- The distance between AC and AVC keeps on decreasing as the distance

between them is of AFC, which keeps on decreasing, as AC = AFC + AVC.
- The AC and AVC curves never intersect each other because there is a gap
between them, of AFC, which never becomes zero.
- AFC can never intersect AC, as AFC can never be equal to AC, because of the
difference between them of AVC.
- MC intersects AVC, before it intersects AC, because AVC rises earlier than
AC. This is because AC consists of AFC, which is falling. Thus AC is more
consistent than AVC.
RELATIONSHIP BETWEEN MC & AC

(i) MC is less than AC, AC falls

(ii) MC is equal to AC, AC is at its minimum
(iii) MC is greater than AC, AC rises
 RELATIONSHIP BETWEEN MC & AVC

(i) MC is less than AVC, AVC falls

(ii) MC equals to AVC, AVC is at its minimum
(iii) MC is greater than AVC, AVC rises

RELATIONSHIP BETWEEN TC & MC

• When TC rises at diminishing rate (up to point A), MC decreases (till point E).
• When TC rises at an increasing rate (beyond point A), MC increases (beyond point
E).
• When rate of increase in TC stops diminishing, MC is at its minimums point (at
point E).

Relationship between Variable Short Run Costs

Output TFC TVC TC AFC AVC ATC MC
(units)
0 12 0 12 ∞ - 0 -
1 12 9 21 12 9 21 9
2 12 15 27 6 7.5 13.5 6
3 12 18 30 4 6 10 2
4 12 22 34 3 5.5 8.5 4
5 12 30 42 2.4 6 8.4 8
6 12 42 54 2 7 9 12

B. Other types of costs

1. Explicit cost Implicit Cost
1. It refers to the expenditure 1. Cost which is incurred on self-
incurred on those factors which owned resources used in
are purchased from market or the production process or the cost in
which payment is not made to
cost in which payment is made
the outsiders.
to outsiders for buying or hiring
of inputs.
2. Examples:
2. Examples:
Salary for own services, rent of own
Expenses on raw materials, fuel
premises etc.
purchases from market
NOTE- While calculating TC, implicit cost also should be taken into consideration:
II) Money cost and real cost
C. MONEY COST
The amount spent in terms of money by a firm for production and sale of a
commodity. (production cost). It is the monetary expenses that the producer bear.
Eg: Interest, Wages etc.
❖ REAL COST
It refers to the efforts, sacrifices, discomforts and pain suffered by the person while
rendering factor services.it is physical expenses that the producer bear.
Real cost is a subjective concept that makes it difficult to calculate.
Eg: Worker works 8 hours for Rs. 100. Then 8 hours is real cost.

III) Private and social cost

❖ PRIVATE COST
It refers to cost of production incurred by an individual firm to produce a commodity.
For an individual firm, private cost includes both explicit and implicit cost.
❖ SOCIAL COST
It refers to the cost or disadvantages that the society has to bear on account of production
of the commodity. Eg: Water pollution, Air pollution etc. cause health hazards and
thereby involves cost of the entire society.
IV) Opportunity Cost
It refers to the sacrifice for the next best alternative use or opportunity cost is
opportunity Lost.
V) Normal Profit
It is the minimum amount which is required by entrepreneur to be sustained in
business.
TC=Explicit Cost+ Implicit Cost+ Normal Profit.

-:HOTS:-
Q.1 As output increase, AC tends to be closer to AVC, Why?
Ans. AC=AFC+AVC. As output increases, AFC must fall as TFC is constant.
Consequently, component of AFC in AC tends to shrink. This brings AC closer to
AVC. The difference between AC and AVC is represented by AFC, which is
falling and the gap is falling and so AC and AVC tend to come closer.
Q.2 AC may continue to decline even when MC is rising. Why?
Ans. Even when MC is rising, AC will continue to fall as long as MC is less than AC.
Q.3 The average cost of producing 5 units of a product is Rs. 5 and that of
producing 6 units is Rs. 6 What is the marginal cost.
Ans. OUTPUT AC TC (AC×OUTPUT)
5 5 25
6 6 36
 MC = TCn - TCn-1
= 36 – 25
= Rs. 11
Q.4 Give reasons and state whether the following are true or false.
(i) Average cost falls only when marginal cost falls.
(ii) When marginal cost rises, average cost will also rise.
(iii) As output is increased, the difference between Average Total Cost (ATC) and
average Variable Cost (AVC) falls ultimately and becomes zero.
(iv) The gap between AC and AVC keeps on decreasing with rise in output.
Ans. (i) False: AC still falls even when MC rises, till AC > MC.
(ii) False: When MC rises, AC may fall or remain constant and or may rise. AC
rises when AC < MC.
(iii) False: Because the different between ATC and AVC falls but never becomes
zero because AFC always remains positive. AC = AVC + AFC.
(iv) True: Because the difference between AC and AVC is AFC, which falls with
increase in output.