Cost Function

• The concept of cost function refers to the mathematical

relation between cost of a product and its various
determinants of costs.

• C= f(O,S,T,P…….)
Where , C= Cost ,
S = size of plant ,
O= Output ,
T= Time ,
U= utilization of output ,
P = Prices of factors of production.
 Determinants of costs

Laws of returns

Size of Plant

Period

Capacity Utilization

Prices of Factors

Technology

Stability in output
1.Money Cost

Money cost is also known

as the nominal cost. It
is nothing but the
expenses incurred by a
firm to produce a
commodity.

For instance, the cost of

producing 400 chairs is
Rs. 20000, and then it
will be called the
money cost of
producing 400 chairs.
Examples

• (i) Depreciation and obsolescence charges.

• (ii) Power fuel charges.
• (iii) Wages and salaries.
• (iv) Cost of machinery, raw material etc.
• (v) Expenses on advertising and publicity,
• (vi) Interest on capital.
• (vii) Expenses on electricity.
• (viii) Insurance charges.
• (ix) Transport costs.
• (x) Packing charges.
• (xi) All types of taxes viz; property tax, license fees, excise
duty.
• (xii) Rent on land.
(1A) Explicit Costs

Explicit costs refer to all those expenses made by a firm to buy

goods directly. They include, payments for raw material, taxes,
transportation, power, high fuel, advertising and so on.

According to Leftwitch, “Explicit costs are those cash payments

which firms make to outsiders for their services and goods.” He
has given stress on the word explicit and it may be called the
approach used by the accountant of the firm. The payments are
explicit-clear-cut, paid to agents (owners) of factors of
production. A contract fixes the rate at which the payments are to
be made.

They are also known as Accounting Costs or Historical Costs.

(1B) Implicit Costs

Implicit costs are the imputed value of the entrepreneur’s

own resources and Services.
These costs refer to the implied or unnoticed costs. They
include the interest on his own capital, rent on his land,
wages of his own labor etc.
These costs go to the entrepreneur himself and are not
recorded in practice.
In the words of Leftwitch, “Implicit costs are the costs of
self-owned, self employed resources.”
 2. Real Costs

• It is a philosophical concept which

refers to all those efforts and
sacrifices undergone by various
members of the society to produce a
commodity.

• According to Marshall, “Real costs

are the exertion of all the different
kinds of labor that are directly or
indirectly involved in making it
together with the abstinence rather
than the waiting required for saving
the capital used in making it, all
these efforts and sacrifices together
will be called the real cost of
production of the commodity.”
3.Opportunity Costs
 Opportunity cost is the cost of production of any unit of
commodity for the value of factors of production used in
producing other unit.
 It is also known as the alternative cost or transfer cost.

According to Prof. Benham, “The opportunity cost of

anything is the next best alternative that could be produced
instead by the same factors or by an equivalent group of
factors, costing the same amount of money.”

Here, one thing is worth-mentioning that if a factor of production

has no alternative use; in that case its opportunity cost will be
zero.
 Importance of Opportunity Costs:

• The concept of opportunity cost has a very wide

application in economic theory and policy.
• Since, there is scarcity of goods and services they
can be put to alternative uses and thus command
price.
• It is applicable in the determination of factor
prices.
• It can also be applied to consumption and public
expenditure.
• Opportunity costs also explain the phenomenon of
prices.
 Limitations of Opportunity cost
• This concept is not applicable for specific factor use.
• This concept rests on the assumption of perfect
competition.
• This costs can not be Recorded. We can not show this
cost in the books of accounts.
• The forgone opportunities are often unascertainable.
 4. Direct Costs & Indirect Costs
Direct costs or traceable costs are readily identified & are
traceable to a particular product, operation or a plant.
These costs include expenses such as those related with
production like product designing , project preparing etc.
Indirect Costs are not readily identified nor visibly
traceable to specific goods, services, operations etc, but are not
charged to job or product.
Electric power costs incurred for general operation of business
benefitting all the products jointly.
 Incremental Cost and Sunk cost
• Incremental cost – denotes the total
additional costs associated with the marginal
batch of output

• Sunk cost – are cost that are not affected or

altered by a change in the level or nature of
activity.
 Historical cost and Replacement cost
• Historical cost – is the actual cost of an asset
incurred at the time the asset was acquired

• Replacement cost – means the price that

would have to be paid currently for acquiring
the same plant
5. Controllable & Non Controllable Costs

Controllable costs are those costs which are capable of

being controlled or regulated by executive vigilance.
E.g.. Inventory costs can be controlled at shop level.
Non Controllable costs are those costs which are not
capable of being controlled or regulated by executive
vigilance.
E.g.. Costs incurred due to obsolete technology &
depreciation.
6.Total costs

The total amount of money

spent in production of
goods & services is
known as total costs.
In short period total costs
are of two types :
• Total fixed cost ( TFC)
• Total variable costs
(TVC)
TC=TFC+TVC
Fixed costs / Supplementary costs
• Fixed costs are those costs which do not change with the
change of output.
• Production may be maximum or zero, fixed costs remains the
same .
• Examples :
1. Rent of building
2. Interest on capital
3. Property taxes
4. Insurance premium
5. License fees
6. Salaries of permanent staff etc.
Variable costs or Prime costs
• Variable costs are those costs which change with the change
of output.
• These are incurred on the use of variable costs of production.
Examples :
1. Expenses on raw material.
2. Wages of labour.
3. Electricity charges.
4. Wear & tear Expenses.
5. Transportation costs etc.
 Output TFC TVC TC AFC AVC ATC MC
0 10 0 10 - - - -
1 10 10 20 10 10 20 10
2 10 18 28 5 9 14 8
3 10 24 34 3.3 8 11.3 6
4 10 28 38 2.5 7 9.5 4
5 10 32 42 2 6.4 8.4 4
6 10 38 48 1.7 6.3 8 6
7 10 46 56 1.4 6.6 8 8
8 10 62 72 1.2 7.8 9 16

TC= TFC+TVC , AFC= TFC/ OUTPUT ,

AVC= TVC/OUTPUT , ATC=AFC+AVC , MC= (TCn – TCn-1)
Average Fixed Cost (AFC)
 AFC refers to fixed cost per unit of output .
 AFC diminishes with every increase in the quantity of output
produced as the fixed cost is spread over the large number of
units.
 AFC never becomes zero.
Average Variable Cost (AVC)
 AVC refers to the variable
expenses per unit of output.
 The AVC is falling , but it begins
to rise after a certain point.
 This happens because in the
initial stage of production , the
law of increasing returns
operates which causes the cost
to diminish.
 But after a point , variable cost
begins to rise due to law of
diminishing returns.
 hence the AVC curve is u shaped.
Average Total Cost (ATC)

 AVC refers to cost per unit of

output.
 ATC depends upon the behavior
of AFC & AVC.
 AFC & AVC falls causing ATC
to fall sharply .
 However with the further
increase in the output there is a
sharp rise in the AVC which
more than offsets the fall in
AFC , thereby causing ATC to
rise.
 ATC becomes U shaped.
Marginal Cost ( MC)
 Addition made to the total cost
as result of the production of
one more unit of a commodity
is called as Marginal Cost.
 At first MC curve falls and
then it begins to rise.
 MC curve is also U shaped as
in the beginning , MC declines
as output expands , thereafter
it remains constant for a while
and then starts rising upwards.
 Relation Between MC & AC

I. Both ATC & MC are calculated

from TC.
II. When ATC Falls, MC are falls
& cuts ATC from below.
III. When ATC rises, MC also
rises.
IV. MC cuts AC at its lowest point.
V. MC & AC are used in price
determination.
Long run Total Cost Curve

The long run total cost of

production is the least possible
cost of producing any given level
of output when all the inputs are
variable.
LTC is always less or equal to the
short run total cost.
LTC represents the least cost of
different quantities of output.
 Long run Average Cost Curve
• It is called as planning
horizon where entrepreneurs
can plan ahead considering
lower ATC.
• Long run consists of all
possible short run situation.
• A firm always operates in
short run but plants in long
run.
• In long run firm can install
new plant whose size leads
to least ATC to expand its
operations.
Long run Marginal Cost Curve

• The long run marginal

cost curve refers to the
effect on total cost due
to production of one
more or less unit of
output as a result of
change in all the factors.
Total Revenue

• Total revenue is the sum of total receipts

earned by a firm from selling its output.
• Total revenue = price per unit * quantity sold

TR curve in perfect competition TR curve in monopoly

Average Revenue

Average revenue refers to the revenue per unit of the

commodity sold. It is obtained by dividing the total
revenue by number of units sold.

AR curve in perfect competition AR curve in monopoly

Marginal Revenue

• Marginal revenue is the revenue earned by selling an

additional unit of a commodity.

MR curve in perfect competition MR curve in monopoly