PRODUCTION COST

MEANING OF COST IN ECONOMICS

Cost is the total expenditure incurred in producing a commodity.

Economic Cost is the sum of actual or direct expenditures on hired inputs (i.e. explicit cost) and the imputed value of the inputs supplied by the owners (i.e. implicit cost) including normal profits.

1. Explicit Cost: It is the actual or direct expenditures on hired inputs. For example, wages paid to the employees, rent paid for hired premises, payment for raw materials, depreciation, taxes on production etc.
2. Implicit Cost: It is the imputed value of the inputs supplied by the owners including normal profit. For example, imputed interest on owner’s capital, imputed rent of owner’s land, imputed salary of owner’s managerial services, etc. Such costs are the costs of owner supplied factors.

 

Normal Profits is the minimum level of profits that the producer must get in order to stay in the line of business.

NOTE: ‘Normal Profit’ is also treated as part of the Implicit Cost.

Cost Function

Cost function refers to the functional relationship between cost and output produced of a commodity.

C = f (Q)                                                                                        (Where: C = Cost of production, Q = Units of output)

 

Opportunity Cost

Opportunity cost is cost of the next best alternative foregone.

SHORT RUN COSTS

Short run cost is defined as the cost of producing a given level of output of a good keeping some inputs fixed and others variable. Short run costs are of two types: (i) Fixed Costs (ii) Variable Costs

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

. TOTAL FIXED COST (TFC)

Fixed Costs refer to those costs which do not vary with the level of output.

Fixed Cost is also known as: (i) Supplementary Cost; or (ii) Overhead Cost

Fixed cost is incurred on fixed factors like machinery, land, building, etc., which cannot be changed in the short run. For example, rent of premises, interest on loan, salary of permanent staff, license fees etc.

TFC Schedule

Output (in units)	TFC (`)
0	12
1	12
2	12
3	12
4	12

TFC

 

Shape of TFC curve: TFC curve is parallel to the x-axis as fixed cost remains same for all levels of output even at zero level of output.

• TOTAL VARIABLE COST (TVC)

Variable costs refer to those costs which vary directly with the level of output.

• Variable costs are incurred on variable factors like raw material, labour, power, etc, which changes with change in level of output.
• Variable costs rise with increase in the output and fall with decrease in the output. For example, payment for raw material, power, fuel, wages of casual labour, etc.

TVC is zero at zero level of output as no variable input is employed. So, TVC curve starts from origin.

TVC Schedule

Output (in units)	TVC (`)
0	0
1	6
2	10
3	15
4	24
5	35

 

 

 

 

 

Shape of TVC curve: The TVC curve is inverse S-shaped due to the Law of Variable Proportions. TVC initially increases at a decreasing rate and then at an increasing rate.

• In the first phase of Law of Variable Proportions, when there are increasing returns to factor, due to increase in efficiency of variable input and better utilisation of fixed inputs, each additional unit of output is produced at a lower cost as compared to the previous unit. Hence variable cost increases at a decreasing rate.

 

• In the second and third phase of Law of Variable Proportions, when there are decreasing returns to factor resulting in a fall in efficiency of variable input due to over-utilisation of fixed inputs, each additional unit of output is produced at a higher cost as compared to the previous unit. Hence variable cost increases at an increasing rate.

Differences Between Total Fixed Cost and Total Variable Cost

Total Fixed Costs	Total Variable Costs
Total fixed costs refer to those costs which do not change with the level of output.	Total variable costs refer to those costs which vary directly with the level of output.
It can never be zero even if there is no production.	It is zero when there is no production or at zero level of output.
It is incurred on fixed factors like land, building etc.	It is incurred on variable factors like labour, raw material etc.
TFC is a horizontal straight line parallel to the X-axis as fixed cost remains the same at all levels of output.	TVC is inverse S-shaped as variable cost increases initially at a decreasing rate and then at an increasing rate.
Salary of permanent staff, license fees, building rent, etc.	Wages of casual labour, payment for raw material, etc.

• 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 all levels of output.

TC = TFC + TVC

Since TFC remains same at all levels of output, the change in TC is entirely due to TVC Total Cost Schedule

Output (units)	TFC(`)	TVC(`)	TC = TFC +TVC (`)
0	12	0	12+0 =12
1	12	6	12+6 =18
2	12	10	12+10=22
3	12	15	12+ 15 = 27
4	12	24	12+ 24 = 36
5	12	35	12 + 35 = 47

• In the given schedule, TC = TFC = 12 at zero level of output because TVC is zero.
• At first 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.

 

 

Any change in TC curve is due to a change in TVC as TFC is constant for all levels of output, hence the TC curve is also inverse S-shaped, due to the Law of Variable Proportions.

 

Relationship between TC, TFC and TVC

1. TC curve lies above TVC and TFC curves as TC is a vertical summation of TVC and TFC curves.
2. At zero level of output, TC is equal to TFC because there is no variable cost (TVC is zero at zero level of output). So, TC and TFC curves start from the same point, which is above the origin while TVC starts from the origin.
3. 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.
4. The vertical distance between TC curve and TFC curve is equal to TVC. As TVC rises with increase in the output, the distance between TC and TFC curves also goes on increasing.

AVERAGE COSTS

There are three types of average costs namely:

1. Average Fixed Cost (AFC)
2. Average Variable Cost (AVC)
3. Average Total Cost (ATC) or Average Cost (AC)

• AVERAGE FIXED COST (AFC)

Average fixed cost refers to the per unit fixed cost of production.

 

AFC =

 

Output (in units)	TFC (`)	AFC= TFC / Output AFC(`)
0	12	—–
1	12	/ 1 = 12
2	12	/ 2 = 6
3	12	/ 3 = 4
4	12	/ 4 = 3
5	12	/ 5 = 2.40

                                                                                                                  AFC Schedule

 

Shape of AFC Curve: AFC is a rectangular hyperbola (area of rectangles formed under the curve are equal. AFC x Q = TFC which is constant for all levels of output), it approaches both the axes. It gets nearer and nearer to the axes, but never touches them.

• AFC can never touch the X-axis i.e. AFC can never be zero as AFC = TFC/Q and TFC can never be zero in the short run.
• 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.
• AFC falls with increase in output as AFC= TFC/Q and TFC remains same for all levels of output.

 

• AVERAGE VARIABLE COST (AVC)

Average variable cost refers to the per unit variable cost of production.

AVC =   

 

Output (in units)	TVC(`)	AVC = TVC/Q (`)
0	0	—
1	6	6/1 = 6
2	10	10/2 = 5
3	15	15/3 = 5
4	24	24/4 = 6
5	35	35/5 = 7

                                                                                                            AVC Schedule

 

 

 

Shape of AVC Curve: AVC curve is U-shaped due to the Law of Variable Proportions. AVC initially falls with increase in output, reaches a minimum and then starts rising.

PRODUCTION COST

• AVERAGE TOTAL COST (ATC) OR AVERAGE COST (AC)

Average cost refers to the per unit total cost of production.

 

AC      =       

Average cost is also defined as the sum of average fixed cost (AFC) and average variable cost (AVC),

AC = AFC + AVC

AC Schedule

Output AFC (`) AVC (`) AFC + AVC = AC (`) 0 — — — 1 12 6 12 + 6 = 18 2 6 5 6+5 =11 3 4 5 4+5 = 9 4 3 6 3 + 6 = 9 5 2.40 7 2.40 +7 = 9.40

 

• In the above given table, AC is calculated by adding AFC and AVC.
• AC curve is obtained by a vertical summation of AFC and AVC curves.

Shape of AC Curve: AC curve is also U-shaped due to the Law of Variable Proportions. AC initially falls with increase in output, reaches a minimum and then starts rising.

Relationship between AC, AVC and AFC

1. AC curve will always lie above the AVC and AFC curve because AC, at all levels of output, is a vertical summation of AVC and AFC curves.
2. The minimum point of AC curve (point A) lies to the right of the minimum point of AVC curve (point B) since even when AVC starts rising, AFC is still falling. AC rises only when the rise in AVC is more than the fall in AFC.
3. As the output increases, the gap between AC and AVC curves decreases because the vertical distance between them is AFC, which decreases with increase in output.
4. As the output increases, AC and AVC curves never intersect each other because the vertical distance between them is AFC, which can never be zero in the short run.

• MARGINAL COST

Marginal cost refers to the addition to total cost when one more unit of output is produced.

                                 MCn = TCn – TCn-1

   Also,                   MC_n = TVC_n – TVC_n-1

 

Where: n = Number of units produced	MCn = Marginal cost of the nth unit
TCn = Total cost of n units	TCn-1 = Total cost of (n – 1) units.
TVCn = Total variable cost of n units	TVCn-1 = Total variable cost of (n – 1) units.

MC is not affected by Fixed Costs

We know, MC isthe 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.

 

• Area under the MC curve is TVC: MC = ΣTVC

MC	=	Change in TC	= Change in TVC
		Change in Output	Change in Output

NOTE: MC is the rate of change of TVC or TC for a given change in output.

 

MC Schedule

Output (in units)	TVC (`)	MC (`)
0	0	0
1	6	6
2	10	4
3	15	5
4	24	9
5	35	11

 

 

 

Shape of MC curve : The MC curve is U- shaped due to the Law of Variable Proportions The MC curve first falls, reaches a minimum and then starts rising.

 

• In the first phase of LVP, when there are increasing returns to factor, due to increase in efficiency of variable input and better utilisation of fixed inputs, each additional unit of output is produced at a lower cost as compared to the previous unit. Hence additions to cost falls or MC falls.
• In the second and third phase of LVP, when there are decreasing returns to factor resulting in a fall in efficiency of variable input due to over-utilisation of fixed inputs, each additional unit of output is produced at a higher cost as compared to the previous unit. Thus, additions to cost increases or MC rises.

RELATIONSHIP BETWEEN SHORT RUN COST CURVES

Relationship between AC and MC

1. When MC is less than AC, AC falls with increase in the output.
2. When MC is equal to AC (when MC and AC curves intersect each other), AC is constant and at its minimum point.
3. When MC is greater than AC, AC rises with increase in output.

Relationship between TC and MC

 

 

1. MC is the addition to TC when one more unit of output is produced.
2. When MC falls, TC increases at a decreasing rate.
3. When MC increases, TC increases at an increasing rate.

 

 

 

Relationship between AVC and MC

 

 

 

•   When MC is less than AVC, AVC falls with increase in the output.

1. When MC is equal to AVC (when MC and AVC curves intersect each other), AVC is constant and at its minimum point.
2. When MC isgreater than AVC, AVC rises with increase in output.

 

Relation between AVC, AC and MC

 

 

• Between AC and AVC

1. AC is greater than AVC by the amount of AFC.
2. AC and AVC curves approach each other with increase in output because the vertical gap between them is AFC, which continues to decline with rise in output.
3. AC and AVC curves never intersect each other as the gap between them is AFC and AFC can never be zero in short run.
4. The minimum point of AC curve (point A) lies to the right of the minimum point of AVC curve (point B) since even when AVC starts rising, AFC is still falling. AC rises only when the rise in AVC is more than the fall in AFC.
5. Both AC and AVC curves are U-shaped due to the Law of Variable Proportions.

 

• With MC

1. When MC is less than AVC(or AC), AVC (or AC), falls with increase in the output.
2. When MC is equal to AVC (or AC), AVC (or AC), is constant and at its minimum point. [MC curve cuts AVC and AC curves at their minimum points.]
3. When MC is greater than AVC (or AC), AVC (or AC) rises with increase in output.

PRODUCTION COST

PRODUCTION COST

PRODUCTION COST