THEORY OF COSTS

MEANING OF COSTS OF

PRODUCTION

In order to produce a good every firm makes use of factor of

production so the amount spent on the use of factor of

production is called factor of production cost of production

mainly depends upon the quantity of production

C=f(Q)Here, C=Cost

F=FunctionQ=Quantity

Cost Of Production

Money costs

Real CostsOpportunit

y costs

Total CostsAverage

CostsMarginal

costs

Explicit Costs

Implicit Cost

Money Costs

According to Prof. Hanson

The money cost of a producing a certain output of a commodity is the sum of all the payments to the factors of

production engaged in the production of that commodity.

Therefore, money costs include the following expenses:1. Depreciation and obsolescence charges.2. Power fuel charges.3. Wages and salaries.4. Cost of machinery, raw material etc.5. Expenses on advertising and publicity.6. Interest on capital.7. Expenses on electricity.8. Insurance charges.9. Transport costs.10.Packing charges.11.All types of taxes viz ; property tax , licence fees, exise duty.12.Rent on land.

Money costs of a firm include two costs as following:

1.Explicit costs 2.Implicit costs1. Explicit costs :-

According to LEFTWITCH“Explicit costs are those cash payments

which firms make to outsiders for their services and Goods.”

This cost includes, payment of raw material, taxes and depreciation charges, transportation, power, high fuel, advertising and so on.2. Implicit costs :-According to LEFTWITCH

“Implicit costs are the costs of self-owned, self employed resources.”

This cost includes the interest on his own capital, rent on his land, wages of his own labour etc.

Real Costs

Prof. MARSHAL has called these costs as the “social costs of

production”

Real costs refers to all those efforts and sacrifies undergone by various members of

the sosiety to produce a commodity

Opportunity Costs

When resourses are used for producing a given commodity , then some

amounts of other commodities in whose production, these resources could have

been helpful, has to be sacrifies

For example: The alternative or opportunity cost for producing one unit

of commodity X is amount of Y.That must be sacrifies in order to produce X rather

than Y.

Cost of Production

Total CostAverage

CostMarginal

Cost

Theories of costs

Total cost

According to Dooley :“Total cost of production is the sum of all

expenditures incurred in producing given volume of output.”

Total costs is the combination of fixed costs and variable costs

TC = FC+VC

Here, TC= Total costFC= Fixed costVC=Variable cost

Short run cost curves

Total Fixed Cost

According to Anatol Murad :-“Fixed costs are costs which do not

change with change in the quantity of output.”

Total Variable Cost

According to Dooley :-“Variable costs are one which vary as the

level of output varies.”

Output Fixed cost Variable cost Total cost

0 40 0 40

1 40 20 60

2 40 30 70

3 40 32 72

4 40 34 74

5 40 36 76

6 40 38 78

7 40 40 80

8 40 46 86

Average cost

According to Dooley :-“The Average cost of production is the total

cost per unit of output.”

It includes average fixed cost and average variable cost.

AC=TC/Q

Here, AC=Average costTC= Total costQ= Output

Average fixed cost

“Average fixed cost is the total fixed cost divided by the number of units of output produced.”

AFC=TFC/Q

Here, AFC=Average fixed costTFC=Total fixed costQ=Output

Average variable cost

“Average variable cost is the total variable cost divided by the number of units of output produced.”

AVC=TVC/Q

Here, AVC=Average variable costTVC=Total variable costQ=Output

Units

TFC

TVC TC AC(TC/Q)

AFC(TFC/Q)

AVC(TVC/Q)

0 40 0 40 0 0 0

1 40 20 60 60 40 20

2 40 30 70 35 20 15

3 40 32 72 24 13.3 10.7

4 40 34 74 18.5 10.0 8.5

5 40 36 76 15.2 8 7.2

6 40 38 78 13.0 6.6 6.3

7 40 40 80 11.4 5.7 5.7

8 40 46 86 10.7 5 5.7

9 40 48 88 9.8 4.4 5.4

Marginal Cost

“Marginal cost is the addition made to Total Cost caused by producing one more unit of output.”

MC=TCn –TCn-1

Here, MC=Marginal CostTCn=Total cost of ‘n’ unitsTCn-1= Total cost of ‘n-1’ units

According to Ferguson: “Marginal cost is the addition to Total

Cost due to the addition of one unit of output”

The derivation of MC can be studied with the help of following table:

Units of output TC MC=(TC n - TCn-1)

1 60 -

2 70 10

3 76 6

4 78 2

5 84 6

6 90 6

7 108 18

8 130 22

Relation between average and marginal cost

The main points of relation between average and marginal cost are as under:1. Average cost and marginal cost can be calculated from total cost.2. When AC falls MC also falls.3. When AC arises MC also arises.4. MC cuts AC at its lowest point.5. When AC is constant MC becomes equal to AC.6. Use of MC and AC in price determination.7. Mutual interaction between MC and AC.

Long run cost curves

“Long run is a period in which there is a suficient time to alter the equipment and the scale or organisation with a view to produce

different quantities of output.”

Long run Total Cost

The long run total cost of production is the minimum possible cost of producing any given level of output when all inputs are variable. Long run TC is always less than or equal to short run

Total cost, but it is never more than STC.

Long run Average cost curve

Long run Average cost is the long run total cost divided by the level of output.

LAC=LTC/Q

According to Robert Awh :-“The Long run average cost curve shows

the lowest average cost of producing output when all inputs can be varied freely.”

Different names of LAC

LAC also known as these two following names:1. Envelope curve2. Planning curve

1.Envelope curve:- It envelopes all the SAC curves. It indicates

that LAC cannot exceed SAC so this curve is called as envelope curve.

2. Planning curve :-With the help of this curve a firm can plan as

to which plant it should used to produce different quantities of output so that production is obtained at minimum cost.

Long run marginal cost

Long run marginal cost shows the change in total cost due to the production of one more unit of commodity.

According to Robert Awh :-“Long run marginal cost curve

is that which shows the extra cost incurred in producing one more unit of output when all inputs can be changed.”

LMC= LTC/ Q

Here, LMC= Long run marginal cost LTC = Change in long run total cost Q = Change in output

Relation between LMC and LAC

The relation between long run marginal cost and long run average cost is similar to that of what it is in short run AC and MC but the only difference in LAC and LMC is that long run marginal and average costs are more flatter than that of SAC and SMC. It is so because in long run all factors are variable.

Relation between LMC and SMC

SMC refers to the effect on total cost due to the production of one more unit of output on account of change in variable factors. When a firm selects a proper scale of plan in order to produce given quantity of output then at this level of output short run and long run marginal cost curves are equal.

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