Institute of English and Economics

Cost of producing a commodity is the payment made to the factors of

production which are used in the production of that commodity
Or Cost is the total expenditure incurred in producing a commodity
TOTAL COST IS THE SUM TOTAL OF EXPLICIT AND IMPLICIT COST
Explicit cost or direct cost is the actual money expenditure incurred by a firm
to purchase or hire the inputs it needs in the production process. These include
wages, rent, interest, payment for power, insurance, advertising, etc. Explicit
cost is also called accounting cost
Implicit cost or imputed cost is the estimated cost of inputs owned by the firm
and used by the firm in its own production process. It includes payment for
owned premises, self- invested capital etc.

Basis Explicit Cost Implicit Cost

Meaning It is the payment made It is the cost of self-
to outsiders for hiring supplied factors
factor services.
Money Payment It involves actual money It involves imputed value
payment on buying and of factors owned by the
hiring inputs firm. There is no money
payment involved.
Example Payment of wages, rent Interest on capital, rent
etc of own land etc.

Opportunity Cost: It is the cost of the next best alternative forgone.

Short Run Costs: Short run is that period during which some factors are in fixed
supply, like plant, machinery, etc and some factors are variable like labour.
Production in the short-run can be increased only to the possible extent by
using fixed factors to the full capacity and by increasing the units of variable
factors
Thus, in short run there are two kinds of costs
1. Fixed Costs
2. Variable Costs
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Institute of English and Economics

The sum of fixed cost and variable cost is equal to total cost.
Total Fixed Cost (TFC) or Fixed Cost: Fixed costs are those costs that do not
change with a change in level of output. They are incurred irrespective of the
level of output of good is produced. They are short-run costs. Fixed costs are
the sum total of expenditure incurred by the producer on the purchase or
hiring of fixed factors of production.
Examples of fixed costs are:
(i) overhead expenses
(ii) wages/salaries of permanents workers
(iii) depreciation of machinery, and
(iv) insurance amount.
Fixed costs are also known as overhead costs
The concept of TFC is explained with the help of a schedule given in Table and
a diagram given below.

The table shows that TFC remains constant at ` 10 whatever be the level of
output. Shown graphically, TFC curve is always a straight line parallel to the x-
axis. Since fixed factors are purchased before production actually starts, fixed
costs are incurred even when output is zero.

Total Variable Cost: Variable costs are those costs which vary with the quantity
of output produced. Examples of variable costs are (i) cost of direct labour, (ii)
running expenses like cost of raw materials, fuel, etc. Variable costs are also
called Prime cost.

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Institute of English and Economics

The TVC schedule is given in the above table and it is graphically shown here

The table shows that when no output is produced, TVC is zero. As output
produced increases, TVC rises initially at a decreasing rate and then at an
increasing rate. Shown graphically, TVC curve is an inverse S-shaped curve. It
originates from the origin, rises at a falling rate till 2 units of output are
produced. Beyond that it rises at an increasing rate. The reason behind its
shape is the law of variable proportion.

TVC curve is inversely S shaped because TVC initially increases at decreasing

rate and later increases at increasing rate.
• Initially TVC rises at decreasing rate because of better utilisation of fixed
factor and increase inefficiency of variable factors.
• Thereafter, TVC rises at an increasing rate because of fall in efficiency of
variable factors due to limitation of fixed factor.

Difference between Fixed Cost and Variable Cost

Total Cost

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Institute of English and Economics

Total Cost (TC) is defined as the sum total of all costs of producing any given
level of output. TC is derived by the sum total of TFC and TVC at various levels
of output.

Since TFC remains same at all the levels of output, the change in TC is entirely
due to TVC.
TC schedule

TC curve is graphically shown below where: TFC is a horizontal line and TVC is
an inverse S-shaped starting from the origin. TC curve is an inverse S-shaped
curve starting from th e level of fixed cost (` 10). A change in TC is entirely due
to change in TVC. TC curve is above the TVC curve by the amount of TFC. The
reason behind the shape of TC curve is the law of variable proportion. The
vertical distance between TVC and TC curves is the amount of TFC. TC is equal
to TFC at zero level of output as the variable cost is zero.

Relationship between TVC, TFC and TC

1. TFC curve is a horizontal straight line parallel to x axis as it remains
constant at all levels of output.

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Institute of English and Economics

2. TVC and TFC curves are S shaped because they rise initially at a
decreasing rate, then at a constant rate and finally, at an increasing rate.
The reason behind their shape is the law of variable proportion.
3. At zero level of output, TC=TFC because there is no variable cost at zero
level of output. So, TC and TFC curve start from the same point, which is
above the origin.
4. The vertical distance between TFC and TC is equal to TVC. As TVC rises
with increase in the output, the distance between TFC and TC also goes
on increasing.
5. TC and TV curves are parallel to each other and the vertical distance
between them remains same at all levels of output because the gap
between them represents TFC, which remains constant at all levels of
output.
Average Cost
Average Cost or the per unit cost can be obtained from Total cost
Three types of average or per unit costs are:
Average Fixed Cost (AFC)
Average Variable cost (AVC)
Average total cost (AC)

Average fixed Cost

AFC is defined as the fixed cost of producing per unit of the commodity. It is
obtained by dividing TFC by the level of output. That is,

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Institute of English and Economics

The AFC curve derived from TFC curve is a rectangular hyperbola. It shows
declining values of fixed cost per unit of output produced. AFC falls with rise
in output because constant TFC is divided by increasing output
The downward sloping AFC curve can never touch the x-axis because TFC
can neve be zero.
AFc curve 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.
Average Variable Cost
Average Variable Cost AVC is defined as the variable cost of producing per
unit of the commodity. It is obtained by dividing TVC by the level of output.
That is,

The AVC curve is derived from TVC curve and is U-shaped. It shows that as
output increases, the value of AVC falls continuously till it reaches a
minimum point. Beyond this point, the AVC starts rising. The reason behind
the U-shape of AVC curve is the law of variable proportion.

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Institute of English and Economics

AVC is a U shaped curve due to the application of Law of Variable

Proportions. Intailly, AVC curve falls due to increasing returns to a factor
with better utilisation of fixed and variable factors. After reaching its
minimum level (optimum level of output), AVC starts increasing with every
increase in output due to diminishing returns to a factor.

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

AC is defined as cost of producing per unit of the commodity
AC can be derived in two ways:
1. AC is obtained by dividing TC by the level of output. Symbolically

The AC curve as derived from TC curve is U-shaped. It shows that as

output increases the value of AC falls continuously till it reaches a
minimum point. Beyond this point, the AC starts rising. The reason
behind the U-shape of AC curve is the law of variable proportion.

2. AC can be obtained by adding AFC and AVC values, i.e.,

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).

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Institute of English and Economics

Phase1 when both AFC and AVC fall, AC also falls.

Phase 2 AFC continues to fall, but AVC remains constant. So, AC falls (due to
falling AFC) till it reaches its minimum.
Phase 3 AC starts rising as the rise in AVC is more than the fall in the AFC,
therefore AC starts rising.

AC curve is U-shaped.
The reasons for U-shape of AC curve are:
1. Basis of AFC. AC includes AFC and AFC falls continuously with increase in
output. Once AVC has reached its minimum point and starts rising, its rise is
initially offset by the fall in the AFC. The result is that AC continues to fall.
Ultimately, the rise in AVC becomes greater than the fall in the AFC so that AC
starts rising.
2. Basis of Law of Variable Proportion. The U-shape of AC curve is due to the
law of variable proportion. The law states that, initially when variable factor is
combined with the fixed factor, production increases at an increasing rate
implying AC falls. The best combination of fixed and variable factors occurs at
point b on the AC curve. Beyond that point AC curve starts increasing due to
overutilisation of the fixed factor

Relationship between AC and AVC Curves

1. AVC is a part of AC since AC = AFC + AVC.
2. The minimum point of AC will always occur to the right of the minimum
point of AVC, i.e., point b will always be to the right of point a.
3. Both AVC and AC are U-shaped due to the law of variable proportion. 4. The
difference between AC and AVC decreases with rise in the level of output
because AC included AFC and AFC falls continuously as output level rises. AVC
and AC can never meet each other because AFC is a rectangular hyperbola and
can never cut x-axis.

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Institute of English and Economics

Marginal Cost (MC)

Marginal cost is defined as addition made to total variable cost or total cost
when one more unit of output is produced. Symbolically,

i.e., sum total of MC corresponding to different level output becomes TVC

MC is not affected by Fixed Costs

MC is addition to TC when one re 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.

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Institute of English and Economics

MC is a U shaped curve due to Law of Variable Proportions. Initially, units of the

variable factors are employed with the fixed factor, which yield increasing
returns and reduces MC. It pushes the MC curve down. Further addition of
variable factors leads to diminishing returns to creep in, thereby increasing MC
after reaching to its minimum level. As a result, MC curve falls to its minimum
level and then rises. Therefore, the short -run marginal cost curve is U- shaped.

Relationship between AC and MC Curves:

1. Both AC and MC are derived from TC by the formulas:

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Institute of English and Economics

2. Both AC and MC curves are U-shaped, reflecting the law of Variable

Proportion.
3. AC includes both variable cost and fixed cost since AC = AFC + AVC. But
MC is addition made only to variable cost when output is increased by
one more unit.
4. When MC < AC, AC falls. 7. When MC = AC, AC is minimum and constant.
5. When MC > AC, AC rises.

6. There is a range over which AC is falling but MC is rising. This range is

between the output levels Xa and Xb .
7. MC curve cuts the AC curve at its minimum point.
Relationship Between AVC and MC Curve

1. 1. Both AVC and MC are derived from TVC by the formulas,

2. Graphical derivation of AVC and MC curves is given

where, Xa = Output corresponding to minimum point of MC curve.
Xb = Output corresponding to minimum point of AVC curve.
Xc = Output corresponding to minimum point of AC curve.

3. Both AVC and MC curves are U-shaped reflecting the law of Variable
Proportion.
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Institute of English and Economics

4. The minimum point of AVC curve (point b) will always occur to the right
of the minimum point of MC curve (point a).
5. When MC < AVC, AVC falls.
6. When MC = AVC, AVC is minimum and constant.
7. When MC > AVC, AVC rises.
8. There is a range over which AVC is falling and MC is rising. This range is
between the output levels Xa and Xb .
9. MC curve cuts AVC curve to its lowest point
Relationship between TC and MC

1. MC is the addition to TC, when one more unit of output is produced.

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.
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Institute of English and Economics

4. When the rate of increase in TC starts rising, the MC is increasing.

Relationship between TVC and MC
MC is addition to TVC when one more uit 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 above diagram, at OQ level of output TVC is equal to the

shaded area OPLQ in the above diagram.

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