Theory of Cost

Introduction:

The concept of cost of a firm is very important in price theory. The sum total of the expenses
incurred plus the imputed cost and the normal profit expected by the producer are together termed
as ‘cost’ or ‘cost of production of the commodity.’ In short, cost refers to the expenses incurred
while producing any kind of product.

The concepts of cost:

1. Real Cost: The term “real cost of production” refers to the physical quantities of various
factors used in producing a commodity. The real cost of production of a commodity refers to the
exertion of labour, sacrifice involved in the abstinence from present consumption by the savers to
supply capital, and social effects of pollution, congestion, and environmental distortions.

According to Marshall, “The real cost of production signifies toils, troubles, sacrifice on account of
loss of consumption for savings, social effects of pollution caused by factory smoke, automobiles etc.
Evidently, the concept of real cost is an abstract idea. Its exact measurement is not possible.

2. Opportunity Cost: Opportunity cost is also known as alternative cost. The opportunity cost
of any economic resources can be defined as the value of next best commodity which could have
been produced by the use of the same resources that can be used to produce many things. The
opportunity cost of producing goods is not any other alternative goods that would be produced with
the same resources; rather, it is the next best alternative goods that could be produced with the
same resources. In other words, the opportunity cost of any goods is the amount of the next best
alternative goods that is given up to produce these goods. The concept of opportunity cost has a
great economic significance. Some of them are as follows:

 Determination of relative price of goods: For example, if the same group of factors can
produce either one car or six scooters, then the price of one car will tend to be at least six
times more than that of one scooter.
 Determination of normal remuneration to a factor: For example, if a college professor can
get an alternative employment in a bank as an officer at salary Rs. 20000 per month, the
college has to pay at least Rs. 20000 salary to retain him in the college.
 Decision making and Efficient Allocation of Resources: The concept is also useful in allocating
the resources efficiently. Suppose, opportunity cost of 1 table is 3 chairs and the price of a
chair is Rs. 100, while the price of a table is Rs. 400. Under such circumstances, it is beneficial
to produce one table rather than 3 chairs. Because, if he produces 3 chairs, he will get only
Rs. 300, whereas a table fetches him Rs. 400, that is, Rs. 100 more.

3. Money Cost: Money costs are the costs which the firm has to incur in purchasing or hiring
productive services. These expenses include: a) all types of rental expenses incurred on land,
machines, and buildings b) wages and salaries paid to labour c) all types of expenses made on
purchasing machinery, equipment, and raw materials d) interest on borrowings e) other monetary
expenses. The actual monetary expenses made on the factors of production are recorded by the firm
on its debit items of accounting books. Total money cost includes explicit as well as implicit costs.
 i. Explicit cost: Explicit costs are the money costs paid by the firm to the owners of
various factor services. These costs are the monetary payments which a firm makes
to those outsiders who supply labour services, materials, fuels, transport services,
power and so forth. In other words, explicit costs are direct contractual monetary
payments incurred through market transactions. The following items of a firm’s
expenditure are explicit money costs:
 Cost of raw materials
 Wages and salaries
 Power charges
 Rent of business or factory premises
 Interest payments of capital invested
 Insurance premiums
 Taxes like property tax, duties, license fees etc.
 Miscellaneous business expenses like marketing and advertising expenses
(selling costs), transportation cost, etc.
ii. Implicit Costs: There are certain factor services which are owned and provided by
the entrepreneur himself for which no money payment is made. The costs incurred
on such self-owned or self-employed resources are implicit cost. For example, the
entrepreneur may contribute his own land, own capital and may provide managerial
and entrepreneurial services to the firm. As such, he is entitled to receive rent on his
land, interest on capital contributed by him and also salary for his managerial
services. However, the cost must also be calculated. But since no payment is made
to anyone outside the firm, these costs are not obvious. Such costs need to be
imputed or estimated from what they could earn in their best alternative uses.

In short, the money payments which the self-employed or self-owned resources

could have earned in their best alternative employments are called implicit costs.
These costs are evaluated on the basis of opportunity cost. Thus, implicit money
costs are as follows:
 Wages of labour rendered by the entrepreneur himself.
 Interest on capital supplied by him.
 Rent of land and premises belonging to the entrepreneur himself and used
in his production.
 Normal returns or profit of entrepreneur. It is defined as the minimum
payment which must accrue to an entrepreneur in order to induce him to
undertake the risk of the business. It is the minimum supply price of the
managerial services and part of the cost.

4. Accounting costs and economic costs: When an accountant evaluates the financial
position of a business, he takes only monetary expenses incurred on factor services owned by
outsiders, except the producer, in the calculation. Thus, it consists of only explicit costs.

Economic costs are the aggregate of explicit costs and implicit costs (i.e. imputed costs and normal
profit). These costs include both actual monetary expenditure on inputs which are purchased or
hired and imputed value of the inputs (e.g. land, labour, and capital) owned and provided by the
entrepreneur including a normal profit.

Accounting cost = Explicit cost

Economic cost = Explicit costs + Implicit cost

or, Economic cost = Accounting cost + ( Imputed cost + Normal Profit )

Types of Production Costs and Their Measurement:

1. Total Fixed Cost: Fixed costs are those which are incurred in hiring the fixed factors of
production whose amount cannot be altered in the short run. They remain fixed at any level
of output in the short run. The fixed costs include- payments of rent for building, interest
paid on capital, insurance premiums, depreciation and maintenance allowances,
administrative expenses (salaries of managerial and office staff etc.), property and business
taxes, license fees etc.
2. Total Variable Cost: Variable costs are those which are incurred on the employment of the
variable factors of production whose amount can be altered in the short run. They are
dependent upon the level of output. The variable costs include- prices of raw materials,
wages of labour, fuel and power charges, excise duties, sales tax, transport expenditure etc.
3. Total Cost: Total cost is the aggregate of expenditures incurred by the firm in producing a
given level of output. Total cost includes all kind of money costs. In the short run, total cost
of a business firm is the sum of its total fixed cost and total variable cost.
TC = TFC + TVC

An example
Consider the following hypothetical example of a boat building firm. The total fixed costs, TFC, include premises,
machinery and equipment needed to construct boats, and are £100,000, irrespective of how many boats are
produced. Total variable costs (TVC) will increase as output increases.

TOTAL
TOTAL FIXED
OUTPUT VARIABLE TOTAL COST
COST
COST
1 100 50 150
2 100 80 180
3 100 100 200
4 100 110 210
5 100 150 250
6 100 220 320
7 100 350 450
8 100 640 740
Plotting this gives us Total Cost, Total Variable Cost, and Total Fixed Cost.

Given that total fixed costs (TFC) are constant as output increases, the curve is a horizontal line on the cost
graph.

The total variable cost (TVC) curve slopes up at an accelerating rate, reflecting the law of diminishing marginal
returns.

The total cost (TC) curve is found by adding total fixed and total variable costs. Its position reflects the amount
of fixed costs, and its gradient reflects variable costs.

4. Average Fixed Cost: Average fixed costs are found by dividing total fixed costs by output. As fixed
cost is divided by an increasing output, average fixed costs will continue to fall.
AFC = TFC/Q

TOTAL FIXED COST AVERAGE FIXED

OUTPUT
(£000) COST (£000)
1 100 100
2 100 50
3 100 33.3
4 100 25
5 100 20
6 100 16.6
7 100 14.3
8 100 12.5
The average fixed cost (AFC) curve will slope down continuously, from left to right.

5. Average variable costs

Average variable costs are found by dividing total fixed variable costs by output.

AVC = TVC/Q

TOTAL VARIABLE AVERAGE VARIABLE

OUTPUT
COST (£000) COST (£000)
1 50 50

2 80 40

3 100 33.3

4 110 27.5
5 150 30

6 220 36.7

7 350 50

8 640 80
The average variable cost (AVC) curve will at first slope down from left to right, then reach a minimum point, and
rise again.

AVC is ‘U’ shaped because of the principle of variable Proportions, which explains the three phases of the curve:

1. Increasing returns to the variable factors, which cause average costs to fall, followed by:
2. Constant returns, followed by:
3. Diminishing returns, which cause costs to rise.

6. Average total cost

Average total cost (ATC) is also called average cost or unit cost. Average total costs are a key cost in the theory of the
firm because they indicate how efficiently scarce resources are being used. Average variable costs are found by
dividing total fixed variable costs by output.

ATC or AC = TC/Q or ATC = AFC + AVC

AVERAGE AVERAGE AVERAGE

OUTPUT FIXED COST VARIABLE TOTAL COSTS
(£000) COST (£000) (£000)
1 100 50 150

2 50 40 90

3 33.3 33.3 67

4 25 27.5 52.5

5 20 30 50

6 16.6 36.7 53.3

7 14.3 50 64.3

8 12.5 80 92.5
Average total cost (ATC) can be found by adding average fixed costs (AFC) and average variable costs (AVC). The ATC
curve is also ‘U’ shaped because it takes its shape from the AVC curve, with the upturn reflecting the onset of
diminishing returns to the variable factor.

7. Marginal costs
Marginal cost is the cost of producing one extra unit of output. It can be found by calculating the change in total
cost when output is increased by one unit. It is also known as ‘extra unit cost’ or ‘incremental cost’. MC = TCn – TCn-1

It can also be calculated by dividing the change in total cost by the one unit.

MC = ∆TC/∆Q

OUTPUT TOTAL COST MARGINAL COST

1 150

2 180 30

3 200 20

4 210 10

5 250 40

6 320 70

7 450 130

8 740 290

It is important to note that marginal cost is derived solely from variable costs, and not fixed costs.

The marginal cost curve falls briefly at first, and then rises. Marginal costs are derived from variable costs and are
subject to the principle of variable proportions.
The significance of marginal cost
The marginal cost curve is significant in the theory of the firm for two reasons:

1. It is the leading cost curve, because changes in total and average costs are derived from changes in
marginal cost.
2. The lowest price a firm is prepared to supply at is the price that just covers marginal cost.

The Relationship between ATC and MC

Since marginal and average costs are measured in the same units, and are derived from the
total cost curve, the relationship between the two is particularly important.

Starting from a zero level of output, AVC and ATC fall as output increases so long as MC is
lower than AVC and ATC. Beyond this point MC rises above AVC and ATC, and AVC and ATC
then rise as output is increased. This relationship is reflected in Figure by the fact that the
AVC and ATC curves decline over the range where the MC curve is below them and increase
over the range where the MC curve is above them. It, therefore, follows that the MC curve
passes through the AVC and ATC curves at their minimum points.

The reason for this relationship between the marginal magnitude Mc and the average
magnitudes AVC and ATC -is strictly mathematical. When the addition to total cost (the
marginal cost) associated with the production of another unit of output is greater than ATC,
ATC rises. Conversely, if the marginal cost of another unit is less than ATC, ATC will fall.
Hence, ATC declines as long as MC is above ATC. When MC is above ATC, ATC rises.
Therefore, at the output level at which MC rises from below ATC to just above it, ATC ceases
to decline and begins to rise.

It follows, therefore, that ATC reaches its lowest point at the output level at which MC
crosses ATC. Exactly the same argument applies to AVC. There is no such relationship
between MC and AFC, however. This is so because AFC depends upon TFC and since TFC is
un-effected by changes in TVC, AFC declines continuously as output changes no matter what
the behaviour of MC.

Three points are to be noted in this context:

1. Marginal cost will always cut average total cost from below.
2. When marginal cost is below average total cost, average total cost will be falling, and when marginal
cost is above average total cost, average total cost will be rising.
3. A firm is most productively efficient at the lowest average total cost, which is also where average total
cost (ATC) = marginal cost (MC).
The Relationship between AFC, AVC and ATC:
The cost-output relationship can also be shown better by joint short output cost curve a run through the use of
graph. It will be seen that the average fixed cost curve (AFC Curve) falls as output rises from lower levels to
higher levels. The shape of the average fixed cost curve, therefore, is a rectangular hyperbola. The average
variable cost curve (AVC curve), First falls and then rises so also that average total cost curve (ATC curve). The
AVC is part of the ATC. Both ATC and AVC are U-shaped, reflecting the law of variable proportions. However,
the minimum point of the ATC occurs to the right of the minimum point of the AVC. This is due to the fact that
ATC includes AFC and the falling effect of AFC is stronger than the rising effect of AVC. After the AVC has
reached its lowest point and start rising, its rise is cover a certain range offset by the fall in the AFC, so that the
ATC continues to fall (over that range) despite the increase in the AVC. However, the rise in AVC eventually
becomes greater that the fall in the AFC so that the ATC starts increasing.

The inter-relationship between AVC, ATC and AFC can be summed up as follows:

1. If both AFC and AVC fall, ATC will fall.

2. If AFC falls but AVC rises;
3. ATC will fall where the drop in AFC is more than the rise in AVC.
4. ATC will not fall where the drop in AFC is equal to the rise in AVC.
5. ATC will rise where the drop in AFC is less than the rise in AVC.
Estimation of Cost Function:

Cost-output relationship is expressed by the cost function. There are the three
common functional forms of cost function in terms of total cost function (TC). a) Linear cost function b)
Quadratic cost function c) Cubic cost function

The typical TC, AC, and MC curves that are based on a linear cost function are shown in Figure. These cost
functions have the following properties: TC is a linear function, where AC declines initially and then becomes
quite flat approaching the value of MC as output increases and MC is constant at b1.
The typical TC, AC, and MC curves that are based on a quadratic cost function are shown in Figure . These cost
functions have the following properties: TC increases at an increasing rate; MC is a linearly increasing function
of output; and AC is a U shaped curve.
The typical TC, AC, and MC curves that are based on a cubic cost function are shown in Figure. These
cost functions have the following properties: TC first increases at a decreasing rate up to output rate
Q1 in the Figure and then increases at an increasing rate; and both AC and MC cost functions are U
shaped functions. The linear total cost function would give a constant marginal cost and
a monotonically falling average cost curve. The quadratic function could yield a U-shaped average
cost curve but it would imply a monotonically rising marginal cost curve. The cubic cost function is
consistent both with a U-shaped average cost curve and a U-shaped marginal cost curve. Thus, to
check the validity of the theoretical cost-output relationship, one should hypothesize a cubic cost
function.