Theory of Cost

COST
It is the price paid for acquiring,
producing or maintaining something
and is measured in money.
For Example
The price of raw material, rewards
of the factors of production, price of
energy inputs, etc.

Types of Costs
Social Costs
It is the cost which the entire society has to pay
for the production. For Exp; The producers do not
pay for the pollution caused by their factories.

Economic Costs
The economic cost depends both on the cost of
the alternative chosen and the benefit that the
best alternative would have provided if chosen.
Economic cost differs from accounting cost
because of the opportunity cost.
For Exp; cost of attending college, setting up
ones own business etc.

 Explicit Costs
Explicit costs are the costs of those resources
which are purchased from the market.

Implicit Costs
Implicit costs are the costs of those resources
which are owned by the producer.

Total costs = Explicit costs +

Implicit Costs

Normal Profit & Economic

Profit
Normal profit is the
minimum amount

which the producer should receive for the

survival of his business.
Normal Profit TR TC = 0
Economic profit is the excess over the
normal profit.
Economic Profit: TR>TC
Under perfect competition, firms earn
normal profits.
If firms receive more than normal profits,
then they are earning super normal profits.

Short-Run Costs
Total Fixed Cost
It is the cost which the firms bear for its fixed
factors of production and it does not change with
the level of output. It is paid even if the output
level is zero.

Total Variable Cost

These are the costs which change with the level
of production. It starts from origin, initially
increases at a decreasing rate and then increases
at an increasing rate.

Total Cost
TC = TFC + TVC

 Average Fixed Cost

It is the per unit fixed cost. AFC = TFC/Q

Average Variable Cost

It is the per unit variable cost. AVC = TVC/Q

Average Total Cost

It is the per unit total cost. ATC = TC/Q

Marginal Cost
It is the change in total cost or total variable cost
due to an additional unit of the output produced.
MC
=TC

TP

TFC

TVC

TC

AFC

AVC

ATC

MC

100

100

100

90

190

100

90

190

90

100

170

270

50

85

135

80

100

240

340

33.33

80

113.3

70

100

300

400

25

75

100

60

100

370

470

20

74

94

70

100

450

550

16.7

75

91.7

80

100

540

640

14.3

77.14

91.43

90

100

650

750

12.5

81.25

93.75

110

100

780

880

11.11

86.67

97.78

130

10

100

930

1030

10

93

103

150

Relationship between AC
and MC

 Average cost and marginal cost curves are

U-shaped.
When average total cost is decreasing,
marginal cost is less than average cost.
When average cost is minimum, marginal
cost is equal to the average cost.
When average cost is rising, marginal cost
is greater than the average cost.
Minimum of MC comes before the minimum
AVC and minimum of AVC comes before the
minimum of ATC.
The MC curve cuts AVC and ATC at their
minimum points.

Long-Run Average Cost

In the long-run the industry and the
firms it comprises can undertake all
the desired resource adjustments.
It can change the inputs and also its
production capacity.
Some firms may enter and some
may leave.
The long-run average cost is the
envelope of short-run average costs.

Returns to Scale
Increasing returns to scale
When the increase in output is greater than the increase in
cost, the per unit cost falls and it is called the phase of IRS.

Constant Returns to Scale

When the proportionate increase in output is same as the
proportionate increase in cost, then the per unit cost is
constant.

Decreasing Returns to Scale

When the increase in output is lesser than the increase in
cost, the per unit cost rises and it is called the phase of
DRS.

Economies of scale
It is the benefit which the firm gets
with the expansion of output. There
are two types of economies of scale.
1. Internal Economies of Scale
It is the benefit which the firm gets internally
from the expansion. E.g. efficient management
technique, specialization, proper use of inputs
and byproducts.

2. External Economies of Scale

It is the benefit received from the expansion of
the industry e.g. infrastructure, cheap factor
market and other small industries.