What is cost curves?
Cost curves in economics represent the relationship between the quantity of goods produced and the costs incurred by a firm. These curves help in analyzing the cost structure of a business. Key cost curves include total cost (TC), fixed cost (FC), variable cost (VC), average total cost (ATC), average fixed cost (AFC), and average variable cost (AVC). They provide insights into cost behavior at different production levels, aiding in decision-making and pricing strategies.
Introduction
To produce output, the firm needs to employ inputs. To acquire inputs a firm has to pay for them. This is called the cost of production. Cost is a derived function. Cost curves is derived from the production function which describes the most efficient method of producing a commodity. The cost of producing a commodity is the payment made to the production factors used in that commodity’s production. When economists talk about the cost of production they are referring to the economic cost of producing the output.
The economic cost includes the money cost of factors of production that have to be paid for, but it also includes the opportunity cost of the factors that aren’t paid. The opportunity cost of a factor of production is the money that you could have got by putting it to its next best use. E.g. if you run your own business the money you could earn doing other work is the opportunity cost of your labor. So, in economics, cost isn’t just a calculation of money spent-it takes into account all of the effort and resources that have gone into production.
Concept of Explicit, Implicit, Fixed, Variable, Total, Average, and Marginal costs
All Firms, regardless of size, incur costs as they make the goods and services they sell. Costs are incurred because a firm uses factor inputs in production, and these must be paid for. Cost is the expense of all the inputs a firm uses in production. A firm’s costs of production will depend on the factors of production it uses. The more factors it uses, the greater its costs will be. The cost of producing a commodity is the payment made to the production factors used in that commodity’s production.
In economics, cost can be defined as the total expenditure of record on accounts, opportunity forgone by a scarcity of inputs, and cost incurred due to a firm’s using resources that it owns or that the owners of the firm contribute to it.
The cost function of the firm depends upon the nature of the physical production function, the prices of the factors used for production, and the technology used for production. Symbolically,
C=f(Q,T,Fp)
Where, C = Cos of production; Q = Output quantity; T = Technology; Fp= Prices of factors
If other factors remaing constant, we can write the cost function as.
C =f(Q), ceteris paribus
Thus, the cost is a sum of the expenses incurred for the production of different levels of output. The term ‘cost’ has a different meaning. Accountants’ view of cost is different from that of economists. Accountants tend to focus on the explicit and historical costs. On the other hand, economists emphasize that for efficient decision-making by the firm, it is the opportunity cost rather than an explicit and historical cost that must be considered.
Explicit cost
A firm’s explicit costs are its actual cash payments for resources: ages, rent, and interest. It is the payments to outside suppliers of inputs. It is a cost that is incurred when an actual (monetary) payment is made. Explicit costs are the opportunity costs of production that require a monetary payment of the out-of-pocket expenses for labor services, raw materials, fuel, transportation, utilities, advertising, and so on.
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 inputs do not belong to the firm itself. These include wages, rent, interest, payment for power, insurance, advertising, etc. Explicit cost is also called accounting cost as it is explicitly shown in the firm’s expenditure account. There is no difference between money cost and explicit cost.
According to Leftwitch, “Explicit costs are those cash payments which firms make to outsiders for their services and goods.” He has given stress on the word explicit and it may be called the approach used by the accountant of the firm. The payments are explicit-clear-cut, paid to agents (owners) of factors of production. A contract fixes the rate at which the payments are to be made.
Implicit Cost
Implicit cost is a cost that represents the value of resources used in production for which no actual (monetary) payment is made. This is where the economist’s and the accountant’s ideas of costs diverge because accountants do not include implicit costs. Implicit costs are the opportunity costs of using resources owned by the firm or provided by the firm’s owners. Examples include the use of a company-owned building use of company funds, and the time of the firm’s owners. Like explicit costs, implicit costs are opportunity costs. But unlike explicit costs, implicit costs require no cash payment and no entry in the firm’s accounting statement, which records its revenues, explicit costs, and accounting profit.
Implicit cost or imputed cost is the cost of inputs owned by the firm and used by the firm in its production process. These costs refer to the implied or unnoticed costs. They include the interest on his capital, rent on his land, wages of his labor, etc. In the words of Leftwitch, “Implicit costs are the costs of self-owned, self-employed resources.” Thus, the explicit and implicit costs together make the economic cost. In short, we can say that:
Economic costs = Explicit costs – Implicit costs
Differences between Explicit cost and Implicit cost
| Explicit cost | Implicit cost |
|---|---|
| It includes actual money expenditure incurred by a firm in hiring or buying the factor it needs in the production process. | It is not actual money expenditure but is the cost of factors owned by the firm and used by the firm in its production process. |
| It is a payment concept. | It is a receipt concept, i.e., the payments are received by the producer for self-supplied services. |
| It is explicitly shown in the firm’s book of accounts and is thus, called accounting cost. | It does not enter in the firm’s books of accounts. |
| Examples: wages, rent, interest, insurance, etc. | It does not enter the firm’s books of accounts. |
Fixed Costs
Fixed costs are those costs that do not vary with changes in output. Fixed costs are associated with the very existence of a firm’s plant and therefore must be paid even if its output is zero. Fixed costs are unavoidable; they do not vary with output in the short run. Fixed costs are also known as overhead.
A firm incurs a fixed cost in the short run, even if no output is produced. In the words of Anatol Murad, “Fixed costs are costs which do not change with change in the quantity of output. These costs are also known as overhead costs or indirect costs because a firm has to incur these costs even if it shuts down temporarily. Thus, fixed costs are unavoidable and occur even at the zero level of output.
The fixed costs include:
- Salaries of administrative staff
- Depreciation ( wear and tear) of machinery
- Expenses for building depreciation and repairs
- Expenses for land maintenance and depreciation (if any)
Variable cost
Variable costs are those costs that change with the level of output. Variable cost, as the name implies, is the cost of variable resources- in this case, labor. They include payments for materials, fuel, power, transportation services, most labor, and similar variable resources. Variable costs refer to those costs which change with the change in the volume of output. These costs are unavoidable or contractual costs. Marshall called these costs as prime costs, direct costs, or special costs. Thus, according to dooley, “Variable costs are one which varies as the level of output varies.”
The variable costs include:
- The cost of raw materials
- The cost of direct labor
- The running expenses of fixed capital, such as fuel, ordinary repairs, and routine maintenance.
Total Costs (TC)
The amount of money spent on the production of different levels of a good at a particular time is called the total cost. According to Dooley, “Total cost of production is the sum of all expenditure incurred in producing a given volume of output.” In the traditional theory of the firm, total costs are split into two groups’ total fixed costs and total variable costs. The total cost (TC) of production is the sum of the total variable costs (TVC) and the total fixed costs (TFC) of production:
TC = TFC+TVC
Where, TC = Total cost
TFC = Total fixed cost
TVC = Total variable cost
Marginal Costs (MC)
Marginal cost is the extra, or additional cost of producing one more unit of output. Marginal cost (MC) is the change in total costs resulting from a one-unit change in output. It is the amount by which total cost and total variable cost change when one more or one less unit of output is produced.
Ferguson: “Marginal cost is the additional to total cost due to the addition of one unit of output.”
Samuelson: “Marginal cost at any level of output is the extra cost for producing one extra unit more or less.”
Marginal cost is the ratio between the change in total cost and the change in quantity produced:
MC = Change in Total Cost/Change in Quantity = ∆TC/∆Q
Or, MC = TCn+1 -TCn = TCn-TCn-1
Where, MC = Marginal Cost
∆TC = Change in Total Cost
∆Q = Change in outputt
TCn = Total cost of n units
TCn-1 = Total cost of n-1 units
Average Costs (AC)
Average cost is the per unit cost or per unit output cost. The average cost of production is the total cost of production divided by the total number of units produced. According to Dooley, “The average cost of production is the total cost per unit of output.”Average cost is measured by the total cost divided by the number of units of output; a per-unit measure of total costs.
AC = TC/Q
Where, AC = Average Cost
Q = Output
The average total cost (ATC) for any output level is found by dividing the total cost (TC) by that output (Q) or by adding AFC and AVC at that output.
AC = TC/Q = TFC/Q + TVC/Q
=AFC+AVC
Where, AFC = Average fixed cost;
AVC = Average variable cost
Short-Run Cost and Derivation of Short-Run Cost Curves
Short-run cost
The short run is the period of time when at least one of a firm’s factors of production is fixed. The short run isn’t a specific length of time- it varies from firm to firm. The short-run costs are the costs over a period during which some factors are in fixed supply, like plant, machinery, etc. It is the sum total of fixed cost and variable cost incurred by the producer in producing the commodity. 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 unit of variable factors.
A firm incurs a fixed cost in the short run, even if no output is produced. The short-run costs are the costs over a period during which some factors are in fixed supply, like plant, machinery, etc. It is the sum total of fixed cost and variable cost incurred by the producer in producing the commodity. 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.
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