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Concept of Cost of Production:

Definition and Meaning:


By "Cost of Production" is meant the total sum of money required for the production of a specific quantity of output. In the word of Gulhrie and Wallace: "In Economics, cost of production has a special meaning. It is all of the payments or expenditures necessary to obtain the factors of production of land, labor, capital and management required to produce a commodity. It represents money costs which we want to incur in order to acquire the factors of production". In the words of Campbell: "Production costs are those which must be received by resource owners in order to assume that they will continue to supply them in a particular time of production".

Elements of Cost of Production:


The following elements are included in the cost of production: (a) Purchase of raw machinery, (b) Installation of plant and machinery, (c) Wages of labor, (d) Rent of Building, (e) Interest on capital, (f) Wear and tear of the machinery and building, (g) Advertisement expenses, (h) Insurance charges, (i) Payment of taxes, (j) In the cost of production, the imputed value of the factor of production owned by the firm itself is also added, (k) The normal profit of the entrepreneur is also included In the cost of production.

Normal Profit:
By normal profit of the entrepreneur is meant in economics the sum of money which is necessary to keep an entrepreneur employed in a business. This remuneration should be equal to the amount which he can earn in some other alternative occupation. If this alternative return is not met, he will leave the enterprise and join alternative line of production.

Types/Classifications of Cost of Production:


Prof, Mead in his book, "Economic Analysis and Policy" has classified these costs into three main sections:

(1) Production Costs:


It includes material costs, rent cost, wage cost, interest cost and normal profit of the entrepreneur.

(2) Selling Costs:


It includes transportation, marketing and selling costs.

(3) Sundry Costs:


It includes other costs such as insurance charges, payment of taxes and rate, etc., etc.

Analysis of Short Run Cost of Production:


Definition of Short Run:
Short run is a period of time over which at least one factor must remain fixed. For most of the firms, the fixed resource or factors which cannot be increased to meet the rising demand of the good is capital i.e., plant and machinery. Short run, then, is a period of time over which output can be changed by adjusting the quantities of resources such as labor, raw material, fuel but the size or scale of the firm remains fixed.

Definition of Long Run:


In the long run there is no fixed resource. All the factors of production are variable. The length of the long run differs from industry to industry depending upon the nature of production. For example, a balloon making firm can change the size of firm more quickly than a car manufacturing firm.

Categories/Types of Costs in the Short Run:


The total cost of a firm in the short run is divided into two categories (1) Fixed cost and (2) Variable cost. The two types of economic costs are now discussed in brief.

(1) Total Fixed Cost (TFC):


Total fixed cost occur only in the short run. Total Fixed cost as the name implies is the cost of the firm's fixed resources, Fixed cost remains the same in the short run regardless of how many units of output are produced. We can say that fixed cost of a firm is that part of total cost which does not vary with changes in output per period of time. Fixed cost is to be incurred even if the output of the firm is zero. For example, the firm's resources which remain fixed in the short run are building, machinery and even staff employed on contract for work over a particular period.

(2) Total Variable Cost (TVC):


Total variable cost as the name signifies is the cost of variable resources of a firm that are used along with the firm's existing fixed resources. Total variable cost is linked with the level of output. When output is zero, variable cost is zero. When output increases, variable cost also increases and it decreases with the decrease in output. So any resource which can be varied to increase or decrease with the rate of output is variable cost of the firm.

For example, wages paid to the labor engaged in production, prices of raw material which a firm. incurs on the production of output are variable costs. A firm can reduce its variable cost by lowering output but it cannot decrease its fixed cost. These expenses remain fixed in the short run. In the long run there are no fixed resources. All resources are variable. Therefore, a firm has no fixed cost in the long run. All long run costs are variable costs.

(3) Total Cost (TC):


Total cost is the sum of fixed cost and variable cost incurred at each level of output. Total cost of production of a firm equals its fixed cost plus its: Formula: TC = TFC + TVC Where: TC = Total cost. TFC = Total fixed cost. TVC = Total variable cost.

Explanation:
Short run costs of a firm is now explained with the help of a schedule and diagrams.

Schedule:
(in Dollars) Total Units of Output (in Hundred) Fixed Cost 0 1 2 3 4 5 6 7 1000 1000 1000 1000 1000 1000 1000 1000 Total Variable Cost 0 60 100 150 200 400 700 1100 Total Cost 1000 1060 1100 1150 1200 1400 1700 2100

The short run cost data of the firm shows that total fixed cost TFC (column 2) remains constant at $1000/- regardless of the level of output. The column 3 indicates variable cost which is associated with the level of output. Total variable cost is zero when production is zero. Total variable cost increases with the increase in output.

The variable does not increase by the same amount for each increase in output. Initially the variable cost increases by a smaller amount up to 3rd unit of output and after which it increases by larger amounts. Column (4) indicates total cost which is the sum of TFC + TVC. The total cost increases for each level of output. The rise in total cost is more sharp after the 4th level of output. The concepts of costs, i.e., (1) total fixed cost (2) total variable cost and (3) total cost can be illustrated graphically.

(i) Total Fixed Cost Curve/Diagram:

In this diagram (13.1) the total fixed cost of a firm is assumed to be $1000 at various levels of output. It remains the same even if the firm's output is zero.

(ii) Total Variable Cost Curve/Diagram:

In the figure (13.2), the total variable cost curve (TVC) increases with the higher level of output. It starts from the origin. Then increases at a diminishing rate up to the 4th units of output. It then begins to rise at an increasing rate.

Total Cost Curve Curve/Diagram:

In the figure (13.3), total cost curve which is the sum of the total fixed cost and variable cost at various levels of output has nearly the same shape. The difference between the two is by only a fixed amount of $1,000. The total variable cost curve and the total cost curve begin to rise more rapidly as production is increased. The reason for this is that after a certain output, the business has passed its most efficient use of its fixed costs machinery, building etc., and its diminishing return begins to set in.

Analytical Importance of Fixed and Variable Costs:


In the time of distinction between fixed cost and variable cost is a matter of degree, it all depends upon the contracts of a firm and .the period of time under consideration. For example, if a firm makes contract with the labor for a certain period, then the firm has to bear the cost of the labor irrespective of the total produce. Under such conditions, the wages paid to the labor will be classified as fixed cost and not variable cost, as discussed under the heading of variable cost. Secondly, when the period of time is short, the distinction between fixed cost and variable cost can be made rigid but not in a longer period of time all fixed costs change into variable cost in the long run.

Average Cost:
Definition and Explanation:
The entrepreneurs are no doubt interested in the total costs but they are equally concerned in knowing the cost per unit of the product. The unit cost figures can be derived from the total fixed cost, total variable cost and total cost by dividing each of them with corresponding output.

Types/Classifications:
(1) Average Fixed Cost (AFC):
Average fixed cost refers to fixed cost per unit of output. Average fixed Cost is found out by dividing the total fixed cost by the corresponding output.

Formula:

AFC = TFC output (Q)


For instance, if the total fixed cost of a shoes factory is $5,000 and it produces 500 pairs of shoes, then the average fixed cost is equal to $10 per unit. If it produces 1,000 pairs of shoes, the average fixed cost is $5 and if the total output is 5,000 pairs of shoes, then the average fixed cost is $1 pair of shoe. From the above example, it is clear, that the fixed cost, i.e., $5,000 remains the same whether the output is 1,000 or 5,000 units.

Behavior of Average Fixed Cost (AFC):


The average fixed cost begins to fall with the increase in the number of units produced, In our example stated above, average fixed cost in the beginning was $10. As the output of the firm increased, it gradually came down to $1. The AFC diminishes with every increase in the quantity of output produced but it never becomes zero.

Diagram/Curve:

The concept of average fixed cost can be explained with the help of the curve, in the diagram (13.4) the average fixed cost curve gradually falls from left to right showing the level of output. The larger the level of output, the lower is the average fixed cost and smaller the level of output, the greater is the average fixed cost. The AFC never becomes zero.

(2) Average Variable Cost (AVC):


Average variable cost refers to the variable expenses per unit of output Average variable cost is obtained by dividing the total variable cost by the total output. For instance, the total variable cost for producing 100 meters of cloth is $800, the average variable cost will be $8 per meter.

Formula:
AVC = TVC (Q)

Behavior of Average Variable Cost:


When a firm increases its output, the average variable cost decreases in the beginning, reaches a minimum and then increases. Here, a question can be asked as to why AVC decreases in the beginning reaches a minimum and then increases. The answer to this question is very simple. When in the beginning, a firm is not producing to its full capacity, then the various factors of production employed for the manufacture of a particular commodity remain partially absorbed. As the output of the firm is increased, they are used to its fullest extent. So the AVC begins to decrease. When the plant works to its full capacity, the AVC is at its minimum. If the production is pushed further from the plant capacity, then less efficient machinery and less, efficient labour may have to be employed. This results in the rise of AVC. It is in this way we say that as the output of

a firm increases, the AVC decreases in the beginning, reaches a minimum and then increases. The AVC can also be represented in the form of a curve.

Diagram/Curve:

The shape of the average variable cost curve (Fig. 13.5) is like a flat U-shaped curve. It shows that when the output is increased, there is a steady fall in the average variable cost due to increasing returns to variable factor. It is minimum when 500 meters of doth are produced. When production is increased to 600 meters, of cloth or more, the average variable cost begins to increase due to diminishing returns to the variable factor.

(3) Average Total Cost (ATC):


Average total cost refers to cost (both fixed and variable) per unit of output. Average total cost is obtained by dividing the total cost by the total number of commodities produced by the firm or when the total sum of average variable cost and average fixed cost is added together, it becomes equal to average total cost.

Formula:
ATC = Total Cost (TC) Output (Q)

Behavior of Average Total Cost:


As the output of a firm increases, average total cost like the average variable cost decreases in the beginning reaches a minimum and then it increases. The reasons for decline of ATC in the beginning are that it is the sum of AFC and AVC. Average fixed cost and average variable costs have both the tendency to fall as output is increased. Average total cost will continue falling so long average variable cost does not rise. Even if average variable cost continues rising, it is not necessary that the average total cost will rise. It can be due to the fact that the increase in average variable cost is less than the fall in average fixed cost. The increase in average variable cost is counterbalanced by a rapid fall of

average fixed cost. If the rise in the average variable cost is greater than the fall in average fixed cost, then the average total cost will rise. The tendency to rise on the part of average total cost-in the beginning is slow, after a certain point it begins to increase rapidly.

Diagram/Curve:

The average total cost is represented here by a shaped curve in Fig. (13.6). The average total cost curve is also like a U-shaped curve. It shows that as production increases from 100 meters to 200 meters of cloth, the cost falls rapidly, reaches a minimum but then with higher level of output, the average fixed cost begins to increase.

Short Run and Long Run Average Cost Curves:


Relationship and Difference: Short Run Average Cost Curve:
In the short run, the shape of the average total cost curve (ATC) is U-shaped. The, short runaverage cost curve falls in the beginning, reaches a minimum and then begins to rise. The reasons for the average cost to fall in the beginning of production are that the fixed factors of a firm remain the same. The change only takes place in the variable factors such as raw material, labor, etc. As the fixed cost gets distributed over the output as production is expanded, the average cost, therefore, begins to fall. When a firm fully utilizes its scale of operation (plant size), the average cost is then at its minimum. The firm is then operating to its optimum capacity. If a firm in the short-run increases its level of output with the same fixed plant; the economies of that scale of production change into diseconomies and the average cost then begins to rise sharply.

Long Run Average Cost Curve:


In the long run, all costs of a firm are variable. The factors of production can be used in varying proportions to deal with an increased output. The firm having time-period long enough can build larger scale or type of plant to produce the anticipated output. The shape of the long run average cost curve is also U-shaped but is flatter that the short run curve as is illustrated in the following diagram:

Diagram/Figure:

In the diagram 13.7 given above, there are five alternative scales of plant SAC1 SAC2, SAC3, SAC4and, SAC5. In the long run, the firm will operate the scale of plant which is most profitable to it. For example, if the anticipated rate of output is 200 units per unit of time, the firm will choose the smallest plant It will build the scale of plant given by SAC1 and operate it at point A. This is because of the fact that at the output of 200 units, the cost per unit is lowest with the plant size 1 which is the smallest of all the four plants. In case, the volume of sales expands to 400, units, the size of the plant will be increased and the desired output will be attained by the scale of plant represented by SAC2 at point B, If the anticipated output rate is 600 units, the firm will build the size of plant given by SAC3 and operate it at point C where the average cost is $26 and also the lowest The optimum output of the firm is obtained at point C on the medium size plant SAC3. If the anticipated output rate is 1000 per unit of time the firm would build the scale of plant given by SAC5 and operate it at point E. If we draw a tangent to each of the short run cost curves, we get the long average cost (LAC) curve. The LAC is U-shaped but is flatter than tile short run cost curves. Mathematically expressed, the long-run average cost curve is the envelope of the SAC curves.

In this figure 13.7, the long-run average cost curve of the firm is lowest at point C. CM is the minimum cost at which optimum output OM can be, obtained. .

Marginal Cost (MC):


Definition:
Marginal Cost is an increase in total cost that results from a one unit increase in output. It is defined as: "The cost that results from a one unit change in the production rate".

Example:
For example, the total cost of producing one pen is $5 and the total cost of producing two pens is $9, then the marginal cost of expanding output by one unit is $4 only (9 - 5 = 4). The marginal cost of the second unit is the difference between the total cost of the second unit and total cost of the first unit. The marginal cost of the 5th unit is $5. It is the difference between the total cost of the 6th unit and the total cost of the, 5th unit and so forth. Marginal Cost is governed only by variable cost which changes with changes in output. Marginal cost which is really an incremental cost can be expressed in symbols.

Formula:
Marginal Cost = Change in Total Cost = TC Change in Output q The readers can easily understand from the table given below as to how the marginal cost is computed:

Schedule:
Units of Output 1 2 3 4 5 6 Total Cost (Dollars) 5 9 12 16 21 29 Marginal Cost (Dollars) 5 4 3 4 5 8

Graph/Diagram:

MC curve, can also be plotted graphically. The marginal cost curve in fig. (13.8) decreases sharply with smaller Q output and reaches a minimum. As production is expanded to a higher level, it begins to rise at a rapid rate.

Long Run Marginal Cost Curve:


The long run marginal cost curve like the long run average cost curve is U-shaped. As production expands, the marginal cost falls sharply in the beginning, reaches a minimum and then rises sharply.

Relationship Between Log Run Average Cost and Marginal Cost:


The relationship between the long run average total cost and log run marginal cost can be understood better with the help of following diagram:

It is clear from the diagram (13.9), that the long run marginal cost curve and the long run average total cost curve show the same behavior as the short run marginal cost curve express with the short run average total cost curve. So long as the average cost curve is falling with the increase in output, the marginal cost curve lies below the average cost curve. When average total cost curve begins to rise, marginal cost curve also rises, passes through the minimum point of the average cost and then rises. The only difference between the short run and long run marginal cost and average cost is that in the short run, the fall and rise of curves LRMC is sharp. Whereas In the long run, the cost curves falls and rises steadily.

Concept of Economic Costs:


We have discussed the important types of cost which a firm has to face. The cost of production from the point of view of an individual firm is split up into the following parts.

(1) Explicit Cost:


Explicit cost is also called money cost or accounting cost. Explicit cost represents all such expenditure which are incurred by an entrepreneur to pay for the hired services of factors of production and in buying goods and services directly. In other words, we can say that they are the expenses which the business manager must take into account of because they must actually be paid by the firm.

Example:
The explicit cost includes wages and salary payments, expenses on the purchase of raw material, light, fuel, advertisements, transportation, taxes and depreciation charges.

(2) Implicit Cost:

The implicit costs are the imputed value of the entrepreneur's own resources and services. Implicit costs can be defined as: "Expenses that an entrepreneur does not have to pay out of his own pocket but are costs to the firm because they represent an opportunity cost".

Example:
For instance, if a person is working as a manager in his own firm or has invested his own capital or has built the factory at his own land, the reward of all these factors of production at least equal to their transfer prices is, included in the expenses of a business. Implicit costs, thus, are the alternative costs of the self-owned and self-employed resources of a firm. The total costs of a business enterprise is the sum total of explicit and implicit costs. If the implicit costs are not included in the firm's total cost, the cost of the firm will be understated and it will result in serious error.

(3) Real Cost:


Real costs are the pains and inconveniences experienced by labor to produce a commodity. These costs are not taken in the costing of a commodity by the firm. Real cost has been defined differently by different economists. Classical economists understood by real costs the pains and sacrifices of labor. AlfredMarshall calls real cost as social cost and describes it: "Real costs of efforts of various qualities and real costs of waiting". The Austrian School of Economists have criticized the meaning given to real cost by the classical economists and new classical economists. They say that to give a subjective value to cost is a hopeless task as when real cost is expressed in terms of sacrifices or pains, it is not amenable to precise measurement and thus it fails to explain the phenomenon of prices.

(4) Opportunity Cost:


The concept of opportunity cost has a very important place in economic analysis. It is defined as: "The value of a resource in its next best use. It is the amount of income or yield that could have been earned by investing in the next best alternative".

Example:
The opportunity cost of a good can be given a money value. For instance, a labor is working in a factory and is getting $2000 P.M. The entrepreneur is paying him this amount because he can earn this amount in the next best alternative employment. If he pays less than this amount, he will move to next best alternative occupation, where he can get $2000 P.M. So in order to obtain a productive service say labor in the present occupation, the cost should be equal to the amount which he can get in some alternative occupation. Similarly, a piece of land or

capital must be paid as much as they could earn in their next best alternative use. The total alternative earnings of the various factors employed in the production of a good constitute the opportunity cost of a good. In a money economy, opportunity or transfer cost is defined as the amount of money which a firm must make to resource suppliers m order to attract these resources away from alternative lines of production. In the words of Lipsay: "The opportunity cost of using any factor is what is currently foregone by using it". The idea of opportunity cost has an important bearing on the decisions involving scarcity of resources, their alternative uses and the choice.