Post on 15-Nov-2014
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THEORY OF COSTS
MEANING OF COSTS OF
PRODUCTION
In order to produce a good every firm makes use of factor of
production so the amount spent on the use of factor of
production is called factor of production cost of production
mainly depends upon the quantity of production
C=f(Q)Here, C=Cost
F=FunctionQ=Quantity
Cost Of Production
Money costs
Real CostsOpportunit
y costs
Total CostsAverage
CostsMarginal
costs
Explicit Costs
Implicit Cost
Money Costs
According to Prof. Hanson
The money cost of a producing a certain output of a commodity is the sum of all the payments to the factors of
production engaged in the production of that commodity.
Therefore, money costs include the following expenses:1. Depreciation and obsolescence charges.2. Power fuel charges.3. Wages and salaries.4. Cost of machinery, raw material etc.5. Expenses on advertising and publicity.6. Interest on capital.7. Expenses on electricity.8. Insurance charges.9. Transport costs.10.Packing charges.11.All types of taxes viz ; property tax , licence fees, exise duty.12.Rent on land.
Money costs of a firm include two costs as following:
1.Explicit costs 2.Implicit costs1. Explicit costs :-
According to LEFTWITCH“Explicit costs are those cash payments
which firms make to outsiders for their services and Goods.”
This cost includes, payment of raw material, taxes and depreciation charges, transportation, power, high fuel, advertising and so on.2. Implicit costs :-According to LEFTWITCH
“Implicit costs are the costs of self-owned, self employed resources.”
This cost includes the interest on his own capital, rent on his land, wages of his own labour etc.
Real Costs
Prof. MARSHAL has called these costs as the “social costs of
production”
Real costs refers to all those efforts and sacrifies undergone by various members of
the sosiety to produce a commodity
Opportunity Costs
When resourses are used for producing a given commodity , then some
amounts of other commodities in whose production, these resources could have
been helpful, has to be sacrifies
For example: The alternative or opportunity cost for producing one unit
of commodity X is amount of Y.That must be sacrifies in order to produce X rather
than Y.
Cost of Production
Total CostAverage
CostMarginal
Cost
Theories of costs
Total cost
According to Dooley :“Total cost of production is the sum of all
expenditures incurred in producing given volume of output.”
Total costs is the combination of fixed costs and variable costs
TC = FC+VC
Here, TC= Total costFC= Fixed costVC=Variable cost
Short run cost curves
Total Fixed Cost
According to Anatol Murad :-“Fixed costs are costs which do not
change with change in the quantity of output.”
Total Variable Cost
According to Dooley :-“Variable costs are one which vary as the
level of output varies.”
Output Fixed cost Variable cost Total cost
0 40 0 40
1 40 20 60
2 40 30 70
3 40 32 72
4 40 34 74
5 40 36 76
6 40 38 78
7 40 40 80
8 40 46 86
Average cost
According to Dooley :-“The Average cost of production is the total
cost per unit of output.”
It includes average fixed cost and average variable cost.
AC=TC/Q
Here, AC=Average costTC= Total costQ= Output
Average fixed cost
“Average fixed cost is the total fixed cost divided by the number of units of output produced.”
AFC=TFC/Q
Here, AFC=Average fixed costTFC=Total fixed costQ=Output
Average variable cost
“Average variable cost is the total variable cost divided by the number of units of output produced.”
AVC=TVC/Q
Here, AVC=Average variable costTVC=Total variable costQ=Output
Units
TFC
TVC TC AC(TC/Q)
AFC(TFC/Q)
AVC(TVC/Q)
0 40 0 40 0 0 0
1 40 20 60 60 40 20
2 40 30 70 35 20 15
3 40 32 72 24 13.3 10.7
4 40 34 74 18.5 10.0 8.5
5 40 36 76 15.2 8 7.2
6 40 38 78 13.0 6.6 6.3
7 40 40 80 11.4 5.7 5.7
8 40 46 86 10.7 5 5.7
9 40 48 88 9.8 4.4 5.4
Marginal Cost
“Marginal cost is the addition made to Total Cost caused by producing one more unit of output.”
MC=TCn –TCn-1
Here, MC=Marginal CostTCn=Total cost of ‘n’ unitsTCn-1= Total cost of ‘n-1’ units
According to Ferguson: “Marginal cost is the addition to Total
Cost due to the addition of one unit of output”
The derivation of MC can be studied with the help of following table:
Units of output TC MC=(TC n - TCn-1)
1 60 -
2 70 10
3 76 6
4 78 2
5 84 6
6 90 6
7 108 18
8 130 22
Relation between average and marginal cost
The main points of relation between average and marginal cost are as under:1. Average cost and marginal cost can be calculated from total cost.2. When AC falls MC also falls.3. When AC arises MC also arises.4. MC cuts AC at its lowest point.5. When AC is constant MC becomes equal to AC.6. Use of MC and AC in price determination.7. Mutual interaction between MC and AC.
Long run cost curves
“Long run is a period in which there is a suficient time to alter the equipment and the scale or organisation with a view to produce
different quantities of output.”
Long run Total Cost
The long run total cost of production is the minimum possible cost of producing any given level of output when all inputs are variable. Long run TC is always less than or equal to short run
Total cost, but it is never more than STC.
Long run Average cost curve
Long run Average cost is the long run total cost divided by the level of output.
LAC=LTC/Q
According to Robert Awh :-“The Long run average cost curve shows
the lowest average cost of producing output when all inputs can be varied freely.”
Different names of LAC
LAC also known as these two following names:1. Envelope curve2. Planning curve
1.Envelope curve:- It envelopes all the SAC curves. It indicates
that LAC cannot exceed SAC so this curve is called as envelope curve.
2. Planning curve :-With the help of this curve a firm can plan as
to which plant it should used to produce different quantities of output so that production is obtained at minimum cost.
Long run marginal cost
Long run marginal cost shows the change in total cost due to the production of one more unit of commodity.
According to Robert Awh :-“Long run marginal cost curve
is that which shows the extra cost incurred in producing one more unit of output when all inputs can be changed.”
LMC= LTC/ Q
Here, LMC= Long run marginal cost LTC = Change in long run total cost Q = Change in output
Relation between LMC and LAC
The relation between long run marginal cost and long run average cost is similar to that of what it is in short run AC and MC but the only difference in LAC and LMC is that long run marginal and average costs are more flatter than that of SAC and SMC. It is so because in long run all factors are variable.
Relation between LMC and SMC
SMC refers to the effect on total cost due to the production of one more unit of output on account of change in variable factors. When a firm selects a proper scale of plan in order to produce given quantity of output then at this level of output short run and long run marginal cost curves are equal.
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