Cost Curves | NEB Class 12 Economics

This chapter covers the concept of cost, short-run total and average cost curves, marginal cost, and the relationship between AC and MC.

Concept of Cost and Its Types

Concept of cost:

In order to produce goods and services, a firm uses raw materials and factors of production which are called inputs. The expenditure incurred by these inputs is called cost. Cost of production is a component of determining the profit of a firm. At a certain price of a commodity, the low cost of production results in high profit and high cost of production results in low profit or loss. There are various kinds of cost. Some of them can be explained as follows:

• Fixed cost:

      Fixed cost includes the expenses incurred by the fixed factors of production. They are those factors which cannot be changed in the short run. The cost incurred by the fixed factor of production remains constant at all levels of outputs. It includes rent of the business premises, interest on capital, salaries of permanent employees, depreciation of machines and furniture, etc. It is also known as an overhead cost.

• Variable cost:

Variable cost includes the expenses incurred by the variable factors of production. They are the factor that can be changed in accordance with the change in production even in the short run. It includes the cost of raw materials, the wage of workers, cost of power and fuel, etc. If the quantity of production increases the cost will increase and vice versa. When the output is zero, the variable cost will be zero.

• Short run cost:

   The short run is a time period in which the firm can vary its output by varying only the amount of variable factors such as labor and raw materials. In the short run, fixed factor such as capital, equipment, top-level management, etc can not increase its output by enlarging the existing plant and building.

• Long run Cost:

The long run is a time period in which all the factor of production is variable. Thus, in the long run, the output can be increased by increasing fixed factors of production like a plant, machinery,  building, etc as well as variable factors.

• Explicit Cost:

An explicit cost is an immediate installment made to others throughout maintaining a business. For example, wage, lease, and materials. The actual cost, likewise called as Real Cost is the cost really acquired by the firm to make all the physical installments and the legally binding commitments. In this way, all the cash costs recorded in the books of records are, for down to earth purposes, the real or explicit cost. This cost goes under the bookkeeping cost idea, as all the physical and effortlessly unmistakable costs caused are recorded in the bookkeeping books, which are then later examined to decide the productivity with which the firm is working.

• Implicit Cost:

An Implicit cost is any cost that has just happened however isn't really appeared or announced as a different cost. The Implicit or certain or ascribed, or imputed cost can be named as a cost which comes about because of utilizing the advantage for one's own particular use as opposed to leasing or offering it, or the salary is inevitable of not deciding to work.

The best case for implicit cost would be an opportunity cost. The credited cost isn't considered while figuring the profit or loss of the firm, yet be that as it may, is vital to choose whether or not to proceed with the factor in its present use. The implicit cost is utilized to ascertain the economic profit. The economic profit is the contrast between the aggregate income produced less aggregate cost.

Derivation of Short-run Total Cost Curves

1. Total fixed cost (TFC):

Fixed cost refers to the expenditure incurred by the producer on the fixed factor of production. It is also known as the total cost made on the fixed factor. In the short run, they do not change with change in output. It remains fixed although the fixed factors are increased or decreased to alter the output.  It can be explained by the help of following schedule and diagram:

In the above diagram, we can see that TFC curve is parallel to x-axis because fixed cost remains constant at all levels of outputs in the short run.

2. Total Variable Cost (TVC)

Variable cost refers to the cost incurred by the variable factors of production. It does not remain constant like the fixed cost at different levels of output. Whenever the output increases or decreases the variable cost will also increase or decrease. It can be explained by the help of following schedule and diagram:

In the above figure, we can see that TVC curve increases at a decreasing rate at first and then increases at an increasing rate after some units of production because of applicability of the law of variable proportion in the short run.

3. Total cost (TC)

Total cost is defined as the total monetary expenditure incurred in the production process. It is the sum of the fixed cost and total variable cost.

Symbolically, TC=TVC + TFC It can also be explained by the help of following schedule and diagram:

In the above figure, costs are shown along y-axis and outputs are shown along the x-axis. TFC is parallel to x-axis because it is constant at all levels of output. TVC is increasing as the output are increasing. TC is also increasing because of variable cost is also included in it. The nature of TC and TVC are similar. They are parallel to each other. The only difference is that TVC starts from origin and TC starts above the origin.

Difference between Fixed Cost and Variable Cost

Difference between fixed cost and variable cost:

Derivation of Short-run Average Cost (AC) Curves

1. Average fixed cost (AFC)

      The average fixed cost is obtained by dividing the total fixed cost by the level of outputs. It is also known as the per unit fixed cost of output.

Symbolically; AFC = TFC / Q It can be explained by the help of following schedule and diagram:

In the above figure, we can see that the AFC curve is a rectangular hyperbola. AFC curve is downward sloping because, as we produce more units of output, AFC declines. It never touches the Y axis because, at zero units of production, AFC is infinite. Similarly, it never touches x-axis because AFC never becomes zero.

2. Average variable cost (AVC)

      Average variable cost is obtained by dividing the total variable cost by the corresponding levels of output. It can be expressed as:

AVC = TVC / Q    We can derive AVC by the help of following schedule and diagram:

In the above figure, we can see that AVC falls at the beginning and then inclines. An AVC curve is 'U' shaped because of the operation of the law of variable proportion.

3. Average Total Cost (ATC/ AC)

        Average total cost is obtained by dividing the total cost by the corresponding level of output. It can be expressed as;

ATC = TC / Q = ( TFC + TVC ) / Q = AFC + AVC It can be derived with the help of following schedule and diagram:

In the above diagram, we can see that ATC falls at the beginning. It becomes minimum and rises after that point. Therefore, it is 'U' shaped. 

Derivation of Marginal Cost (MC) Curve

Marginal cost is defined as the change in the total cost due to one additional unit of change in the output. In other words, it is the ratio of change in the total cost and change in the total output. Symbolically;

MC=∆TC / ∆Q OR MC=TC n - TC n-1 Where; MC = Marginal Cost ∆TC = Change in Total Cost ∆Q = Change in quantity sold TC n = Current Total Cost TC n-1 = Initial Total Cost The concept of Marginal cost can be explained by the help of following schedule and diagram:

In the above figure, SMC or MC represents the short-run marginal cost curve. Up to the second unit of output it has declined to become minimum and rises thereafter. It is also ‘U’ shaped because of the operation of the law of variable proportion in the short run.

Relationship Between AC and MC

  There is a close relationship between AC and MC. MC is the change in TC resulted from the change in the production of one more unit of output whereas AC is the total cost divided by the output. Both AC and MC are derived from TC.

Symbolically; MC = ∆TC / ∆QAC = TC / Q The relationship between these two can be explained with the help of the following diagram:

In the above figure, SMC represents the short-run marginal cost curve and SAC represents the short-run average cost curve. SMC and SAC intersect each other at the minimum point of SAC. It lies to the right of A, the minimum point of SMC I.e point B. The relationship between these two can be summarized  as follows:

1. Both AC and MC curve are calculated from the total cost.
2. Both AC and MC are ‘U’ shaped.
3. When AC is falling, the MC curve lies below AC and MC falls faster than AC.
4. When AC is rising, the MC curve lies above the AC and MC rises faster than AC.
5. When AC is minimum, MC=AC
6. MC intersects at the minimum point of AC.
7. MC cuts AC from below.