Chapter 6 - Cost of Production - Chapter Notes, Micro Economics, class 12

Chapter 6 - Cost of Production - Chapter Notes, Micro Economics, class 12

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Cost of Production

COST FUNCTION :: It studies the FUNCTIONAL RELATIONSHIP between

output and cost of production. It tells the least cost combination of inputs for
different levels of output C = f ( Q )

MEANING OF COST :: Ordinary, money expenditure incurred by a firm in

production of a commodity is called the cost of production. A firm requires factor
inputs and non-factor inputs for producing a commodity and the firm pays them
in the form of money e.g rent to the landlord, salaries and wages to the labour,
interest to the capitalist and expenditure on other inputs like raw material, power,
transportation, Insurance charges, etc.These are costs to the firm and are called
money costs because these are paid in the form of money.
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But in economics, the concept ‘cost’ is used in a broader sense. In
economics sum of explicit costs (accounting) and implicit costs (non-
accounting) constitute the total cost of production.
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In SHORT PERIOD , costs can be categorised into fixed cost and variable cost ,
but in long period all cost are variable cost
TOTAL COST :: It is all the expenditure incurred in production of a commodity.
It is summation of Total Fixed cost (TFC) and Total Variable Cost ( TVC )
BEHAVIOUR OF TOTAL COST
(1) ZERO LEVEL OF OUTPUT :: At zero level of output Total fixed cost
(TFC) is equal to Total Cost (TC) which means that total cost is positive even at
zero level of output and thus TC curve starts from the point as intercept on Y-
axis.
(2) PARALLEL TO TVC :: The vertical distance between Total Cost (TC) and
Total Variable Cost (TVC) on a graph is Total Fixed Cost ( TFC ) [ as TC - TVC
= TFC ].

Since TFC is constant at all levels of output ,therefore the vertical distance
between Total cost and Total variable cost will also be same which means that
both becomes parallel lines.Thus The change in TC is entirely due to TVC as
TFC is constant at all level of output.
(3) SHAPE :: Starts from intercept on Y-axis and is Inverse S-shaped. It
means TC curve starts from origin and Initially increases at a diminishing rate

Then increases at a constant rate

Finally increases at increasing rate
MARGINAL COST :: It is ADDITIONAL COST incurred forPRODUCTION
OF ADDITIONAL UNIT by employing additional factor of production.
(1) MC CURVE IS U - SHAPED which means this cost initially decreases with
increase in output but after reaching a certain point the cost starts increasing.
(2) MC is NOT AFFECTED BY FIXED COST as fixed cost remains constant
for all level of output and can never be additional cost. Thus MC is affected by
variable cost only that changes with change in output

RELATION BETWEEN TVC AND MC

MC refers to additional cost and additional cost can only be variable cost.
Accordingly
sum total of Marginal Cost at all level of output will be total variable cost and
not total cost
because total cost includes fixed cost i.e

GRAPHICALLY

Up to point Q*, TVC is increasing at a decreasing rate, because MC is

decreasing.

Beyond point Q*, TVC is increasing at an increasing rate, because MC is

increasing.

At point Q*, TVC stops increasing at a decreasing rate, because MC touches

its lowest point.

It means that area under MC at any level of output is Total variable cost
( TVC). Thus if OB level of output is produced area OBCD will be equal to total
variable cost Consider any level of output say six units at this level TVC = 48
which is summation of MC

AVERAGE CONCEPTS
(1) AVERAGE FIXED COST (AFC) :: It is PER UNIT FIXED COST of
producing
goods.

SHAPE :: RECTANGULAR HYPERBOLA

(2) AVERAGE VARIABLE COST (AVC ) :: It is PER UNIT VARIABLE

COST of
producing goods

SHAPE :: U - Shaped
(3) AVERAGE TOTAL COST (ATC ) or AVERAGE COST (AC) :: It is PER
UNIT TOTAL COST of producing goods

AFC’S NATURE // PROPERTIES // CHARACTERISTIC

(1) AVERAGE FIXED COST (AFC) GOES ON DECREASING WITH

INCREASE IN
OUTPUT :: AFC is total fixed cost (TFC) divided by output and as the output is
increased , the
constant fixed cost gets distributed to increased number of output and this cause
Average fixed Cost (AFC) to decrease.
As depicted in the example as output is increased from 1unit to 2 unit the TFC
(=20) gets
distributed to 2 units and AFC becomes Rs10/- per unit
(2) AFC IS NEVER ZERO Therefore it never touches X-axis
(3) It assumes the SHAPE OF RECTANGULAR HYPERBOLA which means at
any level of output area under the curve is same.
Area under the AFC curve represents AFC x Q which equals Total fixed Cost
(TFC) and as we know TFC remains constant for all level of output , therefore
Area at all points on rectangular hyperbola is same
At OB level of output , Area = OB x OC = 2 x 10 = 20
At OD level of output , Area = OD x OE = 4 x 5 = 20
RELATIONSHIP BETWEEN AVERAGE TOTAL COST (ATC) WITH
MARGINAL COST (MC)
Note :: It is MC which brings about changes (rise or fall) in AC and not the other
way round.
(1) Both are derived from Total Cost as AC = TC/Q and MC = TC N - TC N-1
(2) When AC is falling , MC is below it ( as MC declines faster than AC) AC >
MC
(3) When AC is rising , MC is above it ( as MC rises faster than AC) AC < MC
(4) MC cuts AC at AC’s minimum point i.e when AC is constant AC = MC
(5) MC CAN RISE WHEN AC IS FALLING :: Since average cost is related to
many or all units of output so any increase or decrease in cost is distributed to all
the units whereas in case of MC any change in cost is borne by additional unit
only which makes MC change faster than AC. Hence MC decreases faster than
AC and reaches its minimum point “A” earlier than minimum point of AC ( point
“B”). MC starts rising thereafter ( from point A to B ) whereas AC continues to
decrease ( from point C to B)
The relationship between marginal cost and average cost is an arithmetic
relationship . To
understand this relationship let us take a numerical example.

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CAN AC RISE WHEN MC IS FALLING ? NO, because when MC falls , AC
will also fall.
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SPECIAL POINT :: The relationship between marginal cost (MC) and
average variable cost (AVC) is similar to the relationship between marginal
cost and average cost because marginal cost is not affected by fixed cost.
Thus , this relationship between marginal cost and average cost is a
generalized relationship and holds valid in case of the marginal and average
values of any variable, be it revenue or product etc.
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SHOW AC (ATC), AVC, MC, AFC ON A SINGLE DIAGRAM
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(1) AFC falls, approaches X - axis but never touches it and thus assumes the
shape of
RECTANGULAR HYPERBOLA
(2) AC, AVC, MC CURVES ARE U - SHAPED that is these cost curves initially
decreases with increase
in output but later on rises
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AC AND AVC

(1) AC CURVE WILL ALWAYS LIE ABOVE THE AVC CURVEbecause AC

includes both AVC and AFC at all levels of output and thus is greater than AVC
by amount of AFC ( AC -AVC = AFC )
(2) AVC REACHES ITS MINIMUM POINT (POINT “C”) AT A LEVEL OF
OUTPUT LOWER THAT THAT OF AC ( POINT “B”) because when AVC is at
its minimum point , AC is still falling because of falling AFC. Thus minimum of
AC is to the right of minimum point of AVC
(3) With increase in output , the GAP/ VERTICAL DSITANCE BETWEEN AC
AND AVC DECREASE because the gap is AFC which coninues to decline with
rise in output
(4) AC AND AVC NEVER INTERSECT each other because AFC can never be
zero
MC WITH AC AND AVC

(1) WHEN MC IS LESS THAN AC & AVC , both of them FALL with increase
in output that is (AC or AVC) > MC
2) When MC becomes equal to AC and AVC , they become constant . MC curve
cuts AC
curve at Point “B” and AVC at point “C” at their minimum points that is ( AC or
AVC) = MC
(3) When MC IS MORE THAN AC AND AVC , both of them RISES with
increase in output that
is MC > (AC or AVC)
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SPECIAL POINT
(a) MC = AVC = TVC at first level of output
(b) Minimum point of MC comes before the minimum points of AC and AVC
curves
(c) MC curve cuts both AC and AVC curves at their minimum points
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WHAT IS U-SHAPED CURVE ? WHY AC, AVC AND MC ARE U-
SHAPED ?
U- shaped cost curve means a curve that initially cost decreases with increase in
output and
after reaching a certain point (minimum point ) it starts rising due to following
reason
(1) APPLICATION OF LAW OF VARIABLE PROPORTION :: According to this
law when in short run additional variable input (like raw material, labour) is
employed on fixed factors, then
- initially increasing return sets in which causes proportional more increase in
output than input and hence cost decreases,
- But after a certain output decreasing return prevails which means proportional
less increases in output and hence cost increases.

(2) DUE TO UTILIZATION OF FIXED FACTORS :: Fixed cost on fixed

factors is constant and hence when more output is produced by fully utilizing
fixed factors, the same fixed cost gets distributed to large number of units
produced which reduces per unit and marginal cost. However, later on frequent
breakdown of fixed factors occurs due to over utilisation which causes repair and
maintenance cost as well as overall cost to increase.
(3) AC IS VERTICAL SUMMATION OF AVC AND AFC :: In earlier stages
both AVC and AFC decreases, these cause AC to decrease. After a certain output
AVC increases and this increase is more powerful than decrease in AFC , thus AC
starts rising
DIFFERENCE BETWEEN EXPLICIT (ACCOUNTING) COST AND
IMPLICIT ( NON ACCOUNTING) COST

EXAMPLE :: Leaving a job of Rs. 40,000 per month and using his factory
evicting where tenant
was paying Rs. 50,000 per month , an entrepreneur undertakes production of
garments. He
pays Rs. 1,00,000 for the purchase of inputs. Find cost of production in terms of
explicit cost
and implicit cost.

HOW TO MEASURE IMPLICIT COST :: Implicit cost is measured by

determining the value of self occupied factors in terms of their market price .
Eg : if a doctor has opened a clinic at his home , then imputed value of salary for
his service will
be calculated on the basis of salary that he would receive if he is employed by
someone else
FORMULA’S AT A GLANCE

NUMERICALS
TYPE NO. 1 OUTPUT AND TOTAL COST IS GIVEN

TYPE NO. 2 FIXED COST IS GIVEN SEPARATELY, QUES. STARTS

FROM OUTPUT ONE

(Q8) Given is AFC at 1 unit production is Rs 60

(a) Is the MC curve U - shaped ?

(b) Derive AVC ? Will it be U -shaped ? Why
or why not
(Q10) If at 5 units of output AVC is Rs 40 and TFC is Rs 50. Find total and
average cost.
(Q11) A firm is producing 20 units. At this level ATC and AVC are 40 and 37
respectively. Find
TFC
(Q12) Calculate the weekly TC and AVC from the following particulars
{ Ans 12300 , 119 }
(Q13) When output increases from 40 to 55 units , TC increases from rs 2500 to
Rs 3250 .
Calculate MC
{ Ans rs 50 }
(Q14) The total cost curve makes an intercept of Rs. 50 on the Y-axis. Calculate
total fixed cost
and total variable cost.

(Q15) Find out the missing figure from the table given below :

(Q16) Calculate total variable cost and marginal cost at each given level of
output from the
following table :

(Q17) A firm’s fixed cost is Rs. 2,000. Compute TVC, AVC, TC and ATC from
the following
table:

(Q18) Form the following information about a firm, find out :

(i) AFC of producing 3 units (ii) AVC of producing 4 units
(iii) The least average cost (AC) level of output. (iv) MC of producing
5th unit
(v) TVC of producing 6 units.

(Q19) AC schedule of a firm is given. Calculate the firm’s MC for (i) 6 and (ii) 7
units.

(Q20) From the following data on the cost of production of a firm, calculate (i)
AFC and (ii) AVC
of producng eight units.

(Q21) TFC = 100 Find TVC , TC , AVC and SAC

(Q22) AFC at 4 unit of output is Rs 5 . Find TVC , TFC , AVC , AFC , SAC ,
SMC