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Nature Of Costs And Cost Curves

 The Nature of Costs and Cost Curves

Accounting and Economic Costs

                 Money costs are the total money outlay sustained by a firm in producing an article. They comprise of wages and salaries of labour, cost of raw materials, outlay on machines and equipments, depreciation and obsolescence charges on machines, building and other capital goods, rent on buildings, interest on capital borrowed, expenses on power, light, fuel, advertisement and transportation, insurance charges and all types of taxes. There are accounting costs which an entrepreneur takes into account in making payments to the various factors of production.

                 “Explicit costs are the payments to outside suppliers of inputs.” There are other types of economic costs called implicit costs. Implicit costs are the imputed value of the entrepreneur’s own resources and services. According to Salvatore, “Implicit costs are the value of owned inputs used by the firm in its own production process.”

Production costs

In the production process many fixed and variable factors are used. They are employed at various prices. The expenditure acquired on them is the total costs of production of a firm. Such costs are divided into total variable costs and total fixed costs.

  1. Total Variable Costs – Those expenses of production which change with the change in the firm’s output. Larger outputs require larger inputs of labour, raw materials, power, fuel etc.

  2. Total Fixed Costs – These are supplementary costs and are those costs of production which do not change with the change in productivity. They are rent and interest payments, depreciation charges, wages and salaries of permanent staffs etc.

Real Costs

Money costs are the outlay of production from the point of view of the producer. The efforts and sacrifices made by capitalist to save and invest by the workers in foregoing leisure and by the landlords in the use of land, all constitute real costs.

Opportunity costs

Benham defines Opportunity cost as “The opportunity cost of anything is the next best alternatives that could be produced instead by the same factors or by an equivalent group of factors costing the same amount of money.”

Private and Social Costs

            These include both explicit and implicit costs. Nevertheless, the production activities of a firm may lead to economic benefit or harm for others. For instance, production of commodities like steel, rubber and chemicals, pollutes the environment which leads to social costs.

The Cost function

The cost function expresses a functional relationship amidst total cost and factors that determine it. Usually the factors that determine total cost of production (C) of a firm are the productivity (Q), the level of technology (T), the prices of factors (Pt) and the fixed factors (F). It is expressed as follows.

                                     C = f (Q, T, Pf, F)
Such a comprehensive cost function requires multi dimensional diagrams which are hard to construct.

The Traditional Theory of Costs

The traditional theory of costs analyses the behaviour of cost curves in the short-run and long run and arrives at the conclusion that both the short run and long run cost curves are U shaped but the long run cost curves are flatter than the short run cost curves.

  1. Firm’s Short Run Cost Curves

The short run is an epoch in which the firm cannot change its plant, equipment and the scale of organisation. To meet the amplified demand, it can raise output by hiring more labour and raw materials or asking the existing labour force to work overtime. The scale of organisation being fixed, the short run total costs TC are divided into total fixed costs (TFC) and total variable costs (TVC), TC = TFC + TVC.

  1. Total Costs – These are those expenses incurred by a firm in producing a given quantity or a commodity. They include payments for rent, interest, wages, taxes and expenses on raw materials, electricity, water, advertising etc.

  2. Total Fixed Cost – These costs of production that do not change with output. They are independent of the level of output.

  3. Total Variable Costs – These costs of production that change directly with productivity. They rise when output increases and fall when output declines.

  4. Short-run average costs – In the short run analysis of the firm average costs are more important than total costs. The units of productivity that a firm produces do not cost the same amount to the firm.

  5. Short run average variable Costs – These are equal total variable costs at each level of output divided by the number of units produced. SAVC = TVC / Q.

  6. Short Run Average Total Costs – These are the average costs of producing any given output. They are arrived at by dividing the total costs at each level of output by the number of units produced. The shape of these curves is U shaped. SAC or SAVC = TC / Q = (TFC / Q) + TVC / Q = AFC + AVC

  7. Short run Marginal Cost – A fundamental concept for the determination of the exact level of output of a firm is the marginal cost.  Marginal Cost is the addition to total cost by producing an additional unit of output.

The curve will look like this: Diagram 1

  1. Firms Long Run Cost Curves

                 In the long run, there are no fixed factors of production and hence no fixed costs. The firm can change its size or scale of plant and employ more or less inputs. Thus in the long run all factors are variable and hence all costs are variable.
                 The long run average total cost or LAC curve of the firm shows the minimum average cost of producing various levels of output from all possible short run average cost curves SAC. Thus the LAC curves are derived from the SAC curves. The LAC curve can be viewed as a series of alternative short run situations into any one of which the firm can move.
                 Each SAC curve represents a plant of a particular size which is suitable for a particular range of output. The firm will therefore make use of various plants up to that level where the short run average costs fall producing various outputs from all the plants used together. Let these three plants represented by their short run average cost curves SAC1, SAC2 and SAC3 which is represented in the diagram 2. Each curve represents the scale of the firm. SAC1 depicts a lower scale while the movement from SAC2 to SAC3 shows the firm to be of a larger size.
                 Given this scale of firm it will produce up to the least cost per unit of output. For producing ON output, the firm can use SAC1 or SAC2 plant. The firm will however use the scale of plant represented by SAC1, since the average cost of production ON output is NB which is less than NA, the cost of producing this output on SAC2 plant. If the firm is to produce OL output it can produce at either of the two plants.


                 But it would be advantageous for the firm to use the plant SAC2 for the OL level of output. But it would be more possible for the firm to produce the larger output OM at the lowest average cost ME from this plant. However for output OH, the firm would use the SAC3 plant where the average cost HG is lower than HF of the SAC2 plant. Thus in the long run in order to produce any level of output the firm will use the plant which has the minimum unit cost.

                 If the firm expands its scale by the three stages represented by SAC1, SAC2, and SAC3 curves, the thick wav like portions of these curves from the long run average cost curve. The dotted portions of these SAC curves are of no consideration during the long run because the firm would change the scale of plant rather than operate on them.


                 In either case, the LAC falls or rises more slowly than the SAC curve because in the long run all costs become variable and few are fixed. The plant and equipment can be worked fully and more efficiently so that both the average variable costs are lower in the long run than in the short run. That is why the LAC curve is flatter than the SAC curve.
                 Likewise, the LMC curve is flatter than SMC curve because all costs are variable and there are few fixed costs. In the short run, the market cost is related to both the fixed and variable costs. As a result the SMC curve falls and rises more swiftly than the LMC curve. It first calls and is below the LAC curve. Then it rises and cuts the LAC curve at its lowest point E and is above the latter throughout its length as given in the diagram 3.

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