Chapter: Cost of Production

1. What is Opportunity Cost?

The basic economic problem is the issue of scarcity. Because resources are scarce but wants are
unlimited, people must make choices. Opportunity cost plays an important role to determine the best choice.
Opportunity cost measures the cost of any choice in terms of the next best alternative foregone.

 Work-leisure choices: The opportunity cost of deciding not to work an extra ten hours a week is the lost
wages foregone. If a labour being paid Rs. 100 per hour to work at the local supermarket, if you take a
day off from work you might lose over Rs.1000 of income

 Government spending priorities: The opportunity cost of the government spending nearly Rs.20
billion on investment in National Health Service might be that Rs.20 billion less is available for
spending on education or improvements to the transport network.

 Investing today for consumption tomorrow: The opportunity cost of an economy investing resources
in capital goods is the production of consumer goods given up for today

2. What are Social Cost and Private Cost?

Private costs for a producer of a good, service, or activity include the costs the firm pays to purchase
capital equipment, hire labor, and buy materials or other inputs. While this is straightforward from the business
side, it also is important to look at this issue from the consumers’ perspective. Environmental Economics
provides an example of the private costs a consumer faces when driving a car: The private costs of this (driving
a car) include the fuel and oil, maintenance, depreciation, and even the drive time experienced by the operator
of the car. Private costs are paid by the firm or consumer and must be included in production and consumption
decisions.

External costs, on the other hand, are not reflected on firms’ income statements or in consumers’
decisions. However, external costs remain costs to society, regardless of who pays for them. Consider a firm
that attempts to save money by not installing water pollution control equipment. Because of the firm’s actions,
cities located down river will have to pay to clean the water before it is fit for drinking. The public may find that
recreational use of the river is restricted, and the fishing industry may be harmed. When external costs like these
exist, they must be added to private costs to determine social costs and to ensure that a socially efficient rate of
output is generated.

Social costs include both the private costs and any other external costs to society arising from the
production or consumption of a good or service. Social costs will differ from private costs, for example, if a
producer can avoid the cost of air pollution control equipment allowing the firm’s production to impose costs
(health or environmental degradation) on other parties that are adversely affected by the air pollution. Let’s also
view how consumers’ actions also may have external costs using previous example on driving: The social costs
include all these private costs (fuel, oil, maintenance, insurance, depreciation, and operator’s driving time) and
also the cost experienced by people other than the operator who are exposed to the congestion and air pollution
resulting from the use of the car.

3. Distinguish between Accounting and economic cost.

Economic cost is a more comprehensive idea that accounting costs. Accounting costs only include what
economists call "explicit costs." These are the amounts that a firm actually pays out to other people in the
process of producing their product. So, if we open a business selling cosmetics from our home, the accounting
costs would include things like the price of the cosmetics, the money we spend on advertising, if any, and the
amount that it costs us to go around selling our product.

Economic costs include both Explicit and Implicit costs. Implicit cost is the same as opportunity costs. In
the example mentioned above, the economic costs of starting this business would also include the value of
whatever else we could have been doing with our time. Economic costs would also include, then, the wages
that we could have been getting if we had gone to work instead of opening this business.

4. Define the short run cost concepts.

Total Cost
In economics, the total cost (TC) is the total economic cost of production. It consists of variable costs and fixed
costs. Total cost is the total opportunity cost of each factor of production as part of its fixed or variable costs.

Variable Costs
Variable cost (TVC) changes according to the quantity of a good or service being produced. It includes inputs
like labor and raw materials. Variable costs are also the sum of marginal costs over all of the units produced
(referred to as normal costs). For example, in the case of a clothing manufacturer, the variable costs would be
the cost of the direct material (cloth) and the direct labor. The amount of materials and labor that is needed for
each shirt increases in direct proportion to the number of shirts produced. The cost "varies" according to
production.
Fixed Costs
Fixed costs (TFC) are incurred independent of the quality of goods or services produced. They include inputs
(capital) that cannot be adjusted in the short term, such as buildings and machinery. Fixed costs (also referred to
as overhead costs) tend to be time related costs, including salaries or monthly rental fees. An example of a fixed
cost would be the cost of renting a warehouse for a specific lease period. However, fixed costs are not
permanent. They are only fixed in relation to the quantity of production for a certain time period. In the long
run, the cost of all inputs is variable.
Average Variable Cost (AVC)

The Average Variable Cost (AVC) is the total variable cost per unit of output. This is found by dividing Total
Variable Cost (TVC) by total output (Q). Total Variable Cost (TVC) is all the costs that vary with output, such
as materials and labor. The easiest way to determine if a cost is variable is to see if as output changes, does the
cost change as well. If it does, then it is a variable cost.

Average Fixed Cost (AFC)

Average fixed cost is the total fixed cost per unit of output incurred when a firm engages in short-run
production. It can be found in two ways. Because average fixed cost is total fixed cost per unit of output, it can
be found by dividing total fixed cost by the quantity of output. Alternatively, because total fixed cost is the
difference between total cost and total variable cost, average fixed cost can be derived by subtracting average
variable cost from average total cost. Average fixed cost decreases with additional production.

Average Total Cost (ATC)

Average total cost is the total cost per unit of output incurred when a firm engages in short-run production.

The standard method of calculating average total cost is to divide total cost by the quantity, illustrated by this
equation:
total cost
average total cost =
quantity of output
An alternative specification for average total cost is found by summing average variable cost and average fixed
cost:
average total cost = average variable cost + average fixed cost
Marginal Cost (MC)

The change in total cost (or total variable cost) resulting from a change in the quantity of output produced by a
firm in the short run. Marginal cost (MC) indicates how much total cost changes for a given change in the
quantity of output.

Here is the first of two formulas for calculating marginal cost:

change in total cost
marginal cost =
change in quantity of output

Because any change in total cost is also an equivalent change in total variable cost (fixed cost DOES NOT
change), marginal cost can be calculated using total variable cost, too:

change in total variable cost

marginal cost =
change in quantity of output
5. What are the Relations between the Average and Marginal Cost Curve!
The relationship between the marginal cost and average cost is the same as that between any other marginal-
average quantities. When marginal cost is less than average cost, average cost falls and when marginal cost is
greater than average cost, average cost rises.

It is illustrated in this figure that when marginal cost (MC) is above average cost (AC), the average cost rises,
that is, the marginal cost (MC) pulls the average cost (AC) upwards. On the other hand, if the marginal cost
(MC) is below the average cost (AC); average cost falls, that is, the marginal cost pulls the average cost
downwards.
The point of intersection L where MC is equal to AC, AC is neither falling nor rising, that is, at point L, AC has
just ceased to fall but has not yet begun to rise. It follows that point L, at which the MC curve crosses the AC
curve to lie above the AC curve is the minimum point of the AC curve. Thus, marginal cost curve cuts the
average cost curve at the latter’s minimum point. But beyond point K and up to point L marginal cost curve lies
below the average cost curve with the result that the average cost curve is falling. This is because though MC is
rising between K and L, it is below AC.

6. Derive the Long run AC curve.

The long run, as noted above, is a period of time during which the firm can vary all its inputs. In the short run,
some inputs are fixed and others are varied to increase the level of output. In the long run, none of the factors is
fixed and all can be varied to expand output. The term ‘plant’ is here to be understood as consisting of capital
equipment, machinery, land etc. In the short run, the size of the plant is fixed and it cannot be increased or
reduced.

On the other hand, long run is a period of time sufficiently long to permit the changes in plant, that is, in capital
equipment, machinery, land etc. in order to expand or contract output. Thus whereas in the short run the firm is
tied with a given plant, in the long run the firm moves from one plant to another; the firm can make a larger
plant if it has to increase its output and a smaller plant if it has to reduce its output.

The long-run average cost of production is the least possible average cost of production of producing any given

These short-run average cost curves are also called plant curves, since in the short run plant is fixed and each of
the short-run average cost curves corresponds to a particular plant. In the short run, the firm can be operating on
any short-run average cost curve, given the size of the plant. Suppose that there are only these three technically
possible sizes of plant, and that no other size of the plant can be built.

Given a size of the plant or a short-run average cost curve, the firm will increase or decrease its output by
varying the amount of the variable inputs. But, in the long ran, the firm can choose among the three possible
sizes of plant as depicted by short-run average cost curves SAC1, SAC2 and SAC3. In the long run the firm will
decide about with which size of plant or on which short-run average cost curve it should operate to produce a
given level of output at the minimum possible cost.
It will be seen from Fig. 19.6. that up to OB amount of output, the firm will operate on the short-run average
cost curve SAC1 though it could also produce with short-run average cost curve SAC2, because up to OB
amount of output, production on SAC1 curve entails lower cost than on SAC2.
If the firm plans to produce an output which is larger than OB (but less than OD), then it will not be economical
to produce on SAC1. It will be seen from Fig. 19.6 that the output larger than OB but less then OD, can be
produced at a lower cost per unit on SAC2 than on SAC1.
If the firm has to produce an output which exceeds OD, then the cost per unit will be lower on SAC3 than on
SAC2. Therefore, for output larger than OD, the firm will employ plant corresponding to the short-run average
cost curve SAC3.
Given that only three sizes of plants, as shown in Fig. 19.6, are technically possible, then the long-run average
cost curve is the curve which has scallops in it. This heavily scalloped long-run average cost curve consists of
some segments of all the short-run average cost curves as explained above.

Suppose now that the size of the plant can be varied by infinitely small gradations so that there are infinite
number of plants corresponding to which there will be numerous short-run average cost curves. In that case, the
long-run average cost curve will be a smooth and continuous curve without any scallops.

Such a smooth long-run average cost curve has been shown in Fig. 19.7 and has been labelled as LAC..

Since an infinite number of short-run average cost curves is assumed, every point on the long-run average cost
curve is a tendency point with some short-run average cost curve. In fact, the long-run, average cost curve is
nothing else but the locus of all these tangency points with short-run average cost curves.

An important fact about the long-run average cost curve is worth mentioning. It is that the long- run average
curve LAC is not tangent to the minimum points of the short-run average cost curves. When the long-run
average cost curve is declining, that is, for output less than OQ, it is tangent to the falling portions of the short-
run average cost curves.