In the previous lesson, we learned about the two Laws of Production. Cost of production is another important concept for a business firm. It determines pricing decisions, profit calculations, and production planning. This lesson covers the different types of costs, short run and long run cost curves — all of which are heavily tested in CMA Foundation MCQs.
What is Cost of Production?
- Cost of production = total expenditure incurred by a firm to produce a given quantity of output
- Includes payments for land, labour, capital, and raw materials
- Cost function: C = f(Q) — cost depends on quantity of output
Types of Cost Concepts
1. Real Cost
- Concept introduced by Alfred Marshall
- All efforts, exertions, and sacrifices involved in production
- Example: physical effort of labour, waiting involved in saving capital
2. Economic Cost
- Total expenses incurred by a firm in producing a commodity
- Economic Cost = Explicit Cost + Implicit Cost + Normal Profit
| Type | Meaning | Example | Recorded in books? |
|---|---|---|---|
| Explicit Cost | Actual money payments made to purchase or hire resources | Rent, wages, raw material, interest on borrowed money | Yes — also called Accounting Cost |
| Implicit Cost | Imputed cost of resources owned by the producer himself | Rent for own land, interest on own capital | No |
| Normal Profit | Minimum return needed to keep entrepreneur in business | — | — |
3. Opportunity Cost
- The value of the next best alternative foregone when a choice is made
- Arises because resources are scarce
- Example: Land used for rice cannot be used for wheat — the wheat foregone is the opportunity cost of growing rice
Applications of Opportunity Cost:
| Application | Explanation |
|---|---|
| Factor pricing | Factors must be paid at least their opportunity cost or they will move to better alternatives |
| Economic rent | Economic rent = actual earnings − opportunity cost |
| Consumption decisions | More of one good means less of another with same income |
| Production planning | More of one commodity means sacrificing some of another |
| National priorities | More resources for defence = less for civilian goods |
4. Private Cost and Social Cost
| Type | Meaning |
|---|---|
| Private Cost | Cost borne by the private firm in production |
| Social Cost | Private cost + external cost imposed on society |
- Example: A firm dumping industrial waste into a river imposes costs on society not reflected in its private cost
- For maximum social welfare: Social Marginal Cost = Marginal Revenue
Short Run Costs
In the short run costs are divided into two types:
| Fixed Cost | Variable Cost | |
|---|---|---|
| Changes with output? | No | Yes |
| When output = 0 | Still positive | Zero |
| Related to | Fixed factors | Variable factors |
| TFC curve | Horizontal — parallel to X axis | — |
| TVC curve | — | Slopes upward from origin |
| Examples | Rent, building, permanent salaries, insurance, interest | Raw materials, fuel, power, daily wages |
| Recovery | May not be recovered | Must at least be recovered |
All Short Run Cost Concepts:
| Cost | Meaning | Formula | Curve shape |
|---|---|---|---|
| TFC | Total Fixed Cost | Given | Horizontal line |
| TVC | Total Variable Cost | Given | Upward from origin |
| TC | Total Cost | TFC + TVC | Upward — starts where TFC starts |
| AFC | Average Fixed Cost | TFC ÷ Q | Rectangular hyperbola — always falling |
| AVC | Average Variable Cost | TVC ÷ Q | U shaped |
| AC | Average Total Cost | TC ÷ Q or AFC + AVC | U shaped |
| MC | Marginal Cost | ΔTC ÷ ΔQ or TCn − TCn−1 | U shaped |
Cost Table:
| Output | TFC | TVC | TC | AFC | AVC | AC | MC |
|---|---|---|---|---|---|---|---|
| 0 | 20 | 0 | 20 | — | — | — | — |
| 1 | 20 | 8 | 28 | 20 | 8 | 28 | 8 |
| 2 | 20 | 14 | 34 | 10 | 7 | 17 | 6 |
| 3 | 20 | 18 | 38 | 6.66 | 6 | 12.66 | 4 |
| 4 | 20 | 22 | 42 | 5 | 5.5 | 10.5 | 4 |
| 5 | 20 | 28 | 48 | 4 | 5.6 | 9.6 | 6 |
| 6 | 20 | 32 | 52 | 3.33 | 5.33 | 8.66 | 4 |
| 7 | 20 | 40 | 60 | 2.85 | 5.71 | 8.56 | 8 |
| 8 | 20 | 50 | 70 | 2.5 | 6.25 | 8.75 | 10 |
Relationship Between MC and AC
Very commonly tested in MCQs:
| Situation | Relationship | Meaning |
|---|---|---|
| AC is falling | MC < AC | MC pulls AC down |
| AC is at minimum | MC = AC | MC cuts AC at its lowest point |
| AC is rising | MC > AC | MC pushes AC up |
| Always | MC changes faster than AC | MC curve is steeper |
- MC curve cuts AC curve at the minimum point of AC
- This minimum point of AC = least cost output = normal profit point
Long Run Costs
- In the long run ALL costs are variable — no fixed costs
- Firm can change its scale of plant
- Each scale of plant has its own short run AC curve
- LAC curve = Long Run Average Cost curve
Key features of LAC curve:
| Feature | Detail |
|---|---|
| Shape | U shaped |
| Also called | Planning curve / Envelope curve |
| Relationship to SAC | LAC is tangent to each short run AC curve |
| Shows | Least possible AC for each level of output when plant size can vary |
| Falling portion | Due to internal economies of scale |
| Rising portion | Due to internal diseconomies of scale |
| LMC curve | Also U shaped like LAC |
Key Concepts to Remember
- Economic cost = explicit cost + implicit cost + normal profit
- Explicit costs are recorded in books; implicit costs are not
- Opportunity cost = value of next best alternative foregone
- TFC is constant at all output levels — even when output is zero
- TVC = zero when output is zero
- TC = TFC + TVC
- AFC always falls as output increases — rectangular hyperbola
- AVC, AC and MC are all U shaped
- MC cuts AC at the minimum point of AC
- When MC < AC → AC falls; when MC > AC → AC rises
- In the long run all costs are variable
- LAC is also called planning curve and envelope curve
- LAC is U shaped due to economies and diseconomies of scale
Note to Students: These notes are designed for quick revision and MCQ preparation. For detailed explanation with examples, watch our YouTube video lessons. Use these notes alongside practice questions and the full PDF for complete exam preparation.
Free Practice MCQs for Lesson 1.5 Part 1
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