Concept of Cost

                           

Concept of Cost
Define Cost.

Ans: Cost is the expenditure incurred by the producer on purchases of factor inputs and non-factor inputs.
Note: Examples
a. factor inputs: land, labour, capital and entrepreneur.
b. Non- factor inputs: Raw material, electricity, transportation, etc,
Define cost function.
Ans: The functional relationship between cost and output is called cost function.

What is Explicit cost? Give two examples.
Ans: Explicit cost is the expenses incurred by the producer for outside payments. This is also called accounting cost.
Examples: a) Wages to Staff and b) house rent

What is Implicit cost? Give two examples.
Ans: Implicit cost refers to the cost of using the self-owned resources by the firm.
Examples: a) Using own house and b) wages of his own labour

Define Total cost (TC).
Ans: Total Cost refers to all expenses incurred by the producer to produce a given quantity of output.
Total Cost (TC)= Total Fixed Cost (TFC) + Total Variable cost(TVC)
TC= TFC + TVC

Define Fixed Costs or Total Fixed Cost (FC or TFC):
Ans: Fixed costs are those cost which do not change with the change in level of output. It is also known as overhead costs or unavoidable cost.
TFC= TC- TVC

Define Variable Cost or Total Variable Cost (VC or TVC).
Ans: Variable costs are those cost which changes with the change in level of output. It is also known as direct cost or prime cost or avoidable cost.

Define Average cost (AC) or Average total cost (ATC).
Ans: Average cost (AC) is define as per unit cost of output produced.
AC= TC/ Q (Q= output)
TC= AC × Q
Define Average Fixed cost (AFC)
Ans: Average fixed cost (AFC) is define as the per unit fixed cost of output produced.
AFC= TFC/ Q where Q= Output
TFC= AFC x Q

Define Average Variable Cost ( AVC)
Ans: Average variable cost (AVC) is define as the per unit variable cost of output produced.
AVC= TVC/ Q
TVC= AVC x Q

Define Marginal Cost (MC)
Ans: Marginal cost (MC) is define as the change in total cost when an additional unit of output is produced.
MC= ∆TC/ ∆Q OR MC= ∆TVC/ ∆Q

Distinguish between fixed cost and variable cost.

Fixed Cost Variable Cost
i. Fixed costs are those cost which do not change with the change in level of output.
ii. These costs will remain same at all level of output.iii. These costs occur even when the level of output is zero.iv. Fixed costs exist in the short period only. In the long run, there is no fixed cost.

v. Salary to the permanent staff, house rent etc.

i. Variable costs are those cost which changes with the change in level of output.

ii. These costs will change with the change in level of output.

iii. These costs become zero when level of output is zero.

iv. Variable costs exist in short period as well as in long period.

v. Raw materials, transportation cost, etc.

 

Explain the relationship between total fixed cost (TFC), total variable cost (TVC) and total cost (TC) with the help of a diagram.
Ans: Diagram
a. Total cost can never become zero even though the level of output is zero, because at zero level also fixed cost is positive and constant.
b. As level of output increases, total cost also increases because of increasing variable costs (TC=TFC+TVC).
c. Total variable cost curve is upward sloping indicating increasing cost. When output is zero total variable cost is also zero.
d. Total cost (TC) and total variable cost (TVC) curves are parallel to each other each any every level of output because TC= TVC+TFC and TFC remains constant at each and every level of output.
e. Total fixed cost (TFC) curve is constant and parallel to X-axis. TFC never become zero even though level of output is zero.

Explain the relationship between average cost (AC) and marginal cost (MC) with the help of a diagram.
Ans: Diagram
a. Both average cost and marginal cost can be derived from total cost in the following way:
AC= TC/Q and MC= ∆TC/∆Q
b. Both AC and MC curves are U- shaped because of the law of variable proportion.
c. When AC decreases, MC is less than AC.
d. When AC increases, MC is more than AC
e. When AC is minimum, MC= AC.
f. MC curve always cuts AC at the minimum point of AC.

Explain the relationship between average variable cost (AC) and marginal cost (MC) with the help of a diagram.
Ans: Diagram
a. Both average variable cost and marginal cost can be derived from total variable cost in the following way:
AVC= TVC/Q and MC= ∆TVC/∆Q
b. Both AVC and MC curves are U- shaped because of the law of variable proportion.
c. When AVC decreases, MC is less than AVC.
d. When AVC increases, MC is more than AVC
e. When AVC is minimum, MC= AVC.
f. MC curve always cuts AVC at the minimum point of AVC.

Explain with diagram why average fixed cost (AFC) curve is rectangular hyperbola?
Ans: Average fixed cost (AFC) curve is derived from total fixed cost (TFC) curve in the following manner:
AFC= TFC/Q where Q= level of output.
Since total fixed cost does not vary with the change in output in the short run, so same figure is divided by the increasing level of output. Hence average fixed cost curve is downward sloping from left to right.

Since total fixed cost remains constant, the area under every point of the average fixed cost curve will be equal to the constant total fixed cost. It follows, therefore that the shape of the average fixed cost curve is of rectangular hyperbola.
Diagram

Explain the relationship between AC, AVC and MC with the help of a diagram.
Ans: Diagram
All the three curves are U- shaped. It means that at first they decrease, reach its minimum level and increase thereafter.

When AVC curve is in minimum level, MC curve cuts AVC curve from below. It is shown at point B. when AC curve is also in minimum level, MC curve cuts it at the minimum point i.e. point B. It means that when both AVC and AC is in minimum point MC=AVC and MC=AC. When AVC and AC decrease, MC curve lies below than AVC and AC which means MC is less than AVC and AC.

On the other hand, when AVC and AC increase, MC lies above than AVC and AC indicating that MC is more than AVC and AC.

Why is Marginal Cost (MC) curve in the short- run U- shaped?
Ans: Marginal Cost (MC) curve in the short run is U- shaped due to operation of law of variable proportion. In the beginning MC decreases, then start rising. Initially total product will increase at increasing rate which means marginal product (MP) also increases. This will reduce additional cost (MC).

Then total product will increase at decreasing rate which means MP decreases. This will increase additional cost of production (MC). Therefore, initially MC decreases and later on it increases which makes MC curve U shaped.

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