Introduction
In the theory of the firm, cost of production occupies a central place. A producer’s decisions regarding output, price and scale of operations are all guided by the behaviour of costs. Modern microeconomics, as presented in “Microeconomics” by T.R. Jain & V.K. Ohri for B.Com Semester I (Panjab University), explains cost behaviour with the help of a cost function and a number of well-defined concepts of cost. A good answer must first clarify what a cost function is and then systematically classify and explain the various cost concepts relevant to economic analysis.
1. Meaning and Definition of Cost Function
In simple words, the cost function expresses the functional relationship between the cost of production and the level of output. Given the prices of factors of production and the technology in use, the cost of producing a particular quantity of output is determined. This relationship can be written in a general form as:
C = f(Q)
where:
- C = total cost of production,
- Q = quantity of output, and
- f = functional relationship depending upon technology and factor prices.
A cost function is a mathematical or analytical expression which shows how the total cost of production varies with the level of output, given the technology and prices of inputs. In other words, it indicates the minimum cost at which different quantities of output can be produced when the firm is using the best available technique.
Short-run and Long-run Cost Functions
- In the short run, some factors are fixed and some are variable. The short-run cost function shows how cost varies with output when plant size is fixed.
- In the long run, all factors are variable. The long-run cost function shows the minimum cost associated with each level of output when the firm is free to choose its most efficient plant size.
The cost function is the basis on which various cost concepts such as fixed cost, variable cost, average cost, marginal cost, etc., are defined and analysed.
2. Broad Classification of Cost Concepts
For a clear and examiner-friendly answer, cost concepts may be classified under the following heads:
- Traditional or General Cost Concepts (money cost, real cost, opportunity cost, etc.)
- Accounting and Economic Cost Concepts (explicit, implicit, accounting, economic cost)
- Short-run Cost Concepts (TFC, TVC, TC, AFC, AVC, SAC, SMC)
- Long-run Cost Concepts (LTC, LAC, LMC)
- Social and Private Costs (where relevant)
3. Traditional / General Concepts of Cost
3.1 Money Cost
Money cost (also called nominal cost) refers to the actual money expenditure incurred by a firm in the production of a commodity. It includes wages, rent, interest, payment for raw materials, power, fuel, taxes, etc., all measured in monetary terms.
From the accounting point of view, money cost is what appears in the firm’s books of accounts and profit and loss statement.
3.2 Real Cost
Real cost refers to the sacrifice involved in terms of efforts and disutility of labour and abstinence of capitalists. In older economic literature, it meant the “pain and sacrifice” undergone by various factors of production in the process of creating output. In modern usage, the term is rarely used in exact measurement, but the idea survives indirectly in opportunity cost.
3.3 Opportunity Cost
Opportunity cost is one of the most important concepts in modern microeconomics.
The opportunity cost of any resource is the value of the next best alternative use that is sacrificed when the resource is used in a particular way.
For example, if a farmer uses his land to grow wheat instead of sugarcane, the opportunity cost of producing wheat is the income forgone from not producing sugarcane. Opportunity cost is the foundation of modern economic cost and is particularly relevant in economic decision-making.
3.4 Explicit and Implicit Cost
- Explicit Cost: These are actual money payments made by the firm to outsiders for hiring factor services and purchasing inputs (wages, rent, interest, raw materials, power, etc.).
- Implicit Cost: These are the imputed costs of self-owned and self-supplied resources for which no direct payment is made. For example, the salary that the owner could earn elsewhere or the interest he forgoes on his own capital invested in the business.
3.5 Accounting Cost and Economic Cost
- Accounting Cost: The cost recorded in the books of accounts, consisting mainly of explicit money expenses. Accounting profit is calculated as total revenue minus accounting cost.
- Economic Cost: The cost used in economic analysis, consisting of both explicit and implicit costs (i.e., including opportunity costs). Economic profit = total revenue − economic cost.
3.6 Private Cost and Social Cost
- Private Cost: Costs actually incurred by the firm or individual in production (wages, rent, materials, etc.).
- Social Cost: Private cost plus any external costs imposed on society due to production, such as pollution, congestion, environmental damage. Social cost is relevant in welfare economics and public policy.
4. Short-run Cost Concepts
In the short run, some factors (like plant, machinery, building) are fixed and others (like labour, raw materials, power) are variable. Accordingly, short-run cost concepts are defined as follows:
4.1 Total Fixed Cost (TFC)
Total Fixed Cost is the total cost of employing the fixed factors of production. It does not vary with the level of output. Even if output is zero, fixed costs must be incurred.
Examples: rent of factory building, insurance, salaries of permanent staff, interest on fixed capital, etc.
Graphically, the TFC curve is a horizontal straight line parallel to the X-axis, indicating that fixed cost remains constant at all levels of output.
4.2 Total Variable Cost (TVC)
Total Variable Cost is the total cost of employing variable factors. It varies directly with the level of output: if output is zero, TVC is zero; as output increases, TVC increases.
Examples: cost of raw materials, wages of casual labour, power, fuel, etc.
4.3 Total Cost (TC)
Total Cost in the short run is the sum of total fixed cost and total variable cost:
TC = TFC + TVC
The TC curve starts from the level of TFC on the cost axis and rises as output increases in the same pattern as the TVC curve.
5. Average and Marginal Cost Concepts (Short Run)
5.1 Average Fixed Cost (AFC)
Average Fixed Cost is the fixed cost per unit of output:
AFC = TFC / Q
As output increases, TFC is spread over more units, so AFC continuously falls and approaches zero but never becomes zero. The AFC curve is downward sloping and hyperbolic in shape.
5.2 Average Variable Cost (AVC)
Average Variable Cost is the variable cost per unit of output:
AVC = TVC / Q
Initially, due to better utilisation of variable factors and increasing returns, AVC falls; after a certain level of output, due to diminishing returns to the variable factor, AVC starts rising. Hence the AVC curve is U-shaped.
5.3 Average Cost (AC) or Average Total Cost (ATC)
Average Cost is total cost per unit of output:
AC = TC / Q = (TFC + TVC) / Q = AFC + AVC
The AC curve is also U-shaped. At low levels of output, both AFC and AVC fall, causing AC to decline. Beyond a certain point, the rise in AVC (due to diminishing returns) dominates the fall in AFC and AC begins to rise.
5.4 Marginal Cost (MC)
Marginal Cost is the addition to total cost when one more unit of output is produced:
MC = ΔTC / ΔQ
Since fixed cost does not change with output, marginal cost is also equal to the change in TVC:
MC = ΔTVC / ΔQ
The MC curve is also U-shaped, falling initially due to increasing returns and rising later due to diminishing returns. MC intersects AVC and AC at their respective minimum points.
6. Diagrammatic Presentation of Short-run Cost Curves
The mutual relationship between AFC, AVC, AC and MC can be shown with the help of the following standard diagram (as used in T.R. Jain & V.K. Ohri):
7. Long-run Cost Concepts
In the long run all factors of production are variable and the firm can change its plant size. The firm has a family of short-run average cost curves corresponding to different plant sizes. Long-run cost concepts are defined as:
7.1 Long-run Total Cost (LTC)
Long-run Total Cost is the minimum cost of producing different levels of output when the firm is free to adjust all inputs and choose the most efficient plant. It represents the envelope of various possible total cost combinations in the long run.
7.2 Long-run Average Cost (LAC)
Long-run Average Cost is the minimum average cost of producing different levels of output when the firm adjusts all factors optimally. It is obtained as:
LAC = LTC / Q
The LAC curve is generally U-shaped or “saucer-shaped”, falling initially due to economies of scale, remaining flat over a range of constant returns to scale, and rising later due to diseconomies of scale. It is often described as an envelope curve of short-run AC curves.
7.3 Long-run Marginal Cost (LMC)
Long-run Marginal Cost is the addition to LTC when one extra unit of output is produced in the long run:
LMC = ΔLTC / ΔQ
The LMC curve relates to the LAC curve in the same way as MC relates to AC in the short run: LMC lies below LAC when LAC is falling, cuts LAC at its minimum point, and lies above LAC when LAC is rising.
8. Summary Table: Major Cost Concepts at a Glance
| Cost Concept | Symbol / Formula | Key Idea |
|---|---|---|
| Money Cost | – | Actual monetary expenditure of the firm. |
| Opportunity Cost | – | Value of next best alternative forgone. |
| Explicit Cost | – | Direct money payments to outsiders. |
| Implicit Cost | – | Imputed cost of owner’s own resources. |
| Accounting Cost | – | Explicit costs recorded in books. |
| Economic Cost | – | Explicit + implicit (opportunity) costs. |
| Total Fixed Cost | TFC | Cost of fixed factors; constant for all Q. |
| Total Variable Cost | TVC | Cost of variable factors; varies with Q. |
| Total Cost | TC = TFC + TVC | Overall cost of producing Q units. |
| Average Fixed Cost | AFC = TFC / Q | Fixed cost per unit; always falling. |
| Average Variable Cost | AVC = TVC / Q | Variable cost per unit; U-shaped. |
| Average Cost | AC = TC / Q = AFC + AVC | Total cost per unit; U-shaped. |
| Marginal Cost | MC = ΔTC / ΔQ | Extra cost of producing one more unit; U-shaped. |
| Long-run Average Cost | LAC = LTC / Q | Minimum average cost at each output when all factors vary. |
| Long-run Marginal Cost | LMC = ΔLTC / ΔQ | Extra cost of one more unit in the long run. |
9. Importance of Cost Function and Cost Concepts
The discussion of cost function and cost concepts is not merely theoretical; it has direct practical relevance:
A firm’s decision about how much to produce depends on the relationship between marginal cost and marginal revenue. Without a clear understanding of MC and AC, the firm cannot correctly determine its equilibrium output and price.
Long-run cost concepts (LAC, LMC) help the firm decide the optimum scale of operations, plant size and level of output at which long-run average cost is minimised.
Distinguishing between fixed and variable costs enables management to identify which items can be controlled in the short run and how the cost per unit can be reduced by increasing capacity utilisation.
For public utilities, regulated industries and taxation policy, the government must understand cost structure and cost behaviour to frame appropriate pricing and subsidy policies.
In Panjab University B.Com (Sem I) examinations, the question “What is cost function? Explain the various concepts of cost.” typically carries high marks. A systematic, well-classified answer covering general, short-run and long-run cost concepts as above is highly scoring and reflects a sound understanding of the prescribed text of T.R. Jain & V.K. Ohri.
Conclusion
To conclude, a cost function captures in a compact form the technological and price conditions under which a firm operates by showing the minimum cost of producing different levels of output. On this foundation, microeconomics builds a rich set of cost concepts—money cost, opportunity cost, explicit and implicit cost, accounting and economic cost, fixed and variable cost, total, average and marginal costs, and long-run cost measures. Together, these concepts form the analytical backbone of the theory of the firm, guiding output, pricing and scale decisions and occupying a core position in the B.Com Semester I Microeconomics syllabus of Panjab University.