Lecture 8Cost and Cost Curve

Nominal and Real Cost• Nominal Cost

– Nominal cost is the money cost of production– It is also called expenses of production– It is important from producer’s point of view

• As he has to cover this and earn profit to remain in business

• Real Cost– Many economists tried to define real cost– Adam Smith regarded

• pains and sacrifices of labour as real cost

– Marshall includes under it• Real cost of efforts of various qualities• Real cost of waiting

– The Austrian School of economists and their followers gave a new concept of real costs• The real cost of production of a given commodity is the next best

alternative sacrificed in order to obtain that commodity• It is also called opportunity cost or displacement cost

Money Cost and Real Cost• It is very seldom that money cost is equal real cost• According to Marshall– If the purchasing power of money in terms of effort

remained about constant and– If the rate of remuneration has also remained about constant – Then the money measure of cost corresponds to the real cost – But such a correspondence is never to be assumed lightly

• Thus, the two cannot be equal in this world

• The earnings of cinema stars, professors, coolies, sweepers, peasants, businessmen etc seldom correspond to the respective efforts and sacrifices undergone by each class

Alternative, Opportunity or Transfer Cost• Since productive resources are limited

– The production of one commodity can only be at the expense of another

– The commodity that is sacrificed is the real cost of the commodity that is produced

• In the words of Henderson– Real Cost of any thing is the curtailment of the supply of other

useful things, which the production of that particular thing entails• Economists defined cost of production of a particular product

– As the value of the foregone alternative products that resources used in its production could have produced.

• Suppose with a sum of Rs 1000/- a manufacturer can produce two sets or a small refrigerator. – Suppose further he decides to produce refrigerator rather than

the radio sets. In this case, the real cost of the refrigerator is equal to the cost of two radio sets i.e. the alternative foregone.

Application and Limitations of OC• Application– It applies to income distribution

• Limitations– Specific productive services– Inertia– Non-pecuniary considerations – Factors not homogenous – Wrong assumptions– Individuals and social costs

Entrepreneur’s Cost• The entrepreneur’s cost of production includes the following

elements:– Wages of labour– Interest on capital– Rent or royalties paid to the owners of land or other properly used– Cost of raw materials– Raw materials– Replacement and repairing charges of machinery– Depreciation of capital goods– profits

• Four broad categories– Production costs– Selling costs– Managerial costs– Other costs, including insurance charges

Long Run and Short Run Costs• Short Run– Short run is a period of time within which the firm

can vary its output by varying only the amount of variable factors e.g. labour and raw material

– In short run, capital equipment, top management personnel, plant size etc. cannot be varied

• Long Run– It is a time period in which quantities of all factors,

variable as well as fixed can be adjusted

Short Run Fixed and Variable Costs• Some costs vary more or less proportionately with the

output while others are fixed and do not vary with the output in the same way– The former are known as variable or prime cost– The later ones are known as fixed or supplementary costs

• The prime cost vary with output– E.g cost of raw materials, daily labour etc.

• The supplementary cost must be paid even production has been stopped– E.g rent of the factory building, interest on capital invested in

machinery, and salary of the permanently employed staff

• In long run all costs are variable

SR: Total, Average and Marginal Costs• Total Costs

– Total cost of a given output is the sum of total fixed cost and total variable cost

• Average Costs – Average cost per unit is the total cost divided by the

number of units produced– It is sum of average fixed cost and average variable cost

• Marginal Costs– Marginal cost is the addition to total cost caused by a small

increment in output

ExampleUnits of output

TFC TVC TC AFC AVC AC MC

(1) (2) (3) (4) (5) (6) (7) (8)

0 30 0 30 - - - -

1 30 10 40 30 10 40 10

2 30 18 48 15 9 24 8

3 30 24 54 10 8 18 6

4 30 32 62 7.5 8 15.5 8

5 30 50 80 6 10 16 18

6 30 72 102 5 12 17 22

Diagram of TC, TFC and TVC

Diagram AC, AVC, AFC, MC

Relationship b/t MC and AC• It can be seen that average variable cost continues

to decline so long as the marginal cost is below it

• It starts rising at the point where marginal cost crosses average variable cost

• The marginal cost will always rise more sharply than the average variable cost

• Similar relation holds between marginal cost and average cost.

Total-Marginal Cost Relationship• When total cost increases with increasing rate– Its corresponding marginal cost rises;

• When total cost increases with decreasing rate– Its corresponding marginal cost is falling

• When total cost has reached maximum– It corresponding marginal cost is zero

Derivation of AC and MC from TC Curve

Long Run Average Cost

Long Run Average Cost

Long Run Marginal Cost

Why LAC curve first falls and then rises?

• The LAC curve slopes downward as the scale of production is enlarged due to various economies of scale– Larger scope of specialization of labour– Increasing use of specialized machinery– Other technological improvements

• The LAC curve rises after a point because of the various diseconomies of scale– E.g. rising cost of the inputs and the difficulty of

management etc.

L-shaped Long-run Average Cost Curve

• Rapid technological progress• Learning to produce at lower cost

Quiz• Define production. What are factors of productions?

Please explain each of them with their peculiarities.

• What are advantages and disadvantages of division of labour?

• What is capital formation? Please explain what are the stages of capital formation

• What was Malthusian Theory and what was criticism on it?