Cost
In order to produce goods and services, a firm uses raw materials and factors
of production called inputs. The expenditure incurred on these inputs is
called cost.
Short-Run Cost
Short-run cost refers to the cost incurred by a firm when at least one factor
of production remains fixed.
Total Cost (TC)
Total cost is the total expenditure incurred by a firm in producing a given
quantity of output. In the short run, total cost consists of two components:
TC = TFC + TVC
Total Fixed Cost (TFC)
Total fixed cost refers to the total expenditure incurred on fixed factors of
production. It remains constant regardless of the level of output.
Total Variable Cost (TVC)
Total variable cost refers to the total expenditure incurred on variable
factors of production. It changes with the level of output.
Average Fixed Cost (AFC)
Average fixed cost is obtained by dividing total fixed cost by the level of
output.
AFC = TFC / Q
Average Variable Cost (AVC)
Average variable cost is obtained by dividing total variable cost by the
corresponding level of output.
AVC = TVC / Q
Average Cost (AC)
Average cost is obtained by dividing total cost by the level of output.
It can also be calculated by adding average fixed cost and average variable cost.
AC = TC / Q
AC = (TFC + TVC) / Q
AC = AFC + AVC
Marginal Cost (MC)
Marginal cost is defined as the change in total cost due to a one-unit change
in output.
MC = TCn − TCn−1
Or,
MC = dC / dQ
Reasons for the U-Shaped Average Cost (AC) Curve
- On the basis of AFC – AFC falls continuously as output increases.
-
On the basis of the Law of Variable Proportions – initially increasing
returns reduce AC, later diminishing returns raise AC.
-
Indivisibility of factors – fixed factors cannot be divided into smaller units.
-
Reserve capacity – underutilized capacity lowers cost initially.
Relationship Between Average Cost (AC) and Marginal Cost (MC)
| Basis |
Relationship |
| Nature |
Both AC and MC are derived from total cost |
| Shape |
Both AC and MC are U-shaped |
| AC falling |
MC lies below AC and falls faster |
| AC rising |
MC lies above AC and rises faster |
| Minimum AC |
MC = AC |
| Intersection |
MC intersects AC at the minimum point of AC |
Quick Exam Points
- TC = TFC + TVC
- AFC falls continuously
- AC = AFC + AVC
- MC determines the behavior of AC
- MC = AC at minimum AC