Cost
Cost Concepts: Fixed, Variable and Total Cost
To produce goods, a firm must pay for its inputs — these payments are its cost of production. A few cost concepts are important. Money cost is the actual money spent; real cost is the effort and sacrifice involved; and opportunity cost is the value of the next-best alternative given up (which we met earlier). Here we focus on the money costs of a firm in the short run, where some factors are fixed.
Short-run costs are divided into two kinds:
- Total Fixed Cost (TFC) — costs that do not change with the level of output. They must be paid even if output is zero (e.g. rent of the factory, salary of permanent staff, insurance). TFC is constant at all levels of output.
- Total Variable Cost (TVC) — costs that change with the level of output. They are zero when output is zero and rise as output rises (e.g. cost of raw materials, wages of casual workers, power).
The sum of the two is the Total Cost (TC):
TC = TFC + TVC
Since TFC is constant, the shape of the TC curve follows the TVC curve, just raised up by the fixed amount. At zero output, TC equals TFC (because TVC is zero). As output rises, TC rises because TVC rises. Understanding the split between fixed and variable cost is the foundation for all the average and marginal cost ideas that follow.
One changes with output, one does not.
- Fixed cost (TFC) does not change with output and must be paid even at zero output (e.g. rent).
- Variable cost (TVC) changes with output and is zero at zero output (e.g. raw materials).
Use TC = TFC + TVC.
- = 500 + 700 = 1200.
At zero output TVC is zero.
- TC = TFC + TVC = TFC + 0 = TFC.
- Fixed cost must still be paid even with no output.
Key Points
- Cost concepts: money cost, real cost, opportunity cost.
- TFC = fixed cost (constant, paid even at zero output — rent); TVC = variable cost (changes with output, zero at zero output — raw materials).
- TC = TFC + TVC; at zero output TC = TFC.
Average and Marginal Cost
From total costs we derive the per-unit and extra-unit costs that a firm watches most closely:
- Average Fixed Cost (AFC) = TFC ÷ Q. As output rises, the same fixed cost is spread over more units, so AFC continuously falls.
- Average Variable Cost (AVC) = TVC ÷ Q. AVC first falls, reaches a minimum, then rises (U-shaped).
- Average Total Cost (AC or ATC) = TC ÷ Q = AFC + AVC. AC is also U-shaped.
- Marginal Cost (MC) = the addition to total cost when one more unit is produced = change in TC (or change in TVC), MC = TCₙ − TCₙ₋₁. MC is U-shaped too.
The table shows these for a firm with TFC = ₹12:
| Q | TFC | TVC | TC | AFC | AVC | AC | MC |
|---|---|---|---|---|---|---|---|
| 1 | 12 | 6 | 18 | 12 | 6 | 18 | 6 |
| 2 | 12 | 10 | 22 | 6 | 5 | 11 | 4 |
| 3 | 12 | 15 | 27 | 4 | 5 | 9 | 5 |
| 4 | 12 | 24 | 36 | 3 | 6 | 9 | 9 |
| 5 | 12 | 40 | 52 | 2.4 | 8 | 10.4 | 16 |
Notice AFC keeps falling, AVC and AC dip then rise, and MC = the change in TC. A key link: AC = AFC + AVC, and MC cuts both AVC and AC at their lowest points.
Averages divide by Q; MC is the change in TC.
- AFC = TFC ÷ Q; AVC = TVC ÷ Q; AC = TC ÷ Q.
- MC = change in TC (TCₙ − TCₙ₋₁).
MC = TC₄ − TC₃.
- = 36 − 27 = 9.
Fixed cost is spread thinner.
- TFC is constant; dividing it by a larger Q gives a smaller value each time.
Key Points
- AFC = TFC÷Q (falls continuously); AVC = TVC÷Q (U-shaped); AC = TC÷Q = AFC + AVC (U-shaped); MC = change in TC (U-shaped).
- MC cuts AVC and AC at their minimum points.
Shapes of the Cost Curves
Plotting the cost figures gives the famous family of cost curves, whose shapes you must know:
- The AFC curve falls continuously and gets closer and closer to the X-axis but never touches it (it is a rectangular hyperbola), because fixed cost is spread over more units.
- The AVC curve is U-shaped — it falls, reaches a minimum, then rises (because of the law of variable proportions acting in reverse on costs).
- The AC (ATC) curve is also U-shaped and lies above the AVC curve; the gap between them is the AFC, which narrows as output rises.
- The MC curve is U-shaped too, and it cuts both the AVC and AC curves at their lowest (minimum) points from below.
These relationships are shown below:
It falls but never reaches zero.
- It falls continuously (a rectangular hyperbola) approaching the X-axis.
- Because fixed cost is spread over more units, but never becomes zero.
Costs fall then rise.
- Each first falls, reaches a minimum, then rises (due to the law of variable proportions acting on costs).
At their lowest points.
- MC cuts both AVC and AC at their minimum points from below.
Key Points
- AFC: falls continuously (rectangular hyperbola), never zero.
- AVC, AC, MC: all U-shaped; AC lies above AVC (gap = AFC, narrowing).
- MC cuts AVC and AC at their minimum points from below.