• The payments made to the factors of production
are known as cost of production. In other words,
cost of production of a commodity means the
payments made to the factors of production of
the commodity. Cost of production mainly
depends on quantity of output.
It can, therefore, be said that cost of production is
a function of output. i.e.
Costs are classified as :
(1) Money Cost
(2) Opportunity Cost
(3) Real Cost
(4) Private, external and Social Cost.
TYPES OF COST
• Money Cost – Ordinarily the term cost
of production refers to the money
expenses incurred in the production of
a commodity. The amount spent in
terms of money to produce a
commodity, is called its money cost.
• The following expenses are included in
monetary cost :
• (1) Cost of Raw Materials
(5) Expenses on power or electricity
(5) Expenses on publicity or selling costs
(7) Packing Charges
(8) Transport Cost
(9) Insurance Charges
(10) Normal Profits
• Explicit Costs – All those expenses that a firm
incurs to make payment to others are called
explicit costs. According to Leftwitch, “Explicit
costs are those cash payments which firms
make to outsiders for their services and goods.”
These include wages paid to the labourers, rent
paid for premises, cost of raw materials, interest
on loans, depreciation charges, premium paid
towards insurance against fire, theft etc.
• Implicit Costs : “Implicit costs are costs of
self owned and self-Employed resources.”
These include the rewards for the
entrepreneurs self owned land, building,
labour and capital.
Total Cost=Explicit Cost+Implicit Cost
• Opportunity Cost – The concept of opportunity
cost is the most important modern concept in
economic theory. According to this concept, in
an economy supply of economic resources is
limited relative to their demand. As such when
resources are used for producing a given
commodity, then some amount of other
commodities, in whose production these
resources could have been helpful, has to be
• Every action we take involves an
opportunity cost. For instance, every
variable factor must be paid what it
receives in its next best alternative, that is
the opportunity cost, otherwise the factor
input cannot be retained in its current
Real Cost – Real cost is computed in terms of the
pain and the discomfort involved for labour when
it is engaged in production and also the
abstinence and sacrifice involved in saving and
The concept of real cost, however, does not
carry any significance in the cost of production
because it is subjective concept and lacks
• Private, External and Social Cost- A cost
that is not borne by the firm, but is
incurred by others in society is called an
Social Cost= Private Cost+External Cost
External Cost= Social Cost-Private Cost
Types of Costs
Fixed Costs :- In the short period the expenses
incurred on fixed factors are called the fixed
costs. These costs do not change with changes
in the quantity of output. Production or no;
production; whatever may be the level of output,
fixed costs remain constant. According to
Benham, “the fixed costs are those costs that do
not vary with the size of its output. “Even if the
production is zero, fixed costs remain the same.
Fixed costs include the following expences.
• Variable Costs: Variable Costs are those
costs which are incurred on the use of
variable factors of production.
according to Dooley “Variable costs are
those costs which vary as the level of
• Total Costs –Total costs of a firm for
various levels of output are the sum of
total fixed costs and total variable costs.
Significance of difference between the Fixed
and Variable Costs.
• 1. Decision to Shut Down the Firm: A
producer tries to cover both fixed and
variable costs while selling his output. But
in the short run due to some reasons price
may fall so much that the producer is
unable to cover all his costs.
• 2. Control over Costs: In the short-run, the
firm has no control over fixed costs.
• 3. Break-even Point: The study of cost-
volume-profit relationship is frequently
referred to as the break-even analysis.
• The break-even point is the point of
intersection of TC and TR curves.
Average Cost and Marginal Cost Curves
• 1. Average Cost: Per unit cost of a good is
called its average cost. “Average Cost is
total cost divided by output.”
• When output increases average cost falls.
After a minimum point, it begins to rise.
Reason being that when output increases,
initially law of increasing returns or
diminishing costs applies.
Why AC curve is a U-shaped
• 1. Behaviour of Average Fixed Cost and
Average Variable Cost:
• 2. Law of Variable Proportions: The “U”
shape of the short run average cost curve
can also be explained in terms of the law
of variable proportions. The average costs
of the firm continue to fall as output
increases, because it operates under
increasing returns, due to various internal
• When the variable factors are increased
further, the firm is able to work that
machines to their optimum capacity. It
produces optimum output and its average
cost of production will be minimum. If the
firm tries to raise output beyond this point
by increasing the quantities of variable
factors, this would lead to diseconomies of
production and diminishing returns.
• Hence, due to the working of the law of
variable proportions in the short-run
average cost curve is U-shaped.
Relationship between Average
Cost and Marginal Cost
• 1. Both AC and MC are derived from TC
• 2. When AC falls, MC is also falling:
• 3. When AC rises, MC is also rising:
• 4. MC begins to rise at a lesser level of
output than AC:
• 5. MC cuts AC at its Minimum point
• 1. Long-run Average Cost (LAC)
• 2. Long-run Marginal Cost (LMC)
• 1. Long-Run Average Cost Curve or
Envelope Curve-Long-run average cost
refers to minimum possible per unit cost
of producing different quantities of output
of a good in the long period.
• The Shape of Average Cost in the Long-
run- In the long-run the average cost curve
is said to be “U”-shaped to show that it
declines, first and rises later. Where it is the
lowest, it is optimum output point.
• 2. Long-Run Marginal Cost Curve- Change
in the total cost, in the long-run due to the
production of one more unit, is called long-
run marginal cost. Long-run marginal cost
curve (LAC) that any given short-run
marginal cost bears to short-run average
cost. LMC curve cuts LAC at its lowest