What is the Cost of Production?

The entire idea of the cost of production or production cost is applied corresponding, or we can say that it is related to monetary cost. Money cost refers to any money expenditure which the firm or supplier, or producer undertakes in purchasing or hiring factor of production or factor services.

For example: For producing any commodity, the firm requires various factors of production like land labor, capital, etc. Therefore, to employ all these factors of production, the producer needs to bear some cost. For hiring labor, he/she needs to pay wages, forgetting the land to set up a plant he/she needs to pay rent. Therefore, all these costs come under money costs.

All these money costs are included in the accounting books of a firm as costs of production.

Money costs made by the firms to the owners of various factor services (i.e., the household) in hiring and purchasing them as per what is required in the production process of goods are explicit costs.

Although, money expenditure only constitutes a part of the cost. Certain factor services are owned by the entrepreneur himself for which no money payment is made. Since no payment is made for such factor services, they are not included in the normal accounting practice cost.

Economic Costs

Economists take the cost of production in a wider sense, i.e., economical cost. Economic cost consists of three components.

They are:

1. Money Cost or Explicit Cost
2. Implicit Cost
3. Normal Cost

Implicit Cost: Implicit Cost refers to the estimated value of inputs owned by the firm and used by it in its production unit. Besides purchasing or hiring resources from others, a producer may also use his/her factor services in the process of production. The owner or the entrepreneur may own certain factor services which he/she may use in his/her own business. For example, the entrepreneur may use his/her land or his/her capital and may provide entrepreneurial and managerial services. As such, he/she is entitled to receive rent on his/her land, interest on the capital contributed by him/her, and payment for such services. Thus, in case of such factors of production that the firm neither purchases nor hires, the cost must also be calculated. Such costs need to be imputed from what they could earn in their best alternative use. Such cost is known as implicit cost.

Normal Profit: Normal profit is regarded as the minimum payment which a producer must get to induce him to undertake the risk of production. Normal profit is the minimum supply price of entrepreneurial services. It is, in a way, a reward or remuneration for the services of the entrepreneurs. It is part of the cost of production because entrepreneurs expect to get it in the long run, he/she is not likely to undertake production. From an economic perspective, normal profit is also cost.

The economic cost is now can be defined as the total of both explicit and implicit costs, including normal profit.

Opportunity Cost

The opportunity cost of producing any good is the next best alternative good given up to produce this good. The cost of producing a quantity of a commodity is measured in terms of the quantity of some other commodity that could have been obtained instead. The concept of opportunity cost arises because of the scarcity of resources and because these resources have alternative uses.

For example:

In an economy, with the available resources, it is possible to produce cloth and bread. Suppose a given amount of resources can produce 1 metre of bread or 20 loaves of bread. Then the cost of 1 meter of cloth is 20 loaves of bread, which must be sacrificed to produce 1 meter of cloth.

[ Note; It is important to know that the opportunity cost of producing a good is not any other alternative that could be produced with the same amount of resources; rather, it is the next best alternative good that could be produced with the same resources.]

Suppose with the given resources it is possible to produce cloth, bread or pencil but bread is the next best alternative good to cloth. In that case, the opportunity cost of producing cloth is expressed in terms of the amount of bread that is given up to produce cloth and not in terms of a pencil to be given up to produce it.

 Real Cost

Real cost advocates the notion of the efforts and sacrifices made by the owners of factors of production used in the production of the commodity. Labor has to put physical and mental efforts into doing work. Owners of capital and land make sacrifices by not using these resources themselves or sacrificing involved in saving and capital accumulation. Thus, real cost refers to the pain, sacrifice, discomfort, and disutility involved in providing factor services required to produce a commodity.

 Private and Social Cost

Private cost refers to the cost of production incurred or beard by an individual firm in producing a commodity. In other words, we can say that private cost is as same as economic cost and also includes both implicit and explicit cost.

On the other hand, social cost refers to the cost that society has to incur on account of the production of a commodity. It is the total cost incurred by the producers of goods and services and the cost experienced by those who have to suffer because of the production of the commodity in terms of external cost.

Now the question comes, that what is the external cost?

External cost is that cost that is not incurred by the firm but is incurred or undertaken by other members of the society or the entire society.

Let us understand this with the help of an example:

Oil refinery may discharge their waste in the river causing water pollution. Those living near the water bodies need to undertake the responsibility and the expenditure to clean the waterbody. Similarly, take the example, buses, and trucks causing air pollution and noise pollution. Such air, water, and noise pollution causes health hazards and thereby involves a cost to the entire society. These costs are not taken into account by the individual producers and are not a part of private costs. But these should be taken into account of the cost of production.

The Behavior of Cost in the Short Run

Fixed Cost and Variable Cost

Corresponding to fixed factors (factors of which the quantity cannot be changed in a short run) and variable factors (factors of which the quantity can be changed in a short run), the economic cost is classified into two categories: (i) Fixed Cost. This cost is incurred on fixed factors. It consists of salary of the permanent staff, interest on the borrowed capital, depreciation of machinery, etc. (ii) Variable costs- The cost which is incurred on variable factors. It consists of expenditure incurred on raw materials, wages and salaries paid to casual workers, etc.

Total Cost Curves

Total obligations incurred by the firm in producing any given quantity of output are known as total cost curves (TC). It is the total of all expenses incurred in producing a certain volume of output. For example: If the total money expense in producing 100 pens is $1000/-, then the total cost of producing 100 pens is $1000/-. Now total cost can be divided into two parts: Total Fixed Cost and Total Variable Cost.

1. Total Fixed Cost (TFC)

Total Fixed Cost refers to the total cost incurred by the firm on the use of all fixed factors.  This cost is independent of output, i.e., it does not change with a change in the quantity of output. It remains constant irrespective of the quantity of output produced. Even if the firm produces one unit of commodity, the fixed cost has to be incurred by the firm.

For example, A shopkeeper has to pay rent for the shop no matter the output or sale during a month. That is why this cost is also known as an unavoidable cost.

2. Total Variable Cost (TVC)

Total variable cost refers to the total cost incurred by a firm using the variable factors. This includes payments for raw materials, wages paid to temporary and casual laborers, payment for fuel and power used in production. This cost is dependent on output, i.e., it does change with a change in the quantity of output. It changes along with the quantity of output produced.

For example: If firms want to produce more shirts, they have to buy more raw materials like yarn and hire more workers. Since these costs change with the change in the volume of output, they are called variable costs. Variable cost is also known as avoidable cost.

3. Total Cost (TC)

Total cost is the cost incurred on all types of inputs- fixed and variable inputs- incurred in producing a given amount of input. The cost of fixed factors is a total fixed cost, and that of variable factors is called total variable costs.

TC = TFC+TFC

Table: 1

TFC Curve:

As table 1 shows, the total fixed cost remains constant at $ 130 for the entire range of output, i.e., from 0 to 6 units. It does not change with a change in output. Even if no output is produced, the firm has to bear the fixed cost because it cannot throw out fixed factors in the short run, and they will remain idle till the firm decides to produce.

TVC Curve

As table 1 shows, total variable cost changes with changes in output. It would be seen from the table that total variable cost increases with output. But the rate of increase is different at different levels of output. The TVC curve is concave downward up to the OQ level of output, indicating that the variable costs increase at a decreasing rate. Subsequently, it is concave upward, indicating that variable costs are increasing at an increasing rate.

TC Curve

Total cost is the total of total fixed cost and total variable cost. It varies directly with output because of an increase in output. TC is obtained by adding up vertically TFC curve and TVC Curve because the total cost is the total of total fixed cost and total variable cost at every level of output.

Average Cost Curves

The average cost curve is nothing but the total cost divided by the number of units of goods produced. Concerning three types of total costs in the short run, there are three types of average costs.

1. Average Fixed Cost (AFC): Average Fixed cost is the per-unit cost of fixed factors. It is obtained by dividing total fixed costs by the total units of output produced.   AFC = TFC/Q, where Q represents a number of outputs. AFC curve slopes downward throughout its length from left to right showing continuous fall in AFC with an increase in output.
2. Average Variable Cost (AVC): Average Variable Cost is the per-unit cost of variable factors of production. It is obtained by dividing the total variable cost by the units of output. AVC=TVC/Q. The AVC curve slopes downward up to output OQ2 showing a decrease in the average variable cost, and slopes upward beyond output OQ2, indicating an increase in the average variable cost. In other words, the AVC curve is U-shaped.
3. Average Cost (AC) or Average total cost (ATC):  Average total Cost is the per-unit cost of both variable and fixed factors of production. It is obtained by dividing the total cost by the units of output. AC=TC/Q. ATC or AC curves can be obtained by adding the AFC and AVC curves. ATC is the vertical summation of AFC and AVC curves. Therefore, at each output level, the ATC curve lies above AVC, equal to the value of the AFC curve.

Marginal Cost (MC)

Marginal cost is the addition to the total cost as one or more unit of output is produced. In other words, marginal cost is the addition to the total cost of producing n units instead of n-1 units (where n is a given number). MC_n= TC_n – TC_n-1

For example, the Marginal Cost of the 4^th unit is the change in total cost when the output is increased from 3 units to 4 units.  Marginal cost is computed by taking the difference between successive total costs corresponding to the different output levels.

Hence, MC=DTC/DQ

Diagrammatically, MC for the level of output can be calculated by taking the slope of the total cost curve corresponding to that level of output.

The U- Shape of the MC curve is because of the law of variable proportions. It is negatively sloped in the initial stage of production due to increasing returns to the variable factor and is positively sloped after that due to decreasing returns to the variable factor.

Context and Applications

This topic is important for the students pursuing the below-mentioned disciplines.

• Masters in Economics 
• Master in Business Administration
• Masters in Commerce
• Bachelors in Economics
• Bachelors in Commerce