In this lesson you will learn about the various elements of ''cost' used in micro economics.

• distinguish between the meaning of cost as used in business and as used in micro economics;
• explain the meaning and importance of various concepts of cost such as, paid out cost, imputed cost and normal profit in micro economics;
• distinguish between fixed costs and variable costs and explain the concepts of total costs, average cost and marginal cost;
• find out total cost from marginal cost and average cost and explain the importance of these costs for a producer;
• find out total fixed cost, total variable cost, average fixed cost, average variable cost, total average cost and marginal cost.

To begin with let us try to understand the concept of cost as used in business. We know that all production involves cost. To produce any commodity a producer or a firm requires inputs.

Take the example of the owner of a farm. For farming he requires a piece of land, agricultural workers, tools and implements, tractor, harvester, water, seeds, manures, power, and so many other things.

A producer has to either incur expenditure on procuring various inputs or he provides these himself. For example, a farmer may have his own land or may hire land on rent. He may have his own tractor or may hire one. He may grow seeds on his own farm and use them for farming or he may purchase seeds from the market. The inputs are partly purchased and partly self-provided. Thus, the owner of a farm, or for that matter, any other producer, may provide some inputs himself and purchase or hire others from the market. Let us term the inputs which are directly purchased from the market as purchased inputs. Let us also term the inputs provided by the owner as self-provided inputs.

A firm purchases the services of assets like building, material/machine etc. It pays hiring charges for building, normally termed as rent. It employs workers, accountant, manager etc. and pays wages and salaries to them. It borrows money and pays interest on it. It purchases raw material, pays electricity bills and makes such other payments. All such actual payments, on purchasing and hiring different goods and services used in production are called 'paid out costs' or 'explicit costs'.

Normally in business, the accountant takes into account only the actual money expenditure as cost. So in business the cost is normally the 'paid out cost' only.

Many a times we find that all inputs are not always bought or hired by the producer from the market: Some of the inputs are provided by the entrepreneur himself. He may use his own building. He may invest his own money in the business. He may be the manager of his own firm. A farmer may cultivate his own land. Now if a producer had rented out his building to another production unit he would have earned rent. In the same way, if he had invested his money in some other business, it would have earned him a certain amount of interest or dividend. S milarly if he had worked for another factory as a manager he would have earned a salary. He is not able to receive these rewards (rent for his building, interest on his money and salary for his services) because he has contributed them for his own business. But he must be compensated for the use of these self-owned and self-employed inputs. By employing these inputs in his own business he has missed the opportunity of earning income on these by using them elsewhere. It is, therefore, a cost to the producer. We can make an estimate of these costs on the basis of their prevailing market prices. Let us term such costs as 'imputed costs' (to distinguish them from paid out cost). One example of such cost is the imputed rent of the self owned factory building. It can be taken as equivalent to-the actual rent paid for a similar type of building. Similarly we can find out imputed interest and imputed wages.

In micro economics, in addition to the paid out cost, imputed cost is also included in the co of production. This is not all. There is yet another element of cost described as 'norm, profit'.

Another component of cost is 'normal profit'. Normal profit is an additional amount over the monetary and imputed cost that must be received by an entrepreneur to induce him to produce the given product. Normal profit is entrepreneur's opportunity cost and therefore enters into cost of production. Opportunity cost is the value of the opportunity or alternative that is sacrificed. You may be wondering how is it that profit is an element of cost? We will try to convince you.

For that let us first understand the meaning of the term 'normal profit'. It is nothing but th minimum assured profit in the next best occupation. Normal profit is the reward which an entrepreneur must receive for the risk and uncertainties he bears in the production of commodity. It can be understood with an example. Suppose there is a publisher who has the option of publishing commerce books or science books. He chooses to publish commerce books because he gets higher return from these. Now suppose that the market for science books is more assured but profit is lower. This would mean that the publisher who is publishing commerce books is sacrificing an assured return on science books is taking a risk. Hi would be prepared to face the risk only when he thinks that he would be able to get at leas the same profit which he would have in any way got from science books. Loss of assured return on science books is then an element of cost for the publisher who is publishing commerce books instead of science books. It is termed as 'normal profit' because it is an estimate of the minimum expectations of a producer from a business. So long as he gets this minimum he will continues to publish commerce books. If, at any stage, he does not get normal amount, he will shift to the publication of science books. So in order that a producer continues to produce a commodity he must get normal profit in addition to recovering, his 'paid out cost' and 'imputed cost'. We hope you are now convinced that minimum expectation of a producer from a business is also an element of cost.

Let us consider an example of the total cost elements for a farmer. He requires following inputs to produce (riee): a piece of land; agricultural workers; tools and implements; tractor and harvester; water, seeds, manures, power, and so many other things. He will either provide these inputs himself or he will purchase them from the market. Suppose- some of these inputs he provides himself and some of these he purchases from the market (see the following chart).




POINTS TO REMEMBER

• Production involves cost.
• Money costs or paid out costs are not the only costs in micro economics.
• The concept of cost as used in business generally refers to money or paid out cost.
• Cost in micro economics includes paid out cost, imputed cost and normal profit.

Expenditure which remains fixed irrespective of the quantity of output produced is classified as fixed cost. It is incurred whether the output is large or small or even when it is zero. It does not change when quantity of output is increased or decreased. For example, a firm producing pens must have a building, machinery and equipment, a manager, a watchman etc. whether it is producing smaller or larger quantity of pens. Suppose that the factory is not functioning for some period of time due to some reason. It means that no output is produced during that period. But still rent will have to be paid for that period, wage permanent employees of the factory will have to be paid. Thus, it is seen that there some unavoidable costs which remain fixed. Examples of fixed costs are rent on fac building, interest on money borrowed, property taxes and salaries of permanent empio like manager, watchman etc. All these costs remain the same whether the output is sma large or zero. Fixed costs are also called 'overhead costs'. Thus fixed costs are costs do not vary with changes in the level of output. They remain fixed whatever may b< level of output.

Costs which change with every change in output are called variable costs. Exampli variable costs are cost on raw materials used in production, casual labour employed, p consumed in production etc. These costs are incurred only when actual production i place. When output is increased, expenditure on raw material and labour also increases example, the firm producing pens will need more raw material, more labour etc. if it v

to produce more pen. But if the firm were to reduce the production, less will have to be spent on these items. In case production is completely stopped, no expenditure need be incurred on these items. This would mean that there are no variable costs at zero output. These costs are avoidable in the period during which the production is avoided due to one reason or the other. These costs are incurred when actual production starts. These costs rise along with the increase in production. Thus variable costs are costs that directly vary with the changes in the level of output.

The concepts of fixed cost and variable cost can be understood better with the help of a schedule and an illustration. Suppose a firm producing pens incurs the following costs at different levels of output (as given in table 18.1). You will see that its fixed cost remains constant whereas variable cost changes with every change in output. In this schedule, the fixed cost is Rs. 60 and remains the same at all levels of output. The variable cost is Rs. 60 when the producer is producing 100 pens. It rises to Rs. 100 when he produces 200 pens and to Rs. 150 at 300 pens and so on.

• Cost is classified into fixed cost and variable cost.
• Fixed costs do not change with a change in output.
• Variable costs change with every change in output.

These two costs together make total cost.

TC = TFC + TVC

Where TC stands for total cost, TFC for total fixed cost and TVC for total variable cost.

When a production unit is established but there is no production, total cost is the same as the total fixed cost. As production takes place, variable cost is also incurred and so total cost changes. Total cost increases as the quantity of output rises. The change in total cost equals the change in total variable cost. This is because total fixed cost remains constant at all quantities of output. Change in total cost is due to changes in variable cost only. The calculate of total cost can be explained through the following example :

The table 18.2 shows that total fixed cost is Rs. 60 and remains the same at all quantities of output. The variable cost equals Rs. 60 when one unit is produced, increases to Rs 100 at 2 units and to Rs. 150 at 3 units and so on. As the total cost is the sum of total fixed cost and total variable cost, it can be obtained by adding them at various quantities of output. For example, when one unit is produced total cost is Rs. 120 (Rs. 60 + Rs. 60) and when two units are produced, it works out to be Rs. 160 (Rs. 60+Rs. 100). Thus, we find that total cost varies directly with the level of output.

• Total cost is the sum of total fixed cost and total variable cost.
• Total ccst changes with a change in output.
• Changes in total cost are due to changes in variable cost only.

TFC

AFC = ———————

Units of output

Fixed cost by definition remains fixed whatever is the output. Therefore, as produ expands, the total fixed cost is distributed over a larger numbers of units. As a re average fixed cost falls with every increase in output. For example, the total fixed co our producer is Rs. 60 when he produces one unit. Average fixed cost is Rs. 60 (Rs. 6C But if the production is increased to 2 units, average fixed cost is Rs. 30 (Rs.60-2). \^ it produces 3 units it is Rs. 20 (Rs. 60 ¸ 3). Therefore, the larger the output the lower wi the average fixed cost.

Average variable cost is obtained by dividing the total variable cost by the units of out produced.

TVC

AVC = ———————

Units of output

When output of pen is one unit TVC is Rs. 60, so AVC will be Rs. 60 (Rs. 60-1). TVC 2 units of pens is Rs. 100, So AVC at 2 units of output of pen is Rs. 50 (Rs. 100-2) and on.

ATC is obtained by dividing the Total Cost (TC) by the total units of output:

TC

ATC = ———————

Units of output

The total cost of producing one unit of pen is Rs. 120. Therefore, ATC is Rs. 120 (Rs.120-1 Total cost of 2 units of output is Rs. 160. So ATC is Rs. 80 (Rs. 160-2). As total cost is th sum ofTFC and TVC, average total cost is the sum ofAFC and AVC. So we can also fin out ATC by adding AFC and AVC :

ATC = AFC + AVC

Check up from the schedule that ATC can also be calculated in this manner.

• Average cost can be obtained by dividing total cost by quantity of output produced.
• Average fixed cost equals total fixed cost divided by quantity of output.
• Average variable cost can be obtained by dividing total variable cost by quantity of out put.
• Sum of average fixed cost and average variable cost is average total cost.

When output level is zero total cost is Rs. 60. As one unit of pens is produced by the producer the total cost rises to Rs. 120. So the marginal cost of producing one unit of output is Rs. 60 (Rs. 120-Rs. 60), when it produces 2 units his total cost increases to Rs. 160, the marginal cost at 2 units of output is Rs. 40 (Rs. 160-Rs. 120). This has been calculated by deducting total cost of 1 unit from total cost of 2 units. Marginal cost at one unit of output is Rs 60. This we got by deducting total cost of zero unit from total cost of one unit.

Alternatively, we can say that MC at any level of output is the cost of the last unit of output. For example, take the output levelof_3 units ofpeHS:4nthi^tase3rd unit of pen is the last unit. Total cost of first 2 units of pens is Rs. 160. Total cost for adding one more unit of output increases to Rs. 210. The additional cost on last unit is Rs. 50 (Rs. 210-Rs. 160). So MC at 3 units of output is Rs. 50.

It should be kept in mind that marginal cost is dependent on me variable cost only. It is not affected by fixed cost because fixed cost remains constant. As output expands changes in

total cost are due to changes in variable cost only. So, marginal cost can also be calculate if only total variable costs are known to us. For example, take the following schedule showin TFC, TVC and TC. When we calculate MC from' either TC or TVC we get the sam result. Calculate yourself and the check the result.

• Marginal cost of producing output is the additional cost incurred on producing the last unit of output.
• Marginal cost of producing output also equals the additional variable cost incurred on producing the last unit of output.
• Marginal cost of a given unit of output equals the total cost upto the given unit less the total cost upto the previous unit of output.

a) A farmer growing seeds and using for cultivation

b) Use of chemical fertilizers by a farmer

c) Use of the services of a tractor owned by the farmer

d) Farming by the farmer who owns the land

e) Unpaid family labour used on farms

f) Transport charges

g) Interest on borrowings

h) Wages paid

i) Use of own building for production

j) Excise duty.

12. Classify the following expenditure into fixed cost and variable cost:

a) Rent of the factory building

b) Wages to watchman

c) Annual licensing fee of factory premises

d) Raw material

e) Rent of the agricultural land

f) Seeds

g) Fertilizers

h) Interest on borrowings

i) Excise duty

j) Transport charges.

14. Calculate (i) TFC and TVC

(ii) AFC and AVC

(iii) MC

from the following data :

15. Suppose that TFC is Rs. 120, find out

(i) TC and TVC

(ii) MC

from the following data :

16. Fill m the blanks

17. Complete the following table

Let us draw the diagram on the basis of the following data :

(a) TC, TVC And TFC curves

We observe the following in the above curves :

We observe the following in the above diagram :

ANSWERS

Intext Questions 18.1

Intext Questions 18.2

Intext Questions 18.3

Intext Questions 18.4

Intext Questions 18.5

Terminal Exercise

16.

17.