Cost Function Notes
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LunaCost Function Notes
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LunaMeaning of Cost
A cost function is a mathematical formula used to calculate the total cost of production
for a given quantity of output. It represents the relationship between the cost of
production and the level of output, incorporating various factors such as fixed costs,
variable costs, and total costs.
In economics cost is the sum total of
(a) Explicit Cost- It is the actual money expenditure on inputs or payment made to
outsiders for hiring their factor services. Example- wages paid to the employees,
rent paid for hired premises etc.
(b) Implicit Cost- It is the estimated value of inputs supplies by the owners including
normal profits. Example- Estimated interest on own capital invested by the owner
in the business.
Cost Function – The relation between cost and output is known as ‘cost function’. It is
expressed as C= f(q).
Opportunity Cost- When a firm produce a particular commodity, then it is always
considers the value of alternative commodity, which is not produced. The value of
alternative commodity is the opportunity cost of the goods that the firm is now
producing.
Total Costs
In the short run, some of the factors are fixed, while other factors are variable. In the
same way, the short-run costs are also categorized into two different kinds:
Fixed and Variable Costs. The sum total of these costs is equal to the Total Cost.
1. Total Fixed Cost (TFC) or Fixed Cost (FC)
The costs on which the output level does not have a direct impact are known as Fixed
Costs. For example, salary of staff, rent on office premises, interest on loans, etc.
2. Total Variable Cost (TVC) or Variable Cost (VC)
The costs on which the output level has a direct impact are known as Variable
Costs. For example, fuel, power, payment for raw materials, etc.
3. Total Cost (TC)
The total expenditure incurred by an organisation on the factors of production which
are required for the production of a commodity is known as Total Cost. In simple
terms, total cost is the sum of total fixed cost and total variable cost at different output
levels.
TC = TFC + TVC
Diagram for the relation among TC, TVC and TFC
Fig 6.3at Page no. 6.6
Average Costs
Average Costs are the per unit costs which explain the relationship between the cost
and output in a realistic manner. These per-unit costs are obtained from Total Fixed
Cost, Total Variable Cost, and Total Cost. The three different types of per-unit
costs are as follows:
1. Average Fixed Cost (AFC)
The per unit fixed cost of production is known as Average Fixed Cost. The formula for
calculating Average Fixed Cost is:
Average Fixed Cost (AFC)=Total Fixed Cost (TFC) divided by Quantity of Output
Diagram of AFC Fig 6.4 at Page 6.8
2. Average Variable Cost (AVC)
The per unit variable cost of production is known as Average Variable Cost. The
formula for calculating Average Variable Cost is:
Average Variable Cost (AVC)=Total Variable Cost (TVC) divided by
Quantity of Output (Q)
Diagram of AVC Fig 6.5 at Page 6.9
3. Average Total Cost (ATC) or Average Cost (AC)
The per unit total cost of production is known as Average Total Cost or Average Cost.
The formula for calculating Average Total Cost is:
Average Cost (AC)=Total Cost (TC) divided by Quantity of Output (Q)
Diagram for AC Fig 6.6 at Page 6.10
C. Marginal Cost
The additional cost incurred to the total cost when one more unit of output is produced
is known as Marginal Cost. For example, if the total cost of producing 2 units is ₹400
and the total cost of producing 3 units is ₹600, then the marginal cost will be 600 –
400 = ₹200.
MCn=TCn–TCn−1
{Where, n = Number of units produced; MCn = Marginal cost of the nth unit; TCn =
Total cost of n units; TCn-1 = Total cost of (n-1) units}
Diagram for Marginal Cost Curve Fig 6.8 at Page 6.12
Relationship between AVC and MC
1. When average cost falls with an increase in output, marginal cost is less than the
average cost (before point B).
2. When average cost rises, marginal cost is greater than the average cost (after
point B).
3. Marginal cost curve cuts the average cost curve at its minimum point (minimum
point on the average cost curve is also the point of optimum capacity) i.e., at the point
of optimum capacity, MC = AC (at point B). With increase in average cost, marginal
cost rises at a faster rate.
