THEORY OF COST

CLASS 11
MICRO ECONOMICS
 NOTES
THEORY OF COST
The expenditure incurred by a producer on factor as well as non
factor inputs at the time of production is called as the cost of
production.

Cost function
The functional relationship between cost and output is called as
cost function.
C = f(Q)
Where, Q = Output
C = cost
Types of cost
1. Total fixed cost(TFC)
The payments which are made by the producer on fixed factors
during the process of production are known as total fixed cost.
Example Payments on building, machinery etc.
They are generally one time investments and hence they are fixed
in nature.
Other names of TFC are supplementary cost,
Indirect cost,
General cost,
Unavoidable cost.

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 NOTES
THEORY OF COST

Quantity of output Total fixed cost

0 100

1 100

2 100

3 100

4 100

5 100

2. Total variable cost(TVC)

The payment made on acquiring the variable factor at the time of
production is known as Total Variable Cost.
Example:-Payment for raw material, labour, fuel etc…
The TVC changes due to change in quantity of output.
TVC is also called as Prime cost
Direct cost
Avoidable cost.
If the producer wants to increase the level of output, then he
must increase the payment made to the variable factors

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THEORY OF COST

Quantity Total Variavle Cost

0 0

1 50

2 80

3 100

4 200

5 370

6 580

3. Total Cost(TC)
It refers to the total expenditure which is paid on both fixed and
variable factor during the process of production.
It is the horizontal summation of Total Fixed cost and Total Variable
Cost.
TC = TFC + TVC
The Total cost and Total Variable Cost curve are always parallel to
each other just because of constant Total Fixed Cost..

Quantity TFC TVC TC

0 100 0 100

1 100 50 150

2 100 80 180

3 100 100 200

4 100 200 300

5 100 370 470

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 NOTES
THEORY OF COST
At zero level of output TVC is zero.
Which means the Total Cost at zero level of output is the Total
Fixed cost made by the producer.
At zero level of output, TC =TFC.

4. Average fixed cost(AFC)

AFC=TFC/Q
It refers to per unit fixed cost of production. It is calculated by
dividing TFC by output produced. It signifies the burden of fixed
cost on each unit of output produced.
It is presented in the given schedule and diagram.

Quantity TFC AFC

0 100 ------

1 100 100

2 100 50

3 100 33.3

4 100 25

5 100 20

The AFC curve slopes downward from left to right. It decreases

as the output increases just because of constant total fixed cost.
Area under the curve remains same at all the points (rectangular
hyperbola).
Average fixed cost curve never touch any of the axis.
(As fixed cost cannot be Zero, even a zero level of output)
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THEORY OF COST
5. Average variable cost(AVC) It refers to per unit variable cost of
production It is computed by dividing Total Variable Cost by quantity
produced. It shows the burden of variable cost on per unit of output
produced.Initially, AVC falls with increase in output but once output
reaches optimum level it started rising again.

AVC = TVC/Q

Quantity TVC AVC

0 0 0

1 50 50

2 80 40

3 100 33.3

4 200 50

5 370 74

6.Average cost(AC)
It refers to per unit cost of production.
It is computed by dividing total cost by the quantity produced.
It signifies the total burden of cost on per unit of output.
It can also be calculated by adding Average Fixed Cost and Average
Variable Cost.
AC = TC/Q or AC = AFC + AVC

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THEORY OF COST

Quantity TFC TVC Total Cost AC

(TFC + TVC)

0 100 0 100 -----

1 100 50 150 150

2 100 80 180 90

3 100 100 200 66.6

4 100 200 300 75

5 100 370 470 94

7. Marginal cost(MC) It refers to an additional cost which can be

derived by producing one more unit of output.
In other words, it refers to the change in Total Cost with respect
to per unit of output produced.

MC = TCn - TCn - 1 or MC = ∆TC/∆Q

Quantity TC MC

0 100 ------

1 180 80

2 240 60

3 280 40

4 350 70

5 450 100

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 NOTES
THEORY OF COST
The curve initially slopes downward with increase in quantity of
output produce due to increasing return in the process of
production, after reaching minimum it starts building back as the
rate of production goes down (law of variable proportion).

Explicit cost It refers to the actual payment made to outsiders

for hiring their services for production.
Example wages to employees, Cost of raw material.

Implicit cost It refers to the self oriented cost because of

employing own factor of production.
Example Own building , Own machinery etc…

Real cost All the efforts and sacrifices with the producer made,
at the time of production in monetary terms are known as real
cost.

Social Cost It refers to the expenditure made by the government

for society or for producing social goods and services are
termed to be the social cost.
Example Cost of construction of road, bridge, cost of increasing
sanitation facility etc

Private Cost The expenditure which is incurred by a private

individual for producing a particular commodity is called the
private cost of that product.
Example The expenditure made by Mukesh Ambani, Billgates etc.

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 NOTES
THEORY OF COST

Relation Between Average Cost and Marginal Cost

S.No Average Cost Marginal Cost

1 It refers to the cost of per unit It refers to change in total cost

of output produced with respect to per unit of
output produced

2 When Average cost decreases The Marginal cost also decreases

3 The rate of decrease in Average The rate of decrease in Marginal

Cost in much slower than Cost in greater than that of
Marginal Cost. Average cost.

4 When AC reaches its minimum MC intersects AC, and both

point MC and AC are equal

5 When AC increases MC also increases, But the rate

of increase in MC is greater than
that of AC

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THEORY OF COST
COMPLETE SCHEDULE
Quantity TFC TVC TC AC AFC AVC MC
0 100 0 100 ----- ----- ----- 100
1 100 80 180 180 100 80 80
2 100 140 240 120 50 70 60
3 100 180 280 93.3 33.3 60 40
4 100 250 350 87.5 25 62.5 70
5 100 350 450 90 20 70 100
6 100 470 570 95 16.6 78.4 120

Formula Used
At zero level of output,
TC = TFC
TC = TFC + TVC
AC = TC/Q or AC = AFC + AVC
AFC = TFC/Q
MC = TCn - TCn-1 or MC= ∆TC/∆Q
AVC= TVC/Q

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