Theory of Cost

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What is meant by Theory of Cost?

The determination of the price for a product or service is not easy. Several other factors govern it. The theory of cost definition states that the costs of a business highly determine its supply and spendings. The modern theory of cost in Economics looks into the concepts of cost, short-run total and average cost, long-run cost along with economy scales. 

The cost function varies concerning factors such as operation scale, output size, price of production, and more. The theory of cost production needs to be understood in detail by economists to run their company and increase its profit and productivity. This article covers all you need to know about cost concepts.

Types of Costs

  • Accounting Costs / Explicit Costs: The cost of production including employee salaries, raw material cost, fuel costs, rent expenses and all the payments made to the suppliers from the accounting costs.

  • Economic Costs / Implicit Costs: According to the modern theory of cost in economics, the investment return amount of a businessman, the amount that could have been earned but not paid to an entrepreneur and monetary rewards for all estates owned by the businessman form the economic costs. These costs include accounting costs and the money also return which the owner could have earned from elsewhere apart from the business.

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  • Outlay Costs: These are the recorded account costs or actual expenditure spent on wages, rent, raw materials and more.

  • Opportunity Costs: These are the missed opportunity costs. They are not recorded in the account books but shows the cost of sacrificed or rejected policies.

  • Direct / Traceable Costs: These costs are easily pointed out or identified expenditures such as manufacturing costs. Such costs cater to specific operations or goods.

  • Indirect / Non-Traceable Costs: These costs are not related directly or identifiable to any operation or service. Costs such as electric power or water supply are some examples because these expenses vary with output. They generally have a functional relationship with production.

  • Fixed Costs: Such costs do not vary with output and are fixed expenditure of the company. For example, taxes, rent, interests are all fixed costs as they do not vary within a constant capacity. Any company cannot avoid these costs.

  • Variable Costs: These costs vary with output and are known as a variable cost. For example, salaries of the employee, raw material costs all fall under variable cost. These directly depend on the fixed amount of resources.

Theory of Cost in Economics

The modern theory of cost in Economics also specifies about economies of scale where an increased production decreases the cost per unit of production. The returns to scale first increases, then stabilizers for some time and then decreases. Let's take a look at the different types of economies—

  • Technical: Technical economies include investment in machinery and more efficient capital equipment to increase production efficiency.

  • Effective Management: When an organization increases operation, they need a better division of labour into various sub-departments for efficient management.

  • Commercial: A large amount of components and raw materials is needed with increased production. Hence raw material costs decrease. The advertisement cost for a unit of production also falls, which such increments.

  • Finance: With a raised Finance, any company becomes popular. Their banking securities increase and Finance is raised at a much lower cost.

  • Risk Management: As the firm becomes more diverse, risk-taking factors also increase.

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Comparing Short Run And Long Run Costs

As per the theory of cost analysis, during the short run period, a company tries to increase its output by changing only the variable factors such as raw materials or labour. The fixed variables remain untouched. The long-run period is where the company can change any factor to obtain desirable outputs as per their interests. Ultimately all these factors result in cost.

Solved Examples

Q1. Draw a relationship between Total Cost, Total Fixed Cost and Total Variable Cost of a Business.

Answer: For any business, 

Total Costs (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC).

Q2. What is the average fixed cost?

Answer: Average fixed cost is defined as the total fixed cost per unit of production. The total fixed cost divided by the number of units gives the average fixed cost.

Fun Facts

  • The average total cost is the sum of the average variable cost and average fixed cost.

  • Marginal cost can be calculated as the total change in cost upon a total change in output.

  • Electricity charges are neither fixed nor variable costs. Instead, they are semi-variable costs.

  • Stair Step variable cost remains constant for a fixed output. But when the output suddenly exceeds its limit, the cost immediately jumps to a new higher level. The graph of total variable cost v/s output looks exactly like a staircase for such cases.

  • According to the modern theory of cost in Economics, the positive slope in the long-run total cost average curve is due to diseconomies of scale.

FAQ (Frequently Asked Questions)

1. What is the shape of an average Long-run Cost Curve? Why?

Answer: The long-run average cost (LAC) curve has a U or L shape. The u-shape is due to the returns to scale. With the expansion of the firm, the returns to scale also increase, then stabilizers and for the decreases. Therefore the LAC curve first moves down then rises eventually. 

Long-run average costs have an inverse relation with returns to scale. Falling long-run costs are experienced due to internal and external economies of scale.

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In contrast, the rising long-run cost is experienced due to the diseconomies of scale (both external and internal). Whenever the state of Technology is constant, we get the flattened U shape as a result of the traditional theory of cost. According to the modern theory of cost in economics, the state of technology changes in the long run and hence the shape turns from U shape to the modern L shape.

2. What is Marginal Cost and how is it related to Average Cost?

Answer: When an addition is made to the production cost by producing extra units of output, the extra cost edition is known as marginal cost. 

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Marginal costs are independent of fixed cost but dependent on changes in variable costs. Marginal cost is less than the average cost when due to an increase in the output the average cost falls. But if the opposite happens and the average cost rises with an increase in output, then the marginal cost exceeds the average cost. However, when the marginal cost is minimum, the average cost becomes equal to it. Short-run average costs are also of various types, and they affect the marginal cost, which varies based on the output and average cost.