1. Lecture 8
Cost and Cost Curve

2. Nominal and Real Cost
• Nominal Cost
– Nominal cost is the money cost of production
– It is also called expenses of production
– It is important from producer’s point of view
• As he has to cover this and earn profit to remain in business
• Real Cost
– Many economists tried to define real cost
– Adam Smith regarded
• pains and sacrifices of labour as real cost
– Marshall includes under it
• Real cost of efforts of various qualities
• Real cost of waiting
– The Austrian School of economists and their followers gave
a new concept of real costs
• The real cost of production of a given commodity is the next best
alternative sacrificed in order to obtain that commodity
• It is also called opportunity cost or displacement cost

3. Money Cost and Real Cost
• It is very seldom that money cost is equal real cost
• According to Marshall
– If the purchasing power of money in terms of effort
remained about constant and
– If the rate of remuneration has also remained about
constant
– Then the money measure of cost corresponds to the real
cost
– But such a correspondence is never to be assumed lightly
• Thus, the two cannot be equal in this world
• The earnings of cinema
stars, professors, coolies, sweepers, peasants, business
men etc seldom correspond to the respective efforts
and sacrifices undergone by each class

4. Alternative, Opportunity or Transfer Cost
• Since productive resources are limited
– The production of one commodity can only be at the expense of
another
– The commodity that is sacrificed is the real cost of the
commodity that is produced
• In the words of Henderson
– Real Cost of any thing is the curtailment of the supply of other
useful things, which the production of that particular thing
entails
• Economists defined cost of production of a particular
product
– As the value of the foregone alternative products that resources
used in its production could have produced.
• Suppose with a sum of Rs 1000/- a manufacturer can
produce two sets or a small refrigerator.
– Suppose further he decides to produce refrigerator rather than
the radio sets. In this case, the real cost of the refrigerator is
equal to the cost of two radio sets i.e. the alternative foregone.

5. Application and Limitations of OC
• Application
– It applies to income distribution
• Limitations
– Specific productive services
– Inertia
– Non-pecuniary considerations
– Factors not homogenous
– Wrong assumptions
– Individuals and social costs

6. Entrepreneur’s Cost
• The entrepreneur’s cost of production includes the
following elements:
– Wages of labour
– Interest on capital
– Rent or royalties paid to the owners of land or other properly
used
– Cost of raw materials
– Raw materials
– Replacement and repairing charges of machinery
– Depreciation of capital goods
– profits
• Four broad categories
– Production costs
– Selling costs
– Managerial costs
– Other costs, including insurance charges

7. Long Run and Short Run Costs
• Short Run
– Short run is a period of time within which the firm
can vary its output by varying only the amount of
variable factors e.g. labour and raw material
– In short run, capital equipment, top management
personnel, plant size etc. cannot be varied
• Long Run
– It is a time period in which quantities of all
factors, variable as well as fixed can be adjusted

8. Short Run Fixed and Variable Costs
• Some costs vary more or less proportionately with the
output while others are fixed and do not vary with the
output in the same way
– The former are known as variable or prime cost
– The later ones are known as fixed or supplementary costs
• The prime cost vary with output
– E.g cost of raw materials, daily labour etc.
• The supplementary cost must be paid even production
has been stopped
– E.g rent of the factory building, interest on capital invested
in machinery, and salary of the permanently employed
staff
• In long run all costs are variable

9. SR: Total, Average and Marginal Costs
• Total Costs
– Total cost of a given output is the sum of total fixed cost
and total variable cost
• Average Costs
– Average cost per unit is the total cost divided by the
number of units produced
– It is sum of average fixed cost and average variable cost
• Marginal Costs
– Marginal cost is the addition to total cost caused by a small
increment in output

10. Example
Units of TFC TVC TC AFC AVC AC MC
output
(1) (2) (3) (4) (5) (6) (7) (8)
0 30 0 30 - - - -
1 30 10 40 30 10 40 10
2 30 18 48 15 9 24 8
3 30 24 54 10 8 18 6
4 30 32 62 7.5 8 15.5 8
5 30 50 80 6 10 16 18
6 30 72 102 5 12 17 22

11. Diagram of TC, TFC and TVC

12. Diagram AC, AVC, AFC, MC

13. Relationship b/t MC and AC
• It can be seen that average variable cost
continues to decline so long as the marginal cost
is below it
• It starts rising at the point where marginal cost
crosses average variable cost
• The marginal cost will always rise more sharply
than the average variable cost
• Similar relation holds between marginal cost and
average cost.

14. Total-Marginal Cost Relationship
• When total cost increases with increasing rate
– Its corresponding marginal cost rises;
• When total cost increases with decreasing rate
– Its corresponding marginal cost is falling
• When total cost has reached maximum
– It corresponding marginal cost is zero

15. Derivation of AC and MC from TC Curve

16. Long Run Average Cost

17. Long Run Average Cost

18. Long Run Marginal Cost

19. Why LAC curve first falls and then rises?
• The LAC curve slopes downward as the scale of
production is enlarged due to various economies
of scale
– Larger scope of specialization of labour
– Increasing use of specialized machinery
– Other technological improvements
• The LAC curve rises after a point because of the
various diseconomies of scale
– E.g. rising cost of the inputs and the difficulty of
management etc.

20. L-shaped Long-run Average Cost Curve
• Rapid technological progress
• Learning to produce at lower cost

21. Quiz
• Define production. What are factors of
productions? Please explain each of them with
their peculiarities.
• What are advantages and disadvantages of
division of labour?
• What is capital formation? Please explain what
are the stages of capital formation
• What was Malthusian Theory and what was
criticism on it?