Cost Concepts

Cost analysis prices out the production relationships of the previous sections. Several different meanings of 'cost' are used, and the Business Economics paper expects a student to distinguish them clearly.

Fixed Cost and Variable Cost

In the short run, the money spent on the fixed factors is Total Fixed Cost ($TFC$) and the money spent on the variable factors is Total Variable Cost ($TVC$).

• Fixed cost does not change with the level of output — it is incurred even at zero output (rent of building, insurance, salary of permanent staff, interest on borrowed capital). It is also called supplementary or overhead cost.
• Variable cost changes directly with the level of output — it is nil at zero output and rises as output rises (raw material, power, wages of casual labour). It is also called prime or direct cost.

Total, Average and Marginal Cost

• Total Cost ($TC$) — the total money spent on all factors to produce a given output.
• Average Cost ($AC$), or cost per unit: $AC = \frac{TC}{Q}$
• Marginal Cost ($MC$) — the addition to total cost from producing one more unit of output: $MC = \frac{\Delta TC}{\Delta Q} = TC_n - TC_{n-1}$ Because fixed cost does not change with output, $MC$ can equally be found from variable cost alone: $MC=\dfrac{\Delta TVC}{\Delta Q}$.

Explicit Cost and Implicit Cost

• Explicit costs are the actual money payments a firm makes to outsiders for factors and services it hires or buys — wages paid, rent paid, price of raw material, interest paid. They are recorded in the account books.
• Implicit costs are the estimated value of the firm's own factors used in the business, for which no payment is actually made to an outsider — the owner's own labour, the owner's own capital, the owner's own premises. They are not entered in the books but are real costs, because those resources could have earned an income elsewhere.

This distinction produces two profit figures:

Because economic cost also charges the firm for its own resources (their opportunity cost — the income forgone in the next-best use), economic profit is always less than or equal to accounting profit.

Money Cost and Real Cost …