Meaning and Nature of Cost

Every business decision about how much to produce rests on knowing what that production costs. In everyday speech 'cost' simply means money spent, but economic analysis gives the word a more precise, decision-useful meaning.

Money cost and real cost. Money cost is the total money expenditure a firm incurs to produce a given output — payments for raw material, labour, power, rent, interest, and so on. Real cost is a broader, non-monetary idea: the effort, sacrifice and resources society gives up to produce that good. For a firm's own decisions, however, it is money cost that matters, and it is money cost that this chapter builds on.

Explicit cost and implicit cost. Explicit costs are the actual money payments a firm makes to outsiders for the resources it hires — wages to hired workers, the price paid for raw material, an electricity bill, rent paid to a landlord. Implicit costs are the value of the resources the owner supplies from their own pocket, for which no direct payment is ever made — the rental value of a shop the owner already owns, or the salary the owner forgoes by running the business instead of working elsewhere. Ignoring implicit cost understates the true cost of production and can make a barely-surviving firm look more profitable than it really is.

The cost function. Cost is not one fixed number; it changes as output changes. This relationship between output (Q) and total cost (TC) is the cost function, written $TC = f(Q)$. Because a firm cannot instantly change every resource it uses — a workshop's size or its major machinery takes time to expand, while raw material and daily labour can be adjusted almost immediately — economists split the analysis of cost into two time periods.

Short run and long run. The short run is a period during which at least one factor of production, typically plant size or heavy machinery, is fixed, and only the variable factors (raw material, casual labour, power) can be adjusted to change output. The long run is a period long enough for the firm to vary every factor of production, including plant size itself — there is no fixed factor left in the long run. This short-run/long-run split is one of the most frequently tested ideas in the GSEB Std 11 Economics syllabus, because every cost curve studied in this chapter is defined separately for each period.