When commodities and services are produced, various expenses have to be incurred, e.g., purchase of raw materials, payment to labour, landlord, capitalist, etc. The sum total of the expenses incurred plus the normal profit expected by the producer is called the cost of production. The various concepts of cost are discussed below:
- Nominal Cost and Real Cost: Nominal cost is the money cost of production. The real costs of production are the pain and sacrifices of labour involved in the process of production.
- Explicit and Implicit costs: Explicit costs are the accounting costs or contractual cash payments which the firm makes to other factor owners for purchasing or hiring the various factors. Implicit costs are the costs of self-owned factors which are employed by the entrepreneur in his own business. These implicit costs are the opportunity costs of the self-owned and self-employed factors of the entrepreneur, that is, the money incomes which these self-owned factors would have earned in their next best alternative uses.
- Accounting Costs and Economic Cost: Accounting costs are the actual or explicit costs which are paid by the entrepreneurs to the owners of hired factors and services. On the other hand, economic costs not only include the explicit costs but also the implicit costs of the self-owned factors or resources which are used by the entrepreneur in his own business.
- Opportunity Cost: The opportunity cost (or transfer earnings) of any good is the expected return from the next best alternative good that is forgone or sacrificed. For example, if a farmer who is producing wheat can also produce potatoes with the same factors. Then, the opportunity cost of a quintal of wheat is the amount of output of potatoes given up.
- Business Cost and Full Cost: Business costs include all the expenses which are incurred in carrying out a business. The concept of business cost is similar to the accounting or actual cost. The concept of Full cost includes two other costs: the opportunity cost and normal profit. Normal profit is a necessary minimum earning which a firm must get to remain in its present occupation.
- Private costs and Social Costs: Private costs are the economic costs which are actually incurred or provided for by an individual or a firm. It includes both explicit and implicit costs. Social cost, on the other hand, implies the cost which a society bears as a result of production of a commodity. Social cost includes both private cost and the external cost. External cost includes (a) the cost of free goods or resources for which the firm is not required to pay for its used, e.g., atmosphere, rivers, lakes etc. (b) the cost in the form of ‘disutility’ caused by air, water, and noise pollution, etc.
- Total, Average and Marginal Costs: Total cost refers to the total outlays of money expenditure, both explicit and implicit on the resources used to produced a given output. Average cost is the cost per unit of output which is obtained by dividing the total cost (TC) by the total output (Q), i.e., TC/Q = average cost. Marginal cost is the addition made to the total cost as a result of producing one additional unit of the product. Marginal cost is defined as ?TC/?Q.
- Fixed Costs and Variable Costs: Fixed costs are the expenditure incurred on the factors such as capital, equipment, plant, factory building which remain fixed in the short run and cannot be changed. Therefore, fixed costs are independent of output in the short run i.e., they do not vary with output in the short run. Even if no output is produced in the short run, these costs will have to be incurred. Variable costs are costs incurred by the firms on the employment of variable factors such as labour, raw materials, etc., whose amount can be easily increased or decreased in the short run. Variable costs vary with the level of output in the short run. If the firm decided not to produce any output, variable costs will not be incurred.
- Short-run and Long-run Cost: Short-run costs are the costs which vary with the change in output, the size of the firm remaining the same. Short-run costs are the same as variable costs. On the other hand, long-run costs are incurred on the fixed assets, like plant, building, machinery, land etc. Long-run cost are the same as fixed-costs. However, in the long-run even the fixed costs become variable costs as the size of the firm or scale or production is increased.
Relation Between Marginal Cost(MC) and Average Cost(AC): The relationship between MC and AC may be explained as follows:
- When MC falls, AC also falls but at lower rate than that of MC. So long as MC curve lies below the AC curve, the AC curve is falling.
- When MC rises, AC also rises but at lower rate than that of MC. That is, when MC curve lies above AC curve, the AC curve is rising.
- MC intersects AC at its minimum. That is, MC = AC at its minimum.