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Traditional Theory of Cost

Updated on July 30, 2017
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IRSHAD CV has been a student in Economics. Now he is doing Masters in Economics. He completed B.A. Economics from the University of Calicut.

Introduction

In every economy, demand and supply are two factors which are very vital. Because it is showing the major functions of an economy like production, consumption etc. when we analyze the demand and supply of commodities of an economy, we can derive the equilibrium condition or equilibrium price or quantity of output. To learn about that concept of demand and supply we must know some other related concepts.

Cost is the most important factor which influences the supply of commodities. Since highest cost reduces the profits of the producer it is very important factor consider very seriously by the producer.

The theory of cost is very important in Economics. Now, the theory has two versions like traditional version and modern version. Here the hub is briefly explained the traditional theory of cost.

Concept of costs

When a producer wants to produce commodities, he should contribute the factors of production. Then only he can produce the commodity. Further he required to spend many other expenses like taxes, duties etc. So, the cost refers to the expenditure incurred by a firm to produce goods and services.

Types of costs

On the basis of the nature of the expenditure costs can be classified to many categories. Some of them are described below.

Money costs / explicit costs: simply money costs refers to the total money expenditure incurred by a firm due to its production activities. Wages to labors, salaries to staffs, expenses to purchase raw materials, rent etc. are the examples for money cost. It is also called as explicit costs.

Implicit costs: Sometimes the entrepreneur may bring his own raw materials, buildings, land etc. to the business. In reality he can claim rent for land and building, interest on investment etc. Simply, implicit cost refers to the cost on self owned resources by the producer.

Private and social costs: Private costs refers to the costs which is related to the firm. This is nothing when we sum up both implicit and explicit costs together we can derive private costs.

A social cost is entirely different from private cost. Suppose a factory creates lots of social issues like pollution. So, social cost is nothing, it is the cost incurred in the society.

Opportunity cost: It is defined as the cost of best alternative cost foregone. Consider a field, where a farmer can produce either Rice or Wheat or other crops. When he wants to produce Rice he should sacrifice the others.

Time and Costs

On the basis of time element costs can be classified in to two. They are

a) Short run period

b) Long run period

In short run period the producer cannot change the fixed capital or factors of production like land, building etc. he can vary only variable inputs like labor, power, raw material etc.

On the opposite side in the long run, the producer can change all inputs both fixed and variable, either increase or decrease according to the demand.

Short run Total Costs and Curves

In short run there are three basic concepts of total costs. Namely.

i) Total Fixed Costs (TFC)

ii) Total Variable Costs (TVC)

iii) Total Costs (TC)

Each of them is briefly described with their curves.

i) Total Fixed Costs (TFC)

Total fixed costs refer to those costs which are unable to vary. For example: land, buildings, machinery etc. Even the output is zero fixed costs will be there. Because, this cannot be variable with respect to the level of production. So, it is also called invariable cost. Since fixed costs are fixed or rigid it can be represented through a curve having horizontal shape to output axis as showed in the figure I.

ii) Total Variable Cost (TVC)

On the opposite of fixed inputs some other variable inputs are there. This can change according to the demand for the production. When the demand is high the producer can increase the output by increasing the variable inputs. TVC curve can be represented as shown in the figure – I.

iii) Total Costs (TC)

Total cost is the total expenditure incurred by a firm during the production process. To find out total cost, we can add both variable and fixed costs. TC always varies with the TVC. It begin with the minimum point of TFC as shown in the Figure - I

Short run Average Cost and Curves

There are mainly three units of Average Costs. They are

i) Average Fixed Cost (AFC)

ii) Average Variable Cost (AVC)

iii) Average Total Cost (ATC)

These costs are also known as unit costs. It can be influence the prices and supply of commodities. Any way each of the concepts of Short run Average Costs is briefly shown below with curves.

i) Average Fixed Cost (AFC)

AFC is the average of total fixed costs. AFC can be obtaining by dividing the total fixed cost by total quantity of output each time produced. Mathematically,

AFC = TFC /quantity

TFC will be always fixed. So it will reduce and never reaches zero. It is showed in the Figure – II

ii) Average Variable Cost (AVC)

AVC is the average of total variable cost. It can be find out by using the following formula.

AVC = TFC / quantity

AVC curve will be a ‘U’ shaped one as showed in the figure – II. Which showing that when the output is raises the cost will decline, but after a certain level the cost starts to increases. That is why due to the variable proportion.

iii) Average Total Cost (ATC)

ATC OR AC is the average of total cost. It can be derived by using the formula

AC = TC / quantity.

ATC is also a ‘U’ shaped curve. Because this will varies with the changes in variable costs. The curve of AC can be represented as showing in the Figure – II

Short run Marginal Cost (MC)

When a producer increases the supply or output of commodities, there arose additional cost. So, Marginal Cost refers to the cost adding to Total Cost when production is increases. Hence MC can be finding by using the formula.

MC = change in TC / change in quantity

Marginal Cost curve is also a ‘U’ shaped one. it can be represented as showing in the Figure – II.

In the Figure – II short run average costs and MC curves are showed. Where AFC has a shape of rectangular hyperbola. And all other curves have a ‘U’ shaped curve.

An important thing noted that, the relationship between SAC and SMC. Where when SAC decline SMC also follows. When SAC reaches at its minimum point, SMC cut SAC from below through the minimum point of SAC.

Long run Cost Curves

Long run refers to, a firm can vary all inputs even fixed inputs. Mainly two concepts of costs are came under the long run. They are

i) Long run Average Cost (LAC)

ii) Long run Marginal Cost (LMC)

Each of them are separately described below.

i) Long run Average Cost ( LAC)

LAC is the sum up of each short run average costs (SAC). LAC showing the average cost for producing per unit of output. So, when we add each of the SAC curve we can develop LAC curve. So, this is also called as envelop curve. It is the planning curve because it enables the producer in decision making. The minimum point of LAC curve is more profitable to producer. LAC curve can be represented in the Figure – III

II) Long run Marginal Cost (LMC)


Since each of the SMC curves passes through the minimum point of SAC, we can draw many SMC curves. But LMC curve will be one which passes through the minimum point of LAC. It is showed in the Figure – IV.

In the Figure IV, the minimum point of LAC is the point which enables the producer to penetrate maximum profits. LMC curve cuts LAC from below through its minimum point.

Conclusion

In the traditional theory of cost, all the average cost curves having ‘U’ shape. In which the producer can earn maximum at a specific point. That is the minimum point of SAC curve in short run and LAC curve in long run.

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      Nkwuo Christian 9 months ago

      Thanks a lot for the help....so much appreciated

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      Aarti Rana 12 months ago

      This is really vry helpul to all the students.