A producer has to work very hard to produce a good or service. He has to make a lot of effort in the process. In the beginning, the producer must arrange money to organise the production activity. Various factors in the form of land, labour, and capital are required to produce goods. These factors are not available for free. The producer must purchase them in the right quantity needed for production.
Similarly, raw materials and other things have to be purchased and stored. To purchase these things, the producer must be ready to pay the price for them. Once the goods or services are produced, the producer sells them in the market to various consumers. At this time, the consumers pay price to the producer to purchase the goods and services. With this the producer starts earning money.
So, in order to produce goods and services, the producer first incurs expenditure to purchase factors of production and then receives money from the consumers by selling those goods and services to them.
Cost is defined as the money expenditure incurred by the producer to purchase (or hire) factors of production and raw materials to produce goods and services. In a way, cost is a kind of sacrifice made by the producer.
For example, a farmer who is producing rice or paddy. It normally takes 5 to 6 months to produce rice. The production of rice involves the following:
How does the farmer get land? It could be possible that, the farmer has ancestral land. Otherwise he has to hire land from others by paying rent. He has also the option of purchasing land by paying a very heavy amount. In the present example, the farmer hires 5 acres of land on rent.
The farmer also needs labourers to work on the field for 5 months. Let us say the farmer hires 4 labourers. In order to hire a labourer, the farmer must pay wage. To grow the crop, the farmer uses some raw materials such as seeds, water, fertilizer, pesticicdes. He also uses tractor for which he pays rent.
There are different types of cost:
1. Fixed Cost
Fixed cost is defined as the expenditure, on hiring or purchasing of fixed factors/ inputs, which are compulsory and has nothing to do with the amount of production of the good or service.
For example, rent paid by the farmer to the owner of the land. Similarly, rent paid for the use of tractor is also a fixed cost.
2. Variable Cost
Variable cost is defined as the expenditure on variable factors/ inputs, such as labour, which can be changed.
3. Explicit Cost
Explicit cost is defined as the money expenditure incurred by the producer for production. Explicit cost is defined as the money expenditure incurred by the producer on both fixed and variable factors of production and raw materials. These are direct payments and are properly calculated and recorded separately.
For example, both the rent and wages paid by the farmer and the expenditure on raw materials are also called explicit cost.
4. Implicit Cost
Besides purchasing factors of production and raw materials, the producer also uses his own factors and materials for producing goods and services. For this he does not pay any money to himself. But he bears this expenditure indirectly.
For example, a farmer uses his own tractor to cultivate land. Had he hired a tractor from somebody else, he would have paid rent for this. In that case it would have been called explicit cost of the farmer.
Implicit cost is the cost of self supplied factors. The value of such cost has to be calculated on the basis of market value.
Total cost is the sum of total fixed cost and total variable cost which are given explicitly. Average total cost or simply the average cost is the ratio of total cost to the total output.
Total Cost (TC) = Total Fixed Cost + Total Variable Cost
Average Cost (AC) = Total Cost/Total Output
Average Cost is the cost per unit of output.
If the producer wants to increase output, then he has to engage extra units of labour. Extra units of labour will lead to extra expenditure on wage paid to the labour. As a result the total cost of production will increase.
Increase in total output will lead to increase in total cost of production. Marginal cost is defined as increase in the total cost due to increase in one extra unit of output.
Example: Suppose a tailor makes 10 pieces of shirts by incurring a total cost of Rs. 1110. Then he increased shirt production to 11 pieces for which he incurred Rs.1199 as total cost. What is the marginal cost?
Here, increase in output is 11-10 = 1 unit. Because of increase in output by one unit, cost increase is Rs.1199 - Rs.1100 = Rs.89.
While there is one value of marginal cost, we can compute two different values of average cost. First value of average cost relates to 10 pieces of shirts. With a total cost of Rs. 1110, AC = 1110/10 = Rs. 111.
Second value of average cost relates to output of 11 shirt pieces with total cost of Rs. 1199. Here, AC = 1199/11 = Rs. 109.
Average cost is calculated for every given level of output. On the other hand, marginal cost is calculated when a given level of output is increased by one unit. That is, marginal cost is calculated between two successive levels of output.