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.

Meaning of Cost 

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.

Types of Cost

There are different types of cost:

  1. Fixed cost
  2. Variable cost
  3. Explicit cost
  4. Implicit 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.

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.

4. Implicit Cost

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 and Average Cost

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.

Marginal Cost (MC)

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.