RAWAL COMMERCE CLASSES

+2 Economics
( Chapter: Cost)
Sudha Rawal Trishi Rawal
9417580925 8837663263
Cost:
Expenditure incurred on producing input is called Cost. Cost is economics is sum, total of Explicit Cost
+ Implicit Cost.
Explicit Cost Implicit Cost
1. It is payment mode to outsider for hiring 1. Cost of self supplied factors.
factor services 2. It involves inputted value of factors
2. It involves actual money payment on buying owned by firms. There is no money
a hiring inputs. payment involved.
3. Payment of wages, rent, insurance 3. Interest on capital, Rent of own land.
premium.

So cost is economics includes actual expenditure on inputs ( explicit cost) and inputted value of
inputs supplied by owners (implicit cost)

Short Run Cost:

Short run cost is of two types.
Fixed Cost Variable Cost
1. Fixed Cost is also known as Overhead 1. Variable Cost is also known as Prime Cost
Cost, Supplementary Cost and General and Direct Cost.
Cost. 2. Variable cost refers to that level of output
2. Fixed cost refers to those costs which do which vary directly with level of outputs.
not vary directly with level of output. 3. Such cost are incurred till there is
3. Fixed cost remains same whether output production and become Zero at Zero level
is small, large or zero. of output.
4. Example: Rent, interest on loan, salary of 4. Example: Payment of raw material,
staff power, fuel, labour.

Output 0 1 2 3 4 5
TFC 12 12 12 12 12 12
TVC 0 6 10 15 24 35

Total Cost:
Total expenditure incurred by sum on factor of production of commodity.
TC=TFC+TVC

TOTAL VARIABLE COST Vs TOTAL FIXED COST

Total Variable Cost Total Fixed Cost
Meaning Total variable cost refers to those which They do not vary directly.
vary directly.

Time Period It can be changed in Short Run. It cannot be changed in Short

Run.
 Cost at output It is Zero when there is no production. It can never be Zero even when
there is no production.
Shape of Curve It is inversely S-shaped as variable cost TFC is horizontal straight line
initially increases at decreasing rate, parallel to X-axis, fixed cost
then at constant rate X then at remains same at all levels of
increasing rate. output.

Eg. Wages of casual labour, Pay of raw Building rent, Insurance Premium.
material.

TVC curve is inversely S-shaped:

It is because TVC initially increases at decreasing rate and later it increases at increasing rate.
• Initially TVC rises at decreasing rate because of better utilisation of fixed factor and increase in
efficiency of variable factors.
• Thereafter, TVC rises at an increasing rate because of fall in efficiency of variable factors due to
limitation of fixed factors.
RELATION BETWEEN TOTAL COST, TOTAL FIXED COST AND TOTAL VARIABLE COST
1. TFC curve is a horizontal straight line parallel X-axis as it
remains constant at all levels of output.
2. TC & TVC curves are inversely S-shaped because they rise
initially at a decreasing rate. The reason behind their
shape is the Law of Variable Properties.
3. At Zero output, TC is equal to TFC because there is no
variable cost at 0 level of output. SO TC & TFC curves
start from the same point, which is above the origin.
4. The vertical distance between TFC curves & TC curves is
equal to TVC & TVS rises with increase in the output, the
distance between TFC & TC curves also goes on
increasing.
5. TC & TVC curves are parallel to each other and the vertical distance between them remains
the same at all levels of output because the gap between them represents TFC, which remains
constant at all levels of output.
Table: Total Cost schedule
Output (Units) Total Fixed Cost or Total Variable Cost or Total Cost or TC (₹)
TFC (₹) TVC( ₹) TFC + TVC = TC
0 12 0 12 + 0 = 12
1 12 6 12 + 6 = 18
2 12 10 12 + 10 = 22
3 12 15 12 + 15 = 27
 4 12 24 12 + 24 = 36
5 12 35 12 + 35 = 47
AVERAGE COST

Average Fixed Cost: Per unit fixed cost of production i.e. PFC= TFC/Q
Average Variable Cost: Per unit variable cost of production i.e.
PVC=TVC/Q
Average Cost: Per unit total cost of Production i.e. AC=TC/Q
Table: Average Cost
Output AFC AVC AC(₹)
(In Units) (₹) (₹) AFC + AVC = AC
0 ∞ -- --
1 12 6 12 + 6 = 18
2 6 5 6 + 5 = 11
3 4 5 4+5=9
4 3 6 3+6=9
5 2.40 7 2.40 + 7 = 9.40

AVERAGE FIXED COST:

Q: Why AFC does not touch X-axis?
Ans: Because TFC can never be zero at any level of output.
Q: Why AFC does not touch Y-axis?
Ans: Because at zero level of output TFC is positive values and
any positive value divided by 0 will be infinity.
Q: Why AFC is rectangular hyperbola?
Ans: Because arc curve remains same at all the points.
Table: Average Fixed Cost
Output TFC (₹) AFC (₹)
TFC ÷ Output = AFC
0 12 12 ÷ 0 = ∞
1 12 12 ÷ 1 = 𝟏𝟐
2 12 12 ÷ 2 = 𝟔
3 12 12 ÷ 3 = 𝟒
4 12 12 ÷ 4 = 𝟑
5 12 12 ÷ 5 = 𝟐. 𝟒

AVERAGE VARIABLE COST (AVC)

Q:Why AVC is U-shaped?
Ans: It is U-shaped as it falls due to increasing returns to factor.
After reaching its (maximum level optimum level) it starts
increasing due to Law of Variable Cost.
Q: Why AC ids U-shaped?
Ans: It is U-shaped as it falls due to increasing return to factor.
After reaching its (maximum level- optimum, level) it starts
increasing due to Law of variable production.
Table: Average Variable Cost
Output 0 1 2 3 4 5
TVC (₹) 0 6 10 15 24 35
 AVC (₹) -- 6÷1=6 10 ÷ 2 = 5 15 ÷ 3 = 5 24 ÷ 4 = 6 35 ÷ 5 = 7
TVC ÷ Ouput = AVC

Relationship Between AC, AFC and AVC

• AC curve lie above AVC curve because AC, at all levels of
output include both AVC & AFC.
• As the output increase the gap between AC and AVC
decreases but never interest each other.
• It happens because vertical distance between them is AFC,
which can never be 0.
• AVC reaches its minimum point (pt. B) which is a level lower
than that of AC (pt. A)
Because when AVC at its minimum point, AC is still falling
because of falling of AFC.

Marginal Cost: It is additional cost, when one more unit of

output is produced.
∆𝑇𝑉𝐶
𝑀𝐶 =
∆𝑄
MC is not affected by fixed cost.
We know MC is addition to TC, when one more unit of output is
produced. We also know TC= TFC + TVC. As TFC does not change
in change in output, MC is independent of TFC and is affected
only by change in TVC.
MC is U-shaped curve due to Law of Variable Productions (i.e.
due to operations of returns to a factor input). Initially, units of
variable factor are employed with the fixed factor which field increase returns and reduces the
addition of variable factors leads to in thereby increase MC after reading to its minimum level. As a
results MC curve falls to its minimum level and then rise.
Table: Marginal Cost
Output TVC TFC TC MC ( In ₹) MC( In ₹)
(Units) (₹) (₹) (₹) MCn = TCn -TCn-1 MCn = TVCn -TVCn-1

0 0 12 12 -- --
1 6 12 18 18 – 12 = 6 6–0=6
2 10 12 22 22 – 18 = 4 10 – 6 = 4
3 15 12 27 27 – 22 = 5 15 – 10 = 5
4 24 12 36 36 – 27 = 9 24 – 15 = 9
5 35 12 47 47 – 36 = 11 35 – 24 = 11
Relationship between AC and MC :
• When MC < AC, AC falls with increase in output till 3 units.
• When MC= AC, when MC & AC curves interest each other at
point A, AC is constant and at its minimum point.
• When MC > AC, AC rises with rise in output from 5 units of
output.
• Therefore, AC & MC rise, but MC rises at faster rate as
compared to rise in AC.
So, MC curve is curve as compared to AC.

Table: Relationship between AC and MC

Output 0 1 2 3 4 5
MC -- 6 4 5 9 11
TC 12 18 22 27 36 47
AC -- 18 11 9 9 9.40
Phase I (MC< AC) I (MC< AC) I (MC< AC) I (MC< AC) II (MC=AC) III (MC>AC)

Q: Can AC rise when MC is falling?

Ans: No, Ac cannot rise when MC is falling because when Mc falls, Ac will also fall.
Q: Can AC fall when MC is rising?
Ans: Yes, AC can fall when MC is rising. It is only possible when MC<AC. S long as MC curve is below
AC curve, Ac with fall even when MC is rising.
𝑇𝐹𝐶
𝐴𝐹𝐶 =
𝑄
𝑇𝑉𝐶
𝐴𝑉𝐶 =
𝑄
𝑇𝐶
𝐴𝑐 =
𝑄
𝐴𝐶 = 𝐴𝐹𝐶 + 𝐴𝑉𝐶
𝑇𝐶 = 𝑇𝐹𝐶 + 𝑇𝑉𝐶
∆𝑇𝑉𝐶
𝑀𝐶 =
∆𝑄
Relationship Between TC and MC
1. MC is the addition to TC, when 1 more unit of output is produced. MC is
calculated as MCn = TCn -TCn-1
2. When TC rises at a diminishing rate MC declines.
3. When the rate of increase in TC stops diminishing MC is at its minimum point
i.e. pt. E.
4. When the rate of increase in TC starts rising, the Mc is in increasing.

Relationship between TVC and MC

We know, MC is addition to TVC when more units of output is produced. So TVC
can be obtained as summation of MC’s of all the units produced if output is
assumed to be perfectly divisible then total area under the MC curve will be
equal to TVC.
Relationship Between AVC and MC
The relationship between AVC and MC is similar to that of AC and MC.
• Both AVC and MC are derived from TVC. AVC refers to TVC per unit of
output and MC is addition to TVC where one more unit of output is
produced.
• Both AVC and MC curves are U-shaped due to Law of Variable
Production.
Table: Relationship between AVC and MC
Output 0 1 2 3 4 5
TVC (₹) 0 6 10 15 24 35
AVC (₹) -- 6 5 5 6 7
MC (₹) -- 6 4 5 9 11
Phase I(MC<AVC) I(MC<AVC) I(MC<AVC) I(MC< AVC) II (MC=AVC) III (MC>AVC)

Relationship between AC, AVC and MC

1. AC is greater than AVC by the amount of AFC.
2. The vertical distance between AC and AVC curves
continues to fall with increase in output below the gap
between them is AFC which to decline.
3. AC and AVC curves never intersect each other as AFC can
never be zero.
4. Both Ac and AVC curves are U-shaped are to Law of
Variable Production.
5. MC curve cuts AVC and AC at their minimum point.
6. The minimum point of AC curve lies always to the height
of the minimum point of AVC curve.
Table: Relationship Between Ac, AVC and MC
Output(Units) 0 1 2 3 4 5
TVC ( In ₹) 0 6 10 15 24 35
AC ( In ₹) -- 18 11 9 9 9.40
AVC ( In ₹) -- 6 5 5 6 7
MC ( In ₹) -- 6 4 5 9 11

IMPORTANT QUESTIONS:

1. At what level of production is total cost equal to total fixed cost?

Ans: At zero level of output.
2. When AC curve slopes downwards, what will be the position of MC curve?
Ans: MC curve will be below the AC curve.
3. What happen to AC when MC is equal to AC?
Ans: Ac is constant at its minimum points.
4. Can AC and AVC curves touches each other?
Ans: No because of difference between AC and AVC is AFC and AFC can never be zero.
5. Why is average total cost greater than average variable cost?
Ans: Average total cost (ATC) is greater than average variable cost (AVC) because ATC also include
average fixed cost (AFC) in addition to AVC at all level of output.
 6. What is the relation between marginal cost and average variable cost when marginal cost is
rising and average variable cost is falling?
Ans: Marginal Cost is less than Average Variable Cost.
7. What is the relation between marginal cost and average cost when average cost is constant?
Ans: Marginal Cost is equal to Average Cost.
8. What is the relation between marginal cost and average cost when average cost is rising?
Ans: Marginal Cost is more than Average Cost.
9. What is the relation between Average Variable Cost and Average Total Cost, if Total Cost is
zero? Ans: Average Variable Cost is equal to Average Total Cost.
10. What happens to the difference between Average Total Cost and Average Variable Cost as
production is increased?
Ans: The difference between Average Total Cost and Average Variable Cost decrease.
11. What happens to the difference between Total Cost and Total Variable Cost as output is
increased?
Ans: The difference between Total cost and Total Variable Cost remains constant.
12. Why are TC and TVC curves parallel to each other?
Ans: TC and TVC curves are parallel to each other because the vertical gap between them
represents TFC which remains constant at all levels of output.
13. What does the area under the marginal cost curve show?
Ans: Area under the marginal cost curve shows total variable cost.
14. Identify implicit cost and explicit cost in each of the individual cases:
(i) A producer borrows money and open a shop. The shop premises is owned by him.
Ans: “ Imputed rent of the shop” is the implicit cost as owner would have earned rent if he
had given his shop on rent. “ Interest paid on the borrowed money” is the explicit cost as it
is actual money expenditure on output.
(ii) A woman borrows money from a bank and starts a business in a building owned by her.
She manages the business herself.
Ans: Interest paid on the borrowed money is explicit cost because it is recorded in accounts.
Imputed rent of the owner’s building is implicit cost because it is not actually paid by the
owner. Imputed salary pf the owner is implicit cost because the owner does not actually
receive any salary.
15. “The gap between AC and AVC keeps on decreasing with rise in output, but they never meet
each other.” Comment.
Ans: The given statement is correct. The gap between Ac and AVC keeps on decreasing because
the difference between them is AFC, which falls with increase in output. However, AFC can never
be zero. Therefore, AC and AVC can never meet each other.
16. “MC can be calculated both from total cost and total variable cost and is not affected by total
fixed cost.” Discuss.
Ans: The given statement is correct. MC is not at all affected by total fixed cost (TFC). MC is
addition to TC or TVC when one more unit of output is produced As TFC remains same with
increase in output. MC is independent of fixed cost and is affected just by change in variable
cost.
17. Classify the following as fixed cost and variable cost:
(i) Payment of insurance premium for insurance of factory. / Fixed Cost.
(ii) Interest on loan taken from ICICI. / Fixed Cost.
(iii) Payment of fuel used in machine. / Variable cost.
18. Answer the following questions:
(i) Why does AFC curve never touch the X-axis?
Ans: AFC curve never touches the X-axis as TFC can never be zero.
(ii) Why does TVC curve start from origin?
Ans: TVC curve starts from origin because TVC is zero at zero level of output.
(iii) Why AC, AVC and MC curves are U-shaped?
Ans: AC, AVC and MC curves are U-shaped because of Law of Variable production.
(iv) Why are the gap between TC curve and TVC curve remains constant with rise in output?
Ans: The gap between them is TFC, which remains same with rise in output.
(v) Why does AC curve lie above the AVC curve?
Ans: AC curve lies between the AVC curve because AC includes both AVC and TFC at all levels
of output.
(vi) Why does TC curve and TFC curve start from the same point above the origin?
Ans: It happens because both TC and TFC are same at zero level of output.
19. What does the Average Fixed Cost Curve look like? Why does it look so?
Ans: The Average Fixed Cost (AFC) Curve looks like a rectangular hyperbola. It happens because
same amount of fixed cost is divided by increasing output. As a result, AFC curve slope
downwards and is rectangular hyperbola, i.e. area under AFC curve remains same at different
points.
20. Why does the SMC curve cut the AVC curve at the minimum point of the AVC curve?
Ans: It happens because when AVC falls, SMC is less than AVC. When AVC starts rising, SMC is
more than AVC. So, it is only when AVC is constant and at its minimum point, that SMC is equal
to AVC. Therefore, SMC curve cuts AVC curve at its minimum point.
21. Dr. Vivek Aggarwal is running a dental clinic at his home. He has invested ₹ 2,00,000 as capital
and gas also borrowed ₹ 1,00,1000 from Axis Bank at an interest rate of 9% p.a. He has also
fixed an assistant at a monthly salary of ₹ 12,000. The estimated monthly rental of his clinic is
₹ 25, 000. Calculate the annual implicit and explicit cost if imputed annual value of services of
Dr. Vivek Aggarwal in ₹ 4,00,000.ss
Ans: (a) Calculation of Annual Explicit Cost
Amt. (₹)
Interest on borrowing of ₹ 1,00,000 @ 9% per annum 9,000
Amount Salary of Assistant (₹ 12,000 X 12) 1,44,000
Total Explicit Cost 1,53,000

(b) Calculation of Annual Implicit Cost

Amt. (₹)
Imputed interest on own capital (₹ 2,00,000 X 9%) 18,000
Annual rental value of clinic (₹ 25,000 X 12) 3,00,000
Imputed annual value of services of owner 4,00,0000
Total Implicit Cost 7,18,000

22. Find Out (a) explicit cost and (b) Implicit cost from the following:
Particulars (₹ in Thousand)
Investment in fixed cost 2,000
Borrowings at 12% Interest per annum 1,500
 Wages paid during the year 120
Annual rental value of the owner factory building 100
Annual depreciation 100
Estimated annual value of the management services of owner 240

Ans: Calculation of Explicit Cost

(₹ in Thousand)
Interest on borrowing of ₹ 1,500 @ 12% per annum 183
Wages paid during the year 120
Annual depreciation 100
Total explicit Cost: 400

Calculation of Implicit cost:

(₹ in Thousand)
Imputed interest on own funds (2,000 – 1,500) @ 12% per 60
annum
Annual rental value of the owner factory building 100
Estimated annual value of the management services of owner 240
Total Implicit Cost: 400