Saturday, 28 November 2015

What is Cost and different types of cost in economics

What is Cost?
Cost is the value of inputs employed in producing an output. It includes the cost of materials involved in producing an output along with the labour charges, rent or depreciation of tools involved in producing the output, interest paid or foregone by employing capital and the value of efforts and sacrifices made by the producer in producing the output.

So, cost can be defined as the monetary value of all materials, resources and efforts involved in producing an output along with the value of time, opportunity foregone and risks involved in producing the output.

For example, you may take the example of a housewife preparing food or any particular recipe.

  • The housewife purchases provisions and vegetables, etc. 
  • She invests money in utensils and gas stove and gas. 
  • She labours in the kitchen for some hours to cut the vegetables, cook food and do other activities. 
  • She employs a maid for washing dishes and pays to her periodically. 
  • She sweats in kitchen instead of enjoying in the hall or her bedroom watching the TV or reading books. 
  • Further, she risks the probabilities of cutting or burning her fingers while working. 
  • So all these factors when taken in their monetary value, constitute the cost factor of the food that she prepared.
This is how the cost of any product is assessed. All these elements taken together, constitute the total cost of the product.

Types of costs in economics
The following are the different types of costs in economics signifying different aspects of the cost.

  • Total cost
  • Fixed cost
  • Variable cost
  • Average cost
  • Marginal cost
  • Explicit cost
  • Implicit cost
Now, let us have a look at the features of each and every aspect of these costs.

Total Cost
Total cost refers to the total amount of expenses incurred in producing the output which includes the monetary value of each and every aspect mentioned in the above example of housewife preparing food. It is the cost as a whole of the produce. So, total cost constitutes all the expenses incurred.

Fixed Cost
Fixed cost is a more or less lumpsum cost that is to be incurred irrespective of the quantity or quality of the product that is produced. It does not have any relation with the volume of output. For example, in the above illustration of housewife preparing the food, you can see that the stove is needed irrespective of the quantity of food to be cooked. Again, you need the utensils also for cooking. So, these are fixed expenses which are needed as a base for cooking the food. Again the risk factor and the the labour factor are also there which also constitute fixed cost for most part of it. So, fixed cost includes all salaries and administrative expenses including value of depreciation of assets during that period. These are compulsory expenses incurred irrespective of production.

Here, you should note one point. The fixed cost for smaller quantities of production may be high whereas if the production quantity gets increased, the fixed cost per unit may become less. With same fixed expenses, you can produce more quantities upto some limits.

Variable cost
Variable cost is variable in nature. It depends upon the quantities and qualities of the produce. If food is to be cooked for more people, the expenses increase and for lesser people, it decreases. If, you have to produce high quality food, you need high quality ingredients which are more costlier. So, the cost depends upon these factors.

In the above example of housewife cooking food, the cost of provisions and vegetables and gas consumption can change depending upon the quantity of food to be prepared. If you are cooking for four people, it will be less. But if you cook for 10 people, the total expenses will be much more. This is one variable cost example.

But, on the whole, you should note that the variable cost per unit of food may remain the same. Because, the same quantity of provisions and vegetables are required per head.

Average cost
Average cost refers to the cost per unit of production. It is derived by dividing the total cost with the number of units produced. Suppose in the above example of cooking food, if total expenses incurred are Rs.1,000 and the food is served to 10 people, the average cost per meal is 1000 / 10 = Rs.100 per meal. Or, if total monthly expense for cooking comes to Rs.6,000, then average cost per day is Rs.200 (6,000 / 30 days = 200). And, if 4 people eat per day, then average cost per head is 200 / 4 = 50.

Marginal cost
Marginal cost is the amount of  extra expenditure incurred per addition of one unit of extra product.

Say, for example, a guest visited your home and you cooked one more plate of meals for him. You had to spend some extra rice, dal and vegetables for him. Now, the value of this extra items is the extra money spent by you. All other expenses remained the same. Only you had to put some more effort in cutting vegetables, etc. So, in this case, the marginal cost incurred by is the value of those extra rice, pulses, vegetables and any other extra ingredient used by you. So, this is the notion or concept of marginal cost.

Explicit Cost
Explicit means clearly and physically visible. You are seeing those expenses clearly without any doubt or misunderstanding. You will be paying the amount, can get bills for them and enter the amounts in your records as proof of payments. In the above example, the cost of provisions, vegetables, utensils and payment to your maid are all explicit costs.

Implicit Cost
Implicit means implied or understood. They can not be directly experienced. You are not making direct payments to outsiders to prove those expenses. But, you can evaluate such expenses with the aid of the prevailing market value of such expenses.

In the above example of preparing food by the housewife, you can see that the gas stove and utensils are used for cooking. So, it is an element of cost. If you hire the same things from market to cook food, you might have had to pay some rent. So that much of rent is an implicit cost of the food. Or, you may calculate the depreciation and include that amount as an implicit cost.

So, whatever items you are using in production which are not directly and completely identifiable with production, and you need to calculate the value of those items through other means of calculation; those costs are known as implicit costs.

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