Theory of Cost Questions and Answers [With PDF]

Every business decision comes back to cost: how much does it cost to make one more unit, and how does that change as output grows? This chapter explains the different types of cost, how to calculate them, why cost curves are U-shaped, and what economies and diseconomies of scale mean. Here are 30 important questions with clear answers and a cost table whose figures are all checked.

This is Chapter 8, the last chapter of our Economics course. It follows Theory of Production.

Meaning and Kinds of Cost

Q1. What is production cost?

Production cost is the money that a producer spends on making a good or providing a service in a given period.

Q2. What is the theory of cost?

The theory of cost studies the relationship between cost and output, that is, how production costs change when output changes.

Q3. What is the money (financial) cost?

The money spent on producing a certain quantity of goods or services at a certain time. It includes wages, raw material costs, rent, interest and similar payments.

Q4. What is explicit cost?

Cash payments made to outsiders for inputs bought from the market, such as wages, interest, rent and raw materials. It is also called accounting cost.

Q5. What is implicit cost?

The value of inputs that the producer supplies himself, for which no cash payment is made. Examples: the salary the owner could have earned elsewhere, and the rent his own building could have earned.

Q6. What is economic cost?

Economic cost includes all explicit costs plus all implicit costs.

Economic cost = Explicit (accounting) cost + Implicit cost

Q7. What is opportunity cost?

The value of the best alternative that is given up when a choice is made. Using your own capital in your business means giving up the interest it could earn in a bank, which is the opportunity cost.

Q8. What is private cost?

The cost a firm bears in producing a good: its explicit and implicit costs. The firm considers it when deciding how much to produce and what price to charge.

Q9. What is social cost?

The cost of an activity to society as a whole. Social cost = Private cost + External cost, where external cost is the harm borne by others, such as pollution from a factory.

Cost Function, Short Run and Long Run

Q10. What is the cost function?

The functional relationship between cost and output, written C = f(Q), where C is the cost of production and Q is the quantity produced.

Q11. What are short-run costs?

The short run is a period in which at least one factor, such as machinery, buildings or the size of the plant, is fixed. Output is changed only by changing variable inputs such as raw materials, labour and power. Costs in the short run therefore have two parts: fixed and variable.

Q12. What are long-run costs?

The long run is a period long enough for all inputs to be changed, and for firms to enter or leave the industry. There are no fixed costs in the long run. All costs are variable.

Q13. What is the difference between short-run and long-run costs?

Short-Run Costs

Q14. What is fixed cost?

Costs that do not change when output changes, even if output is zero. Examples: rent of the factory, interest on long-term loans, insurance, depreciation of machines and salaries of permanent staff. Total fixed cost is written TFC.

Q15. What is variable cost?

Costs that change with the level of output. They rise when output rises and fall when it falls, and are zero when output is zero. Examples: raw materials, wages of production workers and power.

Q16. What is total cost?

The sum of all fixed and variable costs at a level of output: TC = TFC + TVC.

Q17. What is total variable cost?

The total amount spent on variable inputs at a given output, for example labour, raw materials, fuel and the running repairs of machinery. Depreciation and interest on fixed capital are not variable costs, because they are part of fixed cost.

Q18. What is average cost, and what are its types?

Average cost is the cost per unit of output: AC = Total cost / Quantity. There are three kinds:

• Average fixed cost (AFC)
• Average variable cost (AVC)
• Average total cost (ATC)

Q19. What is average fixed cost?

AFC = Total fixed cost / Output. Example: if total fixed cost is 500 and the firm produces 10 units, AFC = 500 / 10 = 50. AFC keeps falling as output rises, because the same fixed cost is spread over more units.

Q20. What is average variable cost?

AVC = Total variable cost / Output. Example: if total variable cost for 10 units is 100, AVC = 100 / 10 = 10.

Q21. What is average total cost?

The total cost per unit: ATC = TC / Q = AFC + AVC. In the examples above, ATC = 50 + 10 = 60.

Q22. What is marginal cost?

The extra cost of producing one more unit: MC = change in TC / change in Q. Example: the cost of 5 pens is 40 and the cost of 6 pens is 48, so the marginal cost of the sixth pen is 48 – 40 = 8. Marginal cost depends only on variable cost, because fixed cost does not change.

Q23. Can you show a full cost table?

A firm has total fixed cost of 100:

Q24. What is the relationship between marginal cost and average cost?

• When MC is below average cost, average cost falls. When MC is above average cost, average cost rises.
• MC cuts the AVC and ATC curves at their lowest points. In the table, MC = AVC = 30 at output 4, which is the minimum AVC. ATC is lowest (54) at output 5, and MC rises above it by output 6 (70 against 56.67).
• AFC always falls as output rises.

Q25. Why are the short-run AVC and ATC curves U-shaped?

At first, adding variable inputs to the fixed plant raises productivity, so unit costs fall (increasing returns). Beyond a point, the fixed plant becomes crowded, so extra inputs add less and less output and unit costs rise (diminishing returns, the law of variable proportions). The curve therefore falls, reaches a minimum and rises.

Long-Run Costs and Economies of Scale

Q26. What is the long-run average cost (LAC) curve?

The long-run average cost curve shows the lowest possible average cost of producing each level of output when all inputs can be changed. It is also called the planning curve, because the firm picks the best plant size for each output. It is made up of points from many short-run ATC curves, and it is typically U-shaped: it falls because of economies of scale and rises because of diseconomies of scale.

Q27. What is the long-run marginal cost (LMC) curve?

The LMC curve shows how total cost changes when one more unit of output is produced and all inputs, including plant size, can be adjusted. It cuts the LAC curve at LAC’s lowest point.

Q28. What are economies of scale?

Cost savings, and so a lower average cost per unit, that a firm gets when it increases the scale of its output or the size of its plant. Main kinds:

• Technical: large machines and better technology.
• Managerial: specialist managers for each function.
• Marketing: advertising and distribution costs spread over more units.
• Financial: big firms can borrow more cheaply.
• Risk-bearing: large firms can spread risk over many products and markets.

Q29. What are diseconomies of scale?

The rise in average cost that happens when a firm grows too large. Causes include management problems such as slow decisions, poor communication, loss of control, and worker motivation falling in a big organization.

Q30. What is the difference between internal and external economies of scale?

Quick Revision Points

• TC = TFC + TVC. AC = TC / Q. MC = change in TC / change in Q.
• Fixed cost is constant. Variable cost changes with output. Long-run costs are all variable.
• MC cuts AVC and ATC at their lowest points.
• Short-run cost curves are U-shaped because of the law of variable proportions. The long-run curve is U-shaped because of economies and diseconomies of scale.
• Internal economies come from the firm’s own growth. External economies come from the industry’s growth.

You have now finished the Economics course. Test yourself with the chapter quiz below, then move on to Management.