Crux First
What to remember for MCQs
- Cost = Monetary value of resources used.
- Explicit cost vs Implicit cost is very important.
- Accounting cost is not equal to Economic cost.
- Fixed vs Variable cost is the core short-run concept.
- TC = TFC + TVC
- AFC, AVC, ATC and MC relationships are very frequently asked.
- MC cuts ATC and AVC at their minimum point.
- Cost curves mainly follow U-shaped logic.
- Opportunity cost = next best alternative forgone.
- Shutdown point = minimum AVC.
1. Meaning of Cost
Basic Idea
- Cost means the value of inputs used in production.
- It includes payments made for resources such as labour, materials, land and capital.
Examples
- Labour wages
- Raw material
- Rent
- Interest
2. Types of Cost
1. Explicit Cost
- Explicit costs are paid in cash.
- They are recorded in the books of accounts.
- Examples: wages, rent, electricity charges.
2. Implicit Cost
- Implicit costs are not paid in cash but represent the opportunity cost of own resources.
- Examples:
- Rent of own building
- Owner’s salary
Economic Cost = Explicit Cost + Implicit Cost
Accounting Cost = Only Explicit Cost
Very Frequently Asked: Economic cost includes both paid-out cost and the value of self-owned resources. Accounting cost includes only paid-out expenses.
3. Opportunity Cost
Definition
- Opportunity cost is the value of the next best alternative sacrificed.
Example
- If a machine is used for Product A instead of Product B, then profit from Product B is the opportunity cost.
MCQ Trap
- Opportunity cost is not historical cost.
- It is not accounting cost.
- It is a future-oriented decision concept.
4. Fixed Cost vs Variable Cost
Fixed Cost (TFC)
- Fixed cost does not change with output.
- It exists even when output is zero.
- Examples: rent, salary of permanent staff.
Variable Cost (TVC)
- Variable cost changes with output.
- Examples: raw material, power.
TC = TFC + TVC
Direct MCQ: Total cost is always equal to total fixed cost plus total variable cost.
5. Short Run Cost Concepts
1. Total Cost (TC)
TC = TFC + TVC
2. Average Fixed Cost (AFC)
AFC = TFC / Q
- AFC always falls as output rises.
- Reason: fixed cost gets spread over more units.
3. Average Variable Cost (AVC)
AVC = TVC / Q
- AVC is generally U-shaped.
4. Average Total Cost (ATC)
ATC = TC / Q
ATC = AFC + AVC
5. Marginal Cost (MC)
MC = Change in TC / Change in Q
- Marginal cost mainly depends on change in variable cost, because fixed cost does not change.
6. Cost Curve Relationship
Most Important MCQ Logic
- MC < ATC → ATC falls
- MC = ATC → ATC is minimum
- MC > ATC → ATC rises
Same logic applies to AVC also.
Super Important
- MC cuts ATC at its minimum point.
- MC cuts AVC at its minimum point.
One of the most repeated ICAI MCQs.
7. Shape of Cost Curves
Why U-Shape?
- Phase 1: Better efficiency leads to falling cost.
- Phase 2: Diminishing returns lead to rising cost.
Logic: Same base logic as the law of production in the short run.
| Curve |
Shape |
| AFC |
Always downward |
| AVC |
U-shaped |
| ATC |
U-shaped |
| MC |
U-shaped |
8. Long Run Cost
- In the long run, all costs are variable.
- There is no fixed cost in the long run.
- Main concept tested here is economies of scale.
Types of Economies
- Internal Economies
- Better machinery
- Specialisation
- External Economies
- Industry growth
- Infrastructure development
Diseconomies
- Management issues
- Coordination problems
9. Shutdown Point
Definition
- A firm continues production if Price ≥ AVC.
- If Price < AVC, the firm should shut down.
Shutdown Point = Minimum AVC
Break-even Point = Minimum ATC
MCQ Gold Point
- Shutdown point = minimum AVC
- Break-even point = minimum ATC
10. Other Important Cost Types
1. Sunk Cost
- Already incurred
- Cannot be recovered
- Should be ignored in decision making
2. Incremental Cost
- Extra cost arising due to a change in decision or output.
3. Replacement Cost
- Cost of replacing an existing asset.
4. Historical Cost
- Original purchase cost of an asset.
MCQ Trap: Historical cost is not necessarily relevant for present decision making.
Final Quick Revision
1-minute recall before the exam
- Economic cost = Explicit + Implicit
- Opportunity cost = next best alternative forgone
- TC = TFC + TVC
- AFC always falls
- MC cuts ATC and AVC at the minimum point
- Shutdown point = Price = AVC
- Break-even point = Price = ATC
- Sunk cost = ignore in decision making
