Question

#1 Please discuss the importance of cost function in economics ?

#2 Discuss also explicit, implicit cost and marginal cost.

#3 Give an example of an opportunity cost that an accountant would not count as a cost. Why would the accountant ignore this cost?

#4 What is marginal product, and what does it mean if it is diminishing?

#5 Define total cost, average total cost, and marginal cost. How are they related?

Answer 1

1. Cost function shows the functional relation between the cost and level of output. It expresses how cost varies with different level of output. The cost function can be expressed as C_q= f(Q_f P_f). C_q is the total cost, Q_f is the quantities of inputs employed and Pf is the price of inputs.

To a firm the cost function is so important because it is the cost that determines the supply of product made by the firm. The cost function helps for the allocation of resources for various alternative uses. The profit of a firm depends upon the variation in cost and prices. While the price remains constant a fall in cost increase the supply of the product and the firms allocate more resources for the production of that particular product. On the other hand if the cost of production of a product increases the firm allocates less resource in production of that product. Thus a cost function helps the firms to determine the allocation of resources among the various alternatives.

The cost function helps the firm to determine the optimum level of output and price. Each firm choose to produce the level of output where its marginal cost is equal to price.

The cost function helps the firm to choose the optimum level of plant size to produce a given level of output. The analysis of longrun average cost helps the firms to achieve the cost reduction either by the economies of scale or scope.

2. Implicit cost is the value imputed on the use of self owned service of an entrepreneur in production. The value is imputed and there is no direct cash payment for it. For example the use of self owned land, capital funds and entrepreneurial ability are valued in a business. The value assigned to such factor or service does not involve the payment of cash. These cost considered only in the valuation of economic profit.

The price paid for the hired factor or services which involve direct cash payments are called explicit cost. In the calculation of accounting profit only the explicit costs are taken. But in the calculation of economic profit both implicit and explicit cost are taken.

Economic profit = Total Revenue -Implicit cost+ Explicit cost.

Accounting profit = Total Revenue – Explicit cost.

Marginal cost is the additional cost incurred by a firm for an additional unit of output. MC= ∆TC/∆Q

3. The calculation of accounting profit takes only the explicit cost which arises out of direct cash payment. The implicit cost are the opportunity cost of self owned factor or services which would otherwise have been obtained unless used in the own business of an entrepreneur. For example the remuneration of the entrepreneurial ability of a person which is used in his own business is the opportunity cost of using the ability outside his business premises. Since no payment is used for such self rendered services, an accountant does not count this cost.

4. Marginal product is the additional product from the employment of an additional labour. It is the product obtained from the last unit of labour. Marginal product of labour is calculated by the formula: MPL= ∆TP/∆L. In the initial stage of production the marginal product increases. Because the workers are more efficient and the given capital and equipments are more sufficient in such a way as to increase the productivity of an additional labour. But after a stage the marginal product decreased due to the operation of diminishing returns. The workers become congested and the available capital becomes insufficient for the congested workers. Thus the additional contribution of additional labour decreases or marginal product decreases.

5. Total cost is the sum of expensed incurred by a firm to produce a given level of output. It is the sum of fixed cost and variable cost. TC=TFC+TVC. Average total cost is the cost per unit of output. ATC=TC/Q. Marginal cost is the additional cost incurred by a firm to produce an additional unit of output. It is the cost of last unit produced. MC=∆TC/∆Q.

There is a relation between total cost and marginal cost and marginal cost and average total cost.

It is the change in marginal cost that makes changes in total cost. When marginal cost is diminishing, the total cost increases at a diminishing rate. When marginal cost is increasing, total cost increased at an increasing rate. When marginal cost reaches its lowest point, total cost stop increasing at a diminishing rate.

The change in marginal cost also exerts it influence in the changes in average total cost. When marginal cost is lower than the average total cost, the average total cost falls. When marginal cost is greater than the average total cost, the average total cost increases. Average total cost does not change when marginal cost is equal to the average total cost.