Cost Concepts

Statement

A firm’s cost of production comprises explicit costs and implicit costs.

• Explicit cost — a cost incurred when an actual monetary payment is made (e.g. rent paid to a landlord, wages paid to workers).
• Implicit cost — an opportunity cost incurred in terms of the next best alternative forgone from making an economic decision (e.g. the rent a firm forgoes by using a building it owns rather than leasing it out).

The cost concepts used to analyse a firm are:

• Total Cost (TC) — the total cost of producing a given output; the sum of total fixed cost and total variable cost: $TC = TFC + TVC$.
• Total Fixed Cost (TFC) — the cost of fixed factors of production, which does not vary with output (e.g. rentals, factory equipment).
• Total Variable Cost (TVC) — the cost of variable factors of production, which varies positively with output (e.g. labour, raw materials).
• Marginal Cost (MC) — the additional cost incurred from producing an additional unit of output.
• Average Cost (AC) — the cost per unit of output: $AC = AFC + AVC$, equivalently $AC = TC / Q$.
• Average Fixed Cost (AFC) — the fixed cost per unit of output.
• Average Variable Cost (AVC) — the variable cost per unit of output.

Notes

Whenever H2 Economics refers to “cost” in analysis, it means economic cost — explicit plus implicit cost — unless stated otherwise. Implicit cost is the opportunity cost of the firm’s own resources, which is why a firm covering only its explicit costs is not yet breaking even in the economic sense.

The split into fixed and variable is a short-run distinction: the short run is a period in which at least one factor is fixed, so some cost cannot be varied with output, whereas in the long run all factors — and hence all costs — are variable. How these magnitudes are deployed in analysis is set out in short-run and long-run costs.