Theory of Cost Class 12 Economics Notes and Questions

Please refer to Economics Theory of Cost Class 12 Economics Notes and important questions below. The Class 12 Economics Chapter wise notes have been prepared based on the latest syllabus issued for the current academic year by CBSE. Students should revise these notes and go through important Class 12 Economics examination questions given below to obtain better marks in exams

Theory of Cost Class 12 Economics Notes and Questions

The below Class 12 Theory of Cost notes have been designed by expert Economics teachers. These will help you a lot to understand all important topics given in your NCERT Class 12 Economics textbook.

Question. Define cost in economics.
Ans. In economics, cost is defined as the sum of explicit cost and implicit cost.

Question. Define explicit cost, implicit cost and opportunity cost.
Ans. Explicit Cost: It refers to that cost which is paid to outsider for using their factor services. Example, rent paid to landlord for the services of building, interest paid on capital borrowed, etc.
Implicit Cost: It refers to the cost of self-supplied factors. In other words, it is the imputed value of those factor services which are provided by the owner himself. Example, Interest forgone on the capital invested by the owner, imputed rent of the building, etc.
Opportunity Cost: It is the cost of next best alternative which is forgone/sacrificed. In other words, it is the amount of other good which is sacrificed for the production of given good.

Short Run Cost Theory

Question. Explain various concepts of short run cost theory.
Ans. 1. Fixed Cost: Those cost which do not change with change in the output level in the short run are called fixed cost.
Thus, fixed cost remains constant irrespective of increase and decrease in output level. Example, rent on building, Interest on loan, salary to permanent employees, insurance premium, etc.
It is also called overhead cost and supplemantary cost.

TFC curve is horizontal in shape, i.e. parallel to x-axis and fixed cost can never become zero even at zero level of output.

2. Variable Cost: Those cost which varies directly with the change in output level, called variable cost. So, variable cost increases with increase in output level and vice-versa. Example, Expenditure on raw material, wages to daily worker, fuel and power, etc.
It is also called operating cost and prime cost.

TVC curve is inversely ‘S’ shaped which is due to the law of variable proportion.
Initially, TVC increases at decreasing rate due to increasing returns to factor.
Later on, TVC increases at increasing rate due to diminishing returns to factor.
TVC curve starts from origin as variable cost will be zero at zero level of production.

3. Total Cost (TC): Total Cost refers to total expenditure incurred by a firm for producing given quantity of a product. In the short run, Total Cost is equal is equal to sum of Total Fixed Cost and Total Variable Cost.
TC= TFC+TVC

TC curve is obtained by the vertical sum of TFC and TVC curve.
TC curve starts from TFC and parallel to the TVC curve.

4. Average Fixed Cost: It refers to per unit fixed cost. It is obtained by dividing TFC by the units of output produced.
𝑨𝑭𝑪 = 𝑻𝑭𝑪 / 𝑸

AFC curve is rectangular hyperbola. It means AFC always decreases with increase in output but it never become zero. Therefore, AFC curve neither touch y-axis nor x-axis.

5. Average Variable Cost: It refers to per unit variable cost. It is obtained by dividing Total Variable Cost and the units of output produced.
𝑨𝑽𝑪 = 𝑻𝑽𝑪/𝑸

AVC curve is of ‘U’ shaped due to the law of variable proportion.

6. Average Cost/Average Total Cost (AC/ATC): It refers to per unit cost of production. It is obtained by dividing total cost by the units of output produced.
𝐴𝐶 = 𝑇𝐶/𝑄
𝐴𝐶 = 𝑇𝐹𝐶 + 𝑇𝑉𝐶 / 𝑄
𝐴𝐶 = 𝑇𝐹𝐶/𝑄 + 𝑇𝑉𝐶/𝑄
𝐴𝐶 = 𝐴𝐹𝐶 + 𝐴𝑉𝐶

AC curve is obtained by the vertical sum of AFC and AVC curve. AC curve is of ‘U’ shaped due to the law of variable proportion.

7. Marginal Cost: It refers to addition in the total cost of producing one more unit of a product.
MC= TC_n-TC_n-1 (Δ𝑇𝐶/Δ𝑄)
MC= TVC_n-TVC_n-1(Δ𝑇𝑉𝐶/Δ𝑄)

MC curve is of ‘U’ shape due to the law of variable proportion.
MC → Addition in TC
→ Addition in (TFC+TVC)
→ Addition in TVC
ΣMC=TVC

Question. Explain the relationship between Average Cost and Marginal Cost with the help of schedule and diagram.
Ans.

I. When Marginal Cost is less than Average Cost, then Average Cost decreases.
II. When Marginal Cost is equal to Average Cost, then Average cost will be minimum and
constant.
III. When Marginal Cost is greater than Average Cost, then Average Cost increases.

Question. Explain the relationship between Average Variable Cost and Marginal Cost.
Ans.

I. When Marginal Cost is less than Average Variable Cost, Average Variable Cost falls.
II. When Marginal Cost is equal to Average Variable Cost, Average Variable Cost is minimum and constant.
III. When Marginal Cost is greater than Average Variable Cost, Average Variable Cost rises.

Question. Explain the relationship between Marginal Cost and Total Cost with the help of schedule and diagram.
Ans.

I. When Marginal Cost decreases, then Total Cost increases at diminishing rate
II. When Marginal Cost attains minimum level, Total Cost stops increasing at diminishing rate.
III. When Marginal Cost increases, Total Cost increases at increasing rate.

Question. Explain the relationship between Marginal Cost and Total Variable Cost with the help of schedule and diagram.
Ans. We know, MC is addition to TVC when one more unit of output is produced. So, TVC can be obtained as summation of MC’s of all the units produced. If product is assumed to be perfectly divisible, then total area under the MC curve will be equal to TVC.

Question. Does Marginal Cost affect Fixed Cost?
Ans. No, Marginal Cost does not affect because Marginal Cost is the addition in Total Cost by producing one more unit in which total cost is the sum of Total Fixed Cost and Total Variable Cost, but Total Fixed Cost does not change with the change in output. Marginal Cost affect variable cost and not fixed cost.

Question. Does AC and AVC curve intersect each other? Give reasons.
Ans. No, AC and AVC curves never intersect each other because the gap between AC and AVC curves is of AFC which always decrease with increase in output but never becomes zero. So, the gap between AC and AVC decreases as output increases but they never intersect each other.

Question. Explain the relationship between Average Variable Cost, Average Cost and Marginal Cost.

I. When Marginal Cost is less than Average Cost and Average Variable Cost, then both Average Cost and Average Variable Cost falls.
II. When Marginal Cost is greater than Average Cost and Average Variable Cost, then both Average Cost and Average Variable Cost increases
III. When Marginal Cost intersect Average Cost and Average Variable Cost, then both Average Cost and Average Variable Cost attains their minimum level.
IV. The gap between Average cost and Average Variable Cost decreases with increase in output but they never intersect each other.
V. Minimum level of Average Cost always occurs after minimum level of Average Variable Cost.

Question. Why is MC curve ‘U’-shaped?
Ans. MC curve is ‘U’-shaped due to the law of variable proportion. In the initial phase of law, the product increases at increasing rate due to better utilization of fixed factor, so Marginal Cost decreases.
Marginal Cost can attain the minimum level at the optimum use of fixed factor but later Total Product increases at decreasing rate due to overuse of fixed factor, so Marginal Cost decreases.

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