The concept of cost of production is used in economics in three important senses to explain its nature. They are: 1. Money Cost of Production 2. Real Cost of Production 3. Opportunity Cost.
1. Money Cost of Production:
Money cost represents the monetary expenses of production of the firm. It includes the amounts of money paid out or contracted to be paid by the firm in order to produce a commodity. It simply refers to the amount of money a firm actually pays or contracts to pay to purchase the productive services of different factors or inputs needed to produce a given output.
It consists of the expenses like rent, wages, interest, charges for erecting buildings, management charges, cost of raw materials, taxes and rates, depreciation charges for the wear and tear of factory buildings and machines, normal profit of the entrepreneur, and so on.
In economics the cost of production includes normal profit, because the services of the entrepreneur are, like the services of other factors or inputs, also spent for producing a given output. In fact, all the payments for factor services, such as wages, interest, rent, and normal profit for the entrepreneur, are to be included into the total money cost of production of a given output. Due to the inclusion of normal profit, the economists’ definition of total cost differs from that of the accountant.
Expenditure and Non-expenditure Costs:
Another important point to note is that total money cost must include both the implicit and the explicit costs of production. Implicit costs are the imputed values of those inputs which the firm itself owns (i.e., the imputed values of non-purchased services like the entrepreneur’s own labour, own factory premises, adequate return on own capital, etc. for which nothing is actually paid out).
These are also known as non-expenditure costs. Explicit costs are, on the other hand, all those payments made by the firm to others for the services of factors or inputs not owned by the firm. In other words, these represent the actual contractual expenses for purchased services such as wages and salaries paid, payments for raw materials, fuel, etc., interest on borrowed capital, taxes, rent on land, etc. These are also known as expenditure or outlay costs. The aggregate of these monetary expenses, both implicit and explicit, is called the total money cost of production.
2. Real Cost of Production:
Money cost of production is considered from the private individual’s point view. But, it has a very little significance from the point of view of the society as a whole. Hence we are concerned with the real cost of production, which represents the philosophical concept of cost.
The real cost of production was defined by Alfred Marshall and J.B. Clark in terms of the amount of ‘pain’, ‘disutility’, ‘abstinence or waiting’, or ‘real human sacrifice’ for producing an output. It is equal to the exertions and sacrifices which are made by the different factors in the course of production of goods and services.
For example, a labourer has to put in efforts for producing a particular commodity, the capitalist has to wait (to abstain from current consumption) before he can get a return on the money invested, and so on. These ‘real exertion’ or ‘disutility’ or ‘waiting and abstinence’, etc. constitute the real cost. In the case of land, since neither the disutility of labour nor the abstinence from current consumption is involved, no real cost was thought to be present. In general, land was considered to be a gift of nature.
Criticism of the Real Cost Doctrine:
But, today few economists employ the ‘real cost’ doctrine, as ‘pain’ or ‘disutility’ or ‘real exertion’ or ‘waiting’, being too subjective a concept, cannot be calculated properly and treated scientifically. Moreover, such a doctrine “breaks down when confronted by the fact that the. salaries and wages of persons in some unattractive occupations (garbage collections), in which disutility of working is presumably very high, are lower than those of persons employed in presumably more attractive occupations”. For all these reasons, the doctrine of real cost has been practically discarded.
3. Opportunity Cost:
The most important cost concept relevant for allocation of scarce resources is opportunity cost in that the cost of production of any commodity can also be looked at in terms of foregone alternatives.
The concept of opportunity cost originated in the work of various Austrian economists who wrote between 1871 and 1914 and is widely accepted even today. In its modern form it states that the cost to the society of producing a unit of any given product, X, is the amount of the next most desirable product, say Y, which could be produced with the given amount of inputs.
When a product is produced, the resources used in its production would not be available for the production of alternative goods. In a full- employment situation, the production of one product involves the sacrifice of its alternatives. Let us suppose that one plot of land can produce either 5 bales of jute or 15 quintals paddy. So, the cost of 5 bales of juste is 15 quintals of paddy.
Similarly, the opportunity cost of tire employment of one person is the earning that he may get from the next-best alternative occupation. For instance, a person in occupation A gets Rs.1500 per month; he may get Rs.1200 in the next-best alternative occupation B. When he is engaged in occupation A, he sacrifices the earning of occupation B.
The opportunity cost of his services in occupation A will be Rs.1200. In occupation A, he must at least earn Rs.1200; otherwise he will transfer his service from occupation A to B. So, the sum of Rs.1200 will be treated as his opportunity cost or his transfer earning. Thus, the opportunity cost of anything may be defined as the next-best alternative that could be produced instead by the same factors or by an equivalent group of factors, costing the same amount of money.
So, opportunity cost is the value of that which must be given up to acquire or achieve something. Economists attempt to take a comprehensive view of the cost of an activity. If a firm invests undistributed profits to spend Rs.1,000 on new machinery which requires less electricity to run than the equipment it replaces, the cost of that machinery is not the outlay of Rs.1,000 alone, what could be earned from the best alternative use of the money also has to be taken into account.
If, for example, the firm is paying 12% interest on an overdraft and the saving in electricity is less than Rs.120 a year, the cost of the investment will be greater than the return; to disregard the full cost of what is being given up to acquire the machinery would be to reach a wrong decision.
If a self-employed person makes a profit of Rs.8, 000 a year but pays himself no wage, he needs to consider the alternative use to which his time could be put. He might, for example, be able to earn Rs.10, 000 a year working for someone else — this is the opportunity cost of his time. However, opportunity cost of resources having no alternative uses is zero. For example, the opportunity cost of an idle factory space is zero.
Accounting costs, as in these examples, normally allow only for outlays. However, cash outlays will only approximate to opportunity costs where competition ensures that the prices of all factors of production are equal to those for their best alternative use.
Uses and Limitations of the Concept:
The concept of opportunity cost has a great value, as in a situation of full-employment prices tend to reflect opportunity costs. If there is full-employment, more of some commodity can be produced only at the cost of producing less of another. So, in such a situation the price of each reflects the cost of sacrificing alternatives.
Again, whenever a choice is involved, the opportunity cost may be employed to determine the social cost of producing anything. Even in the times of unemployment, when opportunity cost of unemployed inputs becomes zero from the social point of view, a problem of choice and of opportunity cost may arise with respect to the question of where to employ such unemployed inputs.
In India, for example, there is surplus labour or disguised unemployment in rural areas. Disguised unemployment implies zero opportunity cost of labour (due to the absence of alternative employment opportunities outside agriculture).
But, where there is no real or close alternative, the opportunity cost becomes useless. Such a situation may exist in the case of highly specialised inputs for which alternative uses are difficult to find out.
However, despite these limitations, the concept has practical implication. It can be applied in the different branches of economic analysis, such as production, consumption, allocation of resources and project evaluation, international trade.