Concepts of Cost of Production: Nominal Cost and Real Cost

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The readers should very clearly distinguish between some concepts of cost of production which are currently used in Economics.

We give them below:

Nominal Cost and Real Cost:

The costs are sometimes classified as nominal cost and real cost.

Nominal or Money Cost:

Nominal cost is the money cost of production. It is also called expenses of production. These expenses are important from the point of view of the producer. These expenses are paid out by him to the factors he employs or for the raw materials he uses in production. He must make sure that the price he gets for the product covers, in the long run, these expenses including normal profit, otherwise he cannot continue in business.

Real Cost:

The real cost of production has been variously interpreted. Adam Smith regarded pains and sacrifices of labour as real cost of production. Marshall included under it the “real cost of efforts of various qualities”, and “real cost of waiting.” This Marshall called as the social cost of production. Some economists define real cost as the next best alternative sacrificed in order to obtain a commodity. It is also called opportunity cost or displacement cost, which we explain below.

It is very seldom that money costs and real costs coincide, because the purchasing power of money in terms of efforts and sacrifices does not remain the same owing to fluctuations in the prices. Hence, there is very little connection between money costs and real costs. For example, land has no real cost.

It is a free gift of nature to man. Its value depends on scarcity. Similarly, the earnings the cinema stars on the one hand, and sweepers and coolies, on the other, seldom correspond to the respective efforts and sacrifices undergone by them.

Explicit Costs and Implicit Costs:

Costs of production can be classified as Explicit Costs and Implicit Costs. Explicit costs are also called paid-out costs. These costs the entrepreneur has to pay to those persons from whom he has obtained factors of production or services. For instance, he has to pay wages to the labour he has employed, interest on the capital that he has borrowed and rent of land or factory or business premises. These are explicit costs.

Implicit costs, on the other hand, are costs which have not to be paid out to others but the costs which the entrepreneur pays to himself, as it were. Perhaps he himself is the owner of the business premises, he may have invested his own capital side by side the capital he may have borrowed from others. He may be a whole-time worker in the business, for instance he may be a managing director for which he may not be drawing any salary.

If he had lent out these factors to others, he would have received remuneration from them. Hence they must be taken into account while calculating profit. But since they are not actually paid out to anybody, they are called implicit costs.

Opportunity Cost:

In modern economic analysis, the term real cost is interpreted in the sense of opportunity cost. It is also called ‘alternative cost’ or ‘transfer cost’. Opportunity cost of a commodity is the alternative sacrificed in order to obtain it. Suppose you have Rs. 5 with you and you have two alternatives before you, either to go to a cinema show or buy a pen. Suppose further that you decide to buy the pen and forego the cinema show. In this case, what is the price of the pen? Apparently, it is Rs. 5, but really it is the cinema show, the alternative you have foregone or sacrificed. This is its opportunity cost.

Since productive resources are limited, if they are used in the production of one commodity, they are not available for the production of another. The commodity which is sacrificed or not produced is the real cost of the commodity that is produced. Thus, the cost of production, in the sense of opportunity cost, means not the efforts and sacrifices undergone, but the most attractive alternative foregone or the next best choice sacrificed. The cost of production of a commodity is fundamentally the sum-total of retention prices that have to be paid to the productive services for retaining them in a particular industry, and this must at least be equal to what they can command elsewhere.

Production Costs:

Production costs refer to the total amount of money spent in the production of goods. They include the cost of raw materials and freight thereon, the costs of manufacture, i.e., the wages of workers engaged in the manufacture of the commodity and salaries of the manager and other office staff including those of peons, chowkidars, etc. They also include other overheads like rent, interest on capital, taxes, insurance and other incidental expenses like costs of repairs and replacements. They include both prime costs and supplementary costs.

Selling Costs:

Selling costs are the costs of marketing, advertisement and salesmanship. These costs are incurred to attract customers, expand market and capture more business and retain the existing business. These costs are essential costs of the competitive economy. They are especially important in the case of imperfect competition in which goods are not identical but substitutes.

The manufacturers resort to what is called product differentiation in order to change the demand curve of a particular seller to his advantage. Instead of improving the quality or lowering the price, high pressure salesmanship is resorted to win customers and this is found more profitable. Selling costs do not necessarily vary with the volume of sales.

A minimum cost of advertisement is essential to retain the existing markets. But it may also be found that sales can be increased by increasing selling costs. In that case, these costs will be variable. Selling costs like production costs are also subject to the law of diminishing returns or increasing costs.

On the whole, selling costs may be regarded as a social waste, because they add to the cost of the commodity without improving its quality or increasing its utility. Their result may be simply to redistribute the market among the existing sellers. Only in cases where the market is expanded may the costs be reduced but the reduction in costs may not be reflected in the lowering of the price. Selling costs are a peculiarity of an imperfect market and have no place in a fully competitive market where the dealers are supposed to be fully aware of the quality of the goods and the conditions of the market.