Principles of Microeconomics- Dr.

Tarek Selim

COMPETITIVE MARKETS
Part A: The Costs of Production
Dr. Selim lecture notes are based on multiple sources, including Mankiw and
Rashwan, Principles of Economics, Arab World Edition, Cengage Learning
Total Revenue, Total Cost, Profit
§  We assume that the firm’s goal is to maximize
profit.

Profit = Total revenue – Total cost

the amount a the market

firm receives value of the
from the sale inputs a firm
of its output uses in
production

1
The Firm’s Costs of Production
1)  Types of Costs
2)  Cost Formulas/Calculations
3)  Cost Curves
4)  Firm Decisions:
§  Efficient Scale of Production
(The Cost Minimization Condition)
§  Expansion Decision
§  Shut Down Decision

2
1) TYPES OF COSTS
§  Explicit, Implicit and Sunk Costs
§  Total, Fixed and Variable Costs (TC,FC,VC)
§  Marginal Cost (MC)
§  Average Costs (ATC, AFC, AVC)

3
Costs: Explicit vs. Implicit
§  Explicit costs require payment of money now or in
the future, e.g., electricity, raw materials, wages etc.
§  Implicit costs do not require a cash outlay,
and are the opportunity cost equal to what a firm
must give up in order to use a factor of production
for which it already owns e.g. opportunity cost of
owner’s time and effort, opportunity cost of money
(interest), opportunity cost of owning an asset (rent).
§  Remember one of the Ten Principles (Principle #2):
The cost of something is
what you give up to get it.
§  This is true whether the costs are implicit or explicit.
4
Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business. The interest
rate is 5% per year. What is your TOTAL annual cost?
§  Case 1: borrow $100,000
§  explicit cost = $5000 interest on loan
§  Implicit cost = $0
§  Case 2: use $40,000 of your savings,
borrow the other $60,000
§  explicit cost = $3000 (5%) interest on the loan
§  implicit cost = $2000 (5%) foregone interest you
could have earned on your $40,000
§  Case 3: use $100,000 from your savings
§  explicit cost = $0 because there is no interest paid
§  implicit cost = $5000 (5%) foregone interest
In all three cases, total annual cost is $5000.
5
Sunk Costs
§  When money is already spent and is
unrecoverable (i.e. permanently lost), then that
money is considered a sunk cost. Sunk costs
cannot be refunded or recovered. For example,
once rent is paid, that amount is no longer
recoverable - it is 'sunk.’
§  Examples of sunk costs (paid and
unrecoverable): rent, inventories, advertising,
R&D, machinery, asset ownership, office
decoration, etc.

6
Total, Fixed and Variable Costs
§  Fixed costs (FC) do not vary with the quantity of
output produced.
§  Examples: rent, cost of equipment, loan
payments
§  Variable costs (VC) vary with the quantity
produced. They are usually written as VC(Q).
§  Examples: raw materials, wages
§  Total cost (TC) = FC + VC(Q)

7
Marginal Cost
§  Marginal Cost (MC)
is the increase in Total Cost from
producing one more unit:
§  MC= Extra TC for one extra unit produced.
§  Usually, businesses do not produce only one
extra unit, so Marginal Cost is extra total costs
divided by extra units produced.
∆TC
§  So, MC =
∆Q

8
Average Costs (ATC, AFC, AVC)
They are defined as the relevant cost divided by
quantity:
ATC = (Total Cost / Quantity)= (TC/Q)
AFC = (Fixed Cost / Quantity)= (FC/Q)
AVC = (Variable Cost / Quantity)= (VC/Q)

Since TC=FC + VC(Q), so if we divide both sides by

quantity Q, we will get:
ATC = AFC + AVC
Average Average Average
Total = Fixed + Variable
Cost Cost Cost
9
 Class Exercise: Types of Costs
A business start-up firm has the following listed items for the
first year. Determine the type(s) of costs for each item: explicit,
implicit, sunk, fixed, and/or variable cost. Then, determine TC,
FC, VC, ATC, AFC, AVC, MC.
Net Economic Profits LE 200,000
Sales Revenues LE 1,000,000
Total Economic Costs LE 800,000
Cash withdrawal from savings account, LE 500,000
Borrowed money (at 10% interest), LE 1,500,000
Advertising, LE 20,000
Office rent and decoration expenses, LE 36,000
Wages paid, LE 180,000
Bonuses to be paid (based on sales), LE 20,000
Electricity, LE 12,000
Raw materials, LE 300,000
Remaining legal expenses, LE 32,000.
Quantity Sold is equivalent to 100 Batches (Batch = 10 units).
Expected Cost to Produce One Extra Batch (Batch =10 units) is LE 4,750.
10
ACTIVE LEARNING 1
Brainstorming on Costs
You are a brand manager for a motor company.
To what extent are the following costs important?
Why?
§  Explicit and Implicit
§  Sunk
§  Fixed
§  Variable
§  Total
§  Marginal
§  “Unit Cost” ATC
§  AFC and AVC
2) COST FORMULAS/CALCULATIONS
Summary Of Cost Formulas:
TC = FC + VC(Q)
∆TC
MC = = Change in TC / Change in Q
∆Q
ATC = (TC/Q) = (Total Cost / Quantity)
AFC = (FC/Q) = (Fixed Cost / Quantity)
AVC = (VC/Q) = (Variable Cost / Quantity)
ATC = AFC + AVC

12
EXAMPLE 1: Farmer Mahmoud
§  Farmer Mahmud must pay LE1000 per month for
renting the land, regardless of how much wheat
he grows. This is his fixed cost per month.
§  The wage for a farm worker is LE2000 per
month. He knows that he can hire up to five
farmers. This is his variable cost.
§  Mahmoud’s output is given in next Table.
§  Question: When he hires three farmers, what
is his marginal cost? Also, find AFC and AVC
when he hires three farmers.
13
 EXAMPLE 1: Farmer Mahmud’s Costs
L Q
Variable Total Marginal
(no. of (bushels Fixed Cost
Cost Cost Cost (MC)
workers) of wheat) in LE
0 0 LE1,000 LE 0 LE1,000
2.00
1 1000 1,000 2,000 3,000
2.50
2 1800 1,000 4,000 5,000
3.33
3 2400 1,000 6,000 7,000
(0.42/bushel) (2.5/bushel) (2.94/bushel) 5.00
4 2800 1,000 8,000 9,000
10.00
5 3000 1,000 10,000 11,000

14
 EXAMPLE 1: How the MC is Calculated
Q
Total Marginal
(bushels
Cost Cost (MC)
of wheat)

0 $1,000
∆Q = 1000 ∆TC = $2000 $2.00
1000 $3,000
∆Q = 800 ∆TC = $2000 $2.50
1800 $5,000
∆Q = 600 ∆TC = $2000 $3.33
2400 $7,000
∆Q = 400 ∆TC = $2000 $5.00
2800 $9,000
∆Q = 200 ∆TC = $2000 $10.00
3000 $11,000 ∆TC
Recall: MC =
∆Q
15
ACTIVE LEARNING 2
Cost Calculations
Fill in the blank spaces of this table.
Q VC TC AFC AVC ATC MC
0 $50 n/a n/a n/a
$10
1 10 $10 $60.00
2 30 80
30
3 16.67 20 36.67
4 100 150 12.50 37.50
5 150 30
60
6 210 260 8.33 35 43.33
ACTIVE LEARNING 2
Cost Calculations - Answers
Answers are in red

Q VC TC AFC AVC ATC MC

0 $0 $50 n/a n/a n/a
$10
1 10 60 $50.00 $10 $60.00
20
2 30 80 25.00 15 40.00
30
3 60 110 16.67 20 36.67
40
4 100 150 12.50 25 37.50
50
5 150 200 10.00 30 40.00
60
6 210 260 8.33 35 43.33
3) COST CURVES
§  APPLICATION: A soda drinks company is
introducing a new refreshing soda drink called MDX.
Based on the table below, MDX has cost data (in $
millions) according to different levels of production
output Q (million units) for its regional market in the
Middle East. The currency is denoted in dollars to
have an international comparison with other regions
of the world. The cost data is focused only on the
new MDX brand.
§  MDX senior management would like to see a
graphical representation of the cost structure of the
new brand, with insights into useful information for
decision making purposes.
18
The Complete Cost Data for MDX
Q FC VC TC AFC AVC ATC MC
0 $100 $0 $100 n/a n/a n/a
$70
1 100 70 170 $100 $70 $170
50
2 100 120 220 50 60 110
40
3 100 160 260 33.33 53.33 86.67
50
4 100 210 310 25 52.50 77.50
70
5 100 280 380 20 56.00 76
100
6 100 380 480 16.67 63.33 80
140
7 100 520 620 14.29 74.29 88.57
200
8 100 720 820 12.50 90 102.50
Note: One unit = a carton of 20 soda packs. Data for example illustration only.
19
FC, VC, and TC
$800 FC
Q FC VC TC $700 VC Total
TC
0 $100 $0 $100 $600
“Fixed expenses are
1 100 70 170 $500
$100 million. Total
expenses can reach

Costs
2 100 120 220 $400
7 times as much.”

3 100 160 260

$300 Variable
4 100 210 310
$200
5 100 280 380 Fixed
$100
6 100 380 480
$0
7 100 520 620 0 1 2 3 4 5 6 7
Q
20
The MC Curve
$200 “The minimum
Q TC MC Recall, Marginal Cost MC(MC)for
expansion is $40 at
is the change
$175
2 to 3inmillion
total units,
cost from
after
0 $100
$70 producing
$150 one more
which unit:will be
expansion
1 170 increasingly costly.”
50 $125 ∆TC
MC =
Costs
2 220 $100 ∆Q
40
3 260 Usually,
$75 MC rises as Q rises, due to
50 diminishing marginal product.
4 310 $50
70 Sometimes (as here), MC falls
5 380 $25
100 before rising.
6 480 $0
140 (In other0examples, MC may be
1 2 3 4 5 6 7
7 620 constant.) Q

21
Average Fixed Cost
Q FC AFC $200
Average fixed cost (AFC)
is$175
fixed cost divided by the
0 $100 n/a
quantity
$150
of output:
“The per unit share of
1 100 $100 the fixed expenses will
AFC = FC/Qfall below $15/unit if
$125

Costs
2 100 50 we produce 7 million
$100 units or more, due to
3 100 33.33 economies of scale.”
Notice
$75 that AFC falls as Q rises:
4 100 25 The firm is spreading its fixed
$50
5 100 20 costs over a larger and larger
$25
number of units.
6 100 16.67 $0
7 100 14.29 0 1 2 3 4 5 6 7
Q
22
Average Variable Cost
Q VC AVC $200
Average variable cost (AVC)
is$175
variable cost divided by the
0 $0 n/a
quantity of output:
“The variable cost per unit
$150 (labor and raw materials) can
1 70 $70
AVC = VC/Q
$125 go down to $52.50/unit, but
definitely never less than

Costs
2 120 60
$100 that, for the time being.”
3 160 53.33 As$75
Q rises, AVC may fall initially.
4 210 52.50 In most cases, AVC will eventually
$50
rise as output rises.
5 280 56.00 $25
6 380 63.33 $0
7 520 74.29 0 1 2 3 4 5 6 7
Q
23
Average Total Cost, or “Unit Cost”

Q TC ATC $200 “The lowest ATC

Usually, as in (minimum
this unit cost) is
example,
$175 $76/unit for MDX,
0 $100 n/a the ATC curve corresponding
is U-shaped.to a
$150 production level of 5
1 170 $170 million units.”
$125

Costs
2 220 110
$100
3 260 86.67
$75
4 310 77.50 $50
5 380 76 $25

6 480 80 $0
0 1 2 3 4 5 6 7
7 620 88.57
Q

24
 Cost Curves For A Typical Firm
$200 ATC, or MC
“Unit Cost” Curve
$175

$150
ATC
$125
AVC
Costs
$100
ATC
AFC
$75
MC AVC
$50
The Cost Curves $25 AFC
for MDX $0
0 1 2 3 4 5 6 7
Q

25
4) FIRM DECISIONS
1.  Efficient Scale of Production
(The Cost Minimization Condition)
2.  Expansion Decision
3.  Shut Down Decision

26
1. EFFICIENT SCALE OF PRODUCTION
Efficient scale: $200 ATC, or “Unit Cost” Curve
The quantity that
minimizes ATC. $175

In the MDX $150

application, the $125
efficient production

Costs
scale is 5 million $100
units. $75
(As Q rises:
$50
Initially,
falling AFC $25
pulls ATC down. $0
Eventually, 0 1 2 3 4 5 6 7
rising AVC
Q
pulls ATC up).
27
 Cost Minimization Condition: Min ATC=MC

If MC < ATC, $200 ATC MC

ATC falls. MC
$175

If MC > ATC, $150 Cost Minimization

Condition:
ATC rises. $125 Min ATC=MC

Costs
ATC
The MC curve $100

crosses the $75

ATC curve at $50
the ATC curve’s $25
minimum.
$0
Cost Minimization 0 1 2 3 4 5 6 7
Condition is: Q
Min ATC = MC 28
2. EXPANSION DECISION
§  Suppose that a firm wants to expand production to
achieve more profits.
§  If the revenue of selling extra units is more than the
additional cost incurred from producing them, then
profits will rise. Otherwise, profits will fall.
§  So, the expansion condition is:
Revenue from extra units > Costs of extra units
§  On a per unit basis:
Revenue per unit > MC
P > MC
29
3. SHUT DOWN DECISION

§  Shutdown:
A short-run temporary decision not to produce
anything because of market conditions. It is NOT the
same as “Exit”.
§  Shutdown costs:
If shut down, the firm must still pay FC.
(If the firm exists, it will not have to pay FC).

30
 Shut Down Condition: P < AVC
§  If firm operates and does not shut down:
Profits = (TR – TC) = TR - FC – VC
§  If firm shuts down, TR=0 and VC=0 and firm still
pays FC:
So, Profits = (TR – TC) = – FC
§  Since “(–FC)” is common in both, so, shut down is
better if 0 > TR – VC, i.e. VC > TR. Hence,
TR < VC
§  Divide both sides by Q: TR/Q < VC/Q
§  So, firm’s decision rule is:
Shut down if P < AVC 31
 Cost Curve Allocations- Recap
$200
MC
$175 D
A. Cost Minimization
B. Economies of Scale $150 C
C. Expansion if P>$150 $125

Costs
D. Large share of fixed ATC
expenses $100 E
A
E. Small share of fixed $75
expenses AVC
$50
F. Shut down price F
G. Minimum MC $25
G AFC
$0 B
0 1 2 3 4 5 6 7
Q

32
Question for Class Discussion
True or False:
1.  The efficient scale of production is when Min ATC=MC.
2.  Firms should expand if price is equal to marginal cost.
3.  The average fixed cost is a constant number.
4.  The difference between ATC and AVC is small when
production level is large.
5.  If ATC is less than MC, then ATC is falling.
6.  Min MC is to the left of Min ATC.
7.  Firms should shut down if price is below ATC because
they will have losses.
33