MICROECONOMICS

Dr. Syeda Farzana Manzoor

BSBBA Program
Department of Management Sciences
 THEORY OF COST
There are many forces behind the process
of price determination for a good. One
such force is supply, which is directly
determined by the costs of the company.
Theory of Cost explores the cost concepts,
costs in the long and short run and
economies of scale.
Cost analysis is all about the study of the
behavior of cost with respect to various
production criteria like the scale of
operations, prices of the factors of
production, size of output, etc. It is all
about the financial aspects of
production.
ACCOUNTING COST/ EXPLICIT COST
When a firm starts producing goods, it has
to pay the price for the factors employed
for the production. These factors include
wages to workers employed, prices for
the raw materials, fuel and power used,
rent for the building he hires, and
interest on the money borrowed for
doing business, etc.
Accounting Costs are these costs which
are included in the cost of production.
Hence, accounting costs take care of all
payments and charges that the firm
makes to suppliers of different
productive factors.
Outlay Cost:
Outlay costs include the actual
expenditure of funds on factors like
material, rent, wages, etc.
Outlay cost concepts are actual
expenditures and the books of accounts
record them.
Opportunity Costs:
Opportunity costs are the costs of missed
opportunities. In other words, it
compares the policy chosen and policy
rejected. Opportunity costs are about
sacrificed opportunities and the books of
accounts do not record them.
Fixed costs - FC or Constant costs are
not a function of the output. That is, they do
not vary with the output up to a certain
extent.
For example, rent, property taxes, interest on
loans,
Businesses cannot avoid fixed costs and are
applicable as long as the business is
operating
Variable costs - VC:
Cost concepts which are a function of the
output in the production period. Variable
costs vary directly with the output. Some
examples of variable costs are the cost of raw
EXAMPLE
Q1. Which of the following is an
example of an “explicit cost” in cost
concepts?
a) The wages a proprietor could have
made by working as an employee of
a large firm.
b) The income that the firm could have
earned in alternative uses by the
resources.
c) The payment of wages by the firm.
d) The normal profit earned by a firm.
 SHORT RUN AND LONG RUN
A short run is a period of time wherein
the firm increases the output by making
changes only to the variable factors
like labor, raw material, etc. Also,
quantities of fixed factors cannot be
changed in the short run.
Long run is a period of time in which
the firm can make changes to all factors
to get the desired output. Hence, we can
say that in the long run, all factors
become variable.
 Short Run Average Costs
1. Average Fixed Cost (AFC)
The average fixed cost is the total fixed cost
divided by the number of units produced.
AFC = TFC / Q
Therefore, AFC is the fixed cost per unit of
output.
Example: The TFC of a firm is Rs. 2,000. If the
output is 100 units, the average fixed cost is,
AFC=TFC / Q
=2000 / 100 = Rs.20
If the output is increased to 200 units, then
AFC = TFC / Q = 2000 / 200= Rs.10
Since TFC is constant, any increase in output
decreases the AFC. Note that, while the AFC can
become really small, it is never zero.
Average Variable Cost (AVC):
Average variable cost is the total variable cost divided by
the number of units produced.
AVC = TVC / Q
Therefore, AVC is the variable cost per unit of
output.
Usually, the AVC falls as the output increases from
zero to normal capacity output. Beyond the
normal capacity, the AVC rises steeply due to the
operation of diminishing returns.
Average Total Cost (ATC):
The average total cost is the sum of the average variable
cost and the average fixed costs. That is,
ATC = AFC + AVC
It is the total cost divided by the number of units
produced.
Marginal Cost (MC):
Marginal cost is the addition made to the cost
of production by producing an additional
unit of the output. In simpler words, it is the
total cost of producing total units.
MC = ΔTC / ΔQ

Example:
A firm produces 5 units at a total cost of Rs.
200. For some reasons, it is required to
produce 6 units instead of 5 and the total
cost is Rs. 250.
Therefore,
Marginal cost is Rs. 250 – Rs. 200 = Rs. 50.
The Diagram below shows the AFC, AVC,
ATC, and Marginal Costs (MC) Curves:
The behavior of the ATC curve depends upon
that of the AVC and AFC curves. Observe
that:
In the beginning, both AVC and AFC curves
fall. Hence, the ATC curve falls as well.
Next, the AVC curve starts rising, but the
AFC curve is still falling. Hence, the ATC
curve continues to fall. This is
because, during this phase, the fall in the
AFC curve is greater than the rise in the
AVC curve.
As the output rises further, the AVC curve
rises sharply. This offsets the fall in the AFC
curve. Hence, the ATC curve falls initially
and then rises.
 Units Total Total Averag Average Average
Total Margin
of fixed variab e fixed variable total
Cost al cost
output cost le cost cost cost cost

0 150 0 150 – – – –

50/6 =
6 150 50 200 25.0 8.33 33.33
8.33
50/10 =
16 150 100 250 9.38 6.25 15.63
5.0
50/13 =
29 150 150 300 5.17 5.17 10.34
3.85
50/15 =
44 150 200 350 3.41 4.55 7.95
3.33
50/11 =
55 150 250 400 2.73 4.55 7.27
4.55
50/5 =
60 150 300 450 2.50 5.0 7.50
10.0
From the table, we can make the following
observations:
Since the fixed cost does not change with
the output, the average fixed cost
decreases as the output increases.
The average variable cost does not
always increase in proportion to an
increase in the output.
Marginal costs also come down until 44
units are produced after which they start
rising.
 Relationship between Average Cost
and Marginal Cost
If the average cost falls due to an increase
in the output, the marginal cost is less
than the average cost.
If the average cost rises due to an
increase in the output, the marginal cost is
more than the average cost.
Marginal cost is equal to the average cost
when the marginal cost is minimum. You
can see in Fig. 1 that the MC curve cuts
the ATC curve at its minimum or optimum
point.
 SHORT RUN TOTAL COSTS
During production, some factors are
easily adjustable to sync with any
change in the level of output. For
example, a firm employs
more workers to increase output or
purchases more raw material to step-up
production. These are variable factors.
However, factors like building, capital
equipment, etc. are not so easily
adjustable. The firm usually requires a
longer time to make changes in them.
These factors are fixed factors.
Fixed Costs -TFC:
In Fig. 1, we can see that fixed costs are
independent of the output. That is, they do
not change with any change in the
output. The firm has to bear these costs even
if it closes down operations in the short run.
Variable Costs - TVC:
In Fig. 2, we can see that variable costs
change with changes in the output. Variable
costs include payments like wages, prices of
raw material, power consumption, etc. If a
firm shuts operation in the short run, then it
does not use the variable factors of
production and hence, does not incur
variable costs.
 Short Run Total Costs – TC Curves
The total cost (TC) of business is the sum of the total
variable costs (TVC) and total fixed costs (TFC).
Hence, we have TC = TFC + TVC
The following diagram represents the TC, TFC, and TVC
 EXPLANATION
 the TFC curve starts from a point on
the Y-axis and is parallel to the X-axis.
This implies that even if the output is
zero, the firm incurs a fixed cost.
The TVC curve rises upwards. This
implies that TVC increases as the
output increases. This curve starts from
the origin which shows that variable
costs are nil when the output is zero.
The total cost curve (TC) is obtained by
adding the TFC and TVC vertically.
Q1. Total cost in the short run is
classified into fixed costs and variable
costs. Which one of the following is a
variable cost?
a) Cost of raw materials.
b) Cost of equipment.
c) Interest payment on past borrowings.
d) Payment of rent on the building.