Micro Economic Analysis: Module I - Cost
MC will intersect the
Analysis
Money Cost
When production cost is expressed in terms of
monetary units, it is called money cost. It means the
aggregate money expenditure incurred by a producer
on the purchase, procurement and processing of
inputs.
Real Cost
Real cost refers to the payments made to the factors
of production to compensate for disutility’s of
rendering their services. It is computed in terms of
the toil, trouble, pain and discomfort involved for
labour, when it is engaged in production.
Explicit and Implicit cost
An explicit cost is a direct payment made to others
in the course of running a business, such as wage,
rent and materials, as opposed to implicit costs,
which are those where no actual payment is made.
The implicit cost for a firm can be thought of as the
opportunity cost related to undertaking a certain
project or decision, such as the loss of interest
income on funds, or depreciation of machinery used
for a capital project.
Sunk Cost
Sunk cost is a cost that has already been incurred
and thus cannot be recovered.
Traditional theory of costs
Short run costs are costs over a period during
which some factors
are fixed. The long
run costs are the
costs over a period
during which all
factors are variable.
Short run cost
curves
Fixed costs (FC) are business expenses that are
not dependent on the level of output produced.
Eg. Salaries of administrative staff, Depreciation of
machinery, Expenses of building depreciation and
repairs, Expenses of land maintenance and
depreciation
Variable costs (VC) are expenses that change in
according to the level of output.
Eg. Raw materials, Cost of direct labor, Running
expenses like fuel, ordinary repairs and routine
maintenance.
Total cost (TC) is made up of variable costs
and fixed costs
TC = TFC + TVC
Average cost curves
Average fixed cost = TFC / qty of output
AFC is a rectangular hyperbola. AFC falls
continuously with increase in output.
Average variable cost = TVC / qty of output
Average cost = TC / qty of output
Reason for the U shape of AVC and AC
The U Shape of both AVC and ATC curve reflects the
law of variable
proportions. Initially
ATC declines, it
reaches a minimum
and subsequently
rises again.
Marginal cost
Marginal cost is the
change in total cost that arises when the quantity
produced changes by one unit. MC is the slope of
TC curve.
Relationship between ATC and AVC
The minimum point of ATC occur to the right of the
minimum point of AVC. This is because ATC keeps to
fall because of the continuously falling AFC, even
after AVC has reached its minimum.
Relationship between MC and ATC
When MC is less than AC, AC falls
When MC = AC, AC is at its minimum
When MC is more than AC, AC rises
Long run cost curves
In the traditional theory of cost, LAC curve is U-
shaped and is called the envelope curve because it
envelopes the SRAC curves as shown in the figure.
The long run average cost curve LRAC is the
envelopes the short run average cost curves SRAC 1,
SRAC2, SRAC3 etc. which corresponds to different
plant sizes MC is the slope of TC curve.
Modern theory of cost ATC at its minimum point.
The most distinctive feature of the modern theory of Relationship between SAVC and MC
costs from the traditional theory is the introduction of Over the flat stretch, SAVC = MC
the concept of reserve capacity. Firms will have some To the left of the flat stretch, MC lies below SAVC
reserve capacity to meet unexpected demand or to To the right of the flat stretch, MC lies above SAVC
have greater flexibility in production.
Saucer – Shaped SAVC in modern theory of
cost
The traditional U-shape of the cost curves has been
questioned by several economists. In 1939, George
Stigler suggested that the short run average variable
cost curve has a flat stretch over a range of output.
This is so
because a
number of
Average total cost
firms build
ATC falls continuously up to the level of output at
their plants in
which the reserve capacity is exhausted. Beyond that
such a
level, ATC start rising.
manner that
a range of
output can
be produced by them at the same average variable
cost. This range of output is referred to as the
reserve capacity of the firm. In traditional theory the
short-run average variable cost is U-shaped. In the
modern theory, the short-run average variable cost
curve is ‘saucer-shaped’. The flat stretch at the
bottom begins at output OQ1 and continues till output
OQ2. The firm can produce output Q 1Q2 at the same
AVC, which is the lowest.
Excess capacity and reserve capacity Long run - L’ shaped curve.
Excess capacity arise with traditional U shaped curve The L-Shape of the production cost curve is
when the production is happening not at the output explained by the technical economies of large scale
corresponding to the minimum cost level. It is the production. Production costs fall smoothly at very
difference between the minimum cost output level X m large scales while managerial costs may rise only
and actually produced lower output level X slowly at very large scales. We draw LAC curve by
Reserve capacity is planned and is a feature of SAVC joining the points on the SATC curves corresponding
curve in the modern theory. Reserve capacity leads to the two thirds of the full capacity of each plant size.
to a flat stretch in SAVC over a range of output
Marginal cost The major differences of LAC in modern theory from
Marginal cost is the change in total cost that arises that of traditional theory is that (a) it does not turn up
when the quantity produced changes by one unit.
at very large scales of output (b) it does not
envelopes the SATC curves