INDIAN SCHOOL MUSCAT

MICROECONOMICS
CLASS - XI
UNIT – III
PRODUCER BEHAVIOUR AND SUPPLY

COST
 INDIAN SCHOOL MUSCAT
Cost:
Short Run Costs
Meaning of Cost in Economics
 Cost’ in economics refers to the sum of actual money
expenditure on inputs and the imputed (i.e., estimated)
expenditure in the form of inputs supplied by the owners
including normal profit.
Normal profit is a part of total cost
 Normal profit is the minimum reward that is just sufficient
to keep the entrepreneur supplying his factor service. Since
total cost includes payment made to primary inputs: land, labour,
capital and enterprise, therefore, total cost includes rent, wages,
interest and (normal) profits.
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Explicit Cost & Implicit Cost

Explicit Cost
 Actual money expenditure on inputs is called explicit cost.
 Explicit cost is shown in accounts because the owner
actually pays for it.
 Examples: Expenditure on purchase of raw materials,
payment of wages and salary, interest paid on borrowed funds,
rent of premises, depreciation, etc.
Implicit Cost
 Imputed (i.e., estimated) expenditure in the form of inputs
supplied by the owners including normal profit is called
implicit cost.
 Implicit cost is not recorded in accounts because the owner
actually does not pay for it. However, it is a cost.
 Examples: Imputed wages or salary of the owners estimated
rent of the owner’s building, estimated interest of own money
invested by the owners, etc.
 INDIAN SCHOOL MUSCAT

Explicit Cost & Implicit Cost

Illustrative Example
A producer borrows money and starts a business.
He himself looks after the business. What are the
explicit costs and implicit costs in it directly
identifiable ? Give reasons for your answer.
Answer:
i. Interest paid on borrowings is the explicit
cost because it is actual money expenditure.
ii. Estimated salary of the owner is the implicit
cost because the owner could have earned
this salary if employed in a firm not owned by
him.
 INDIAN SCHOOL MUSCAT
Short Run Costs

Fixed Cost Variable Cost

The cost which does not change The cost which changes with
with the change in output is called change in output is called
fixed cost. variable cost.
It is the cost incurred on fixed It is the cost incurred on
inputs. variable inputs.
Examples: Rent of business Examples: Wages, expenditure
premises, salary of permanent on raw materials, etc.
staff, interest paid on borrowed
funds, licence fees, etc.
 INDIAN SCHOOL MUSCAT
Short Run Costs
Total Fixed Cost (TFC)
In the short run, the cost that a
firm incurs to employ the fixed
inputs is called the total fixed cost.
TFC remains constant at all levels of
output (even at zero output).
In other words, TFC does not change
with the change in output.
TFC curve is a horizontal straight
line cutting Y-axis at a vertical
distance of TFC from the origin.

An example of cost function of a typical firm.

The first column shows different levels of
output.
For all levels of output, TFC is ₹20. Even at zero
output, TFC = ₹20.
 INDIAN SCHOOL MUSCAT
Short Run Costs
Total Variable Cost (TVC)
In the short run, the cost that a
firm incurs to employ the variable
inputs is called the total variable
cost (TVC).
 TVC is zero at zero output.
 TVC curve starts from the origin.
As output increases, TVC increases
because in order to increase the
production of output, the firm must
employ more of the variable inputs.
Also, as output increases TVC initially
increases at decreasing rate, then at
increasing rate due to the Law of
Variable Proportions. Therefore, TVC
curve is inverse S-shaped.
 INDIAN SCHOOL MUSCAT
Short Run Costs
Total Cost (TC)
Total Cost is the sum of total fixed cost and total variable cost.
TC = TFC + TVC
 As output increases, TFC remains fixed, but TVC increases. As
a result, TC also increases as output increases.
 As output increases TC initially increases at decreasing rate, then at
increasing rate due to the Law of Variable Proportions. Therefore, TC
curve is inverse S-shaped like TVC curve.
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Relationship between TFC, TVC and

TC
 TC = TFC + TVC. Therefore, TC curve is the vertical summation of
TVC curve and TFC curve.
 Since TC = TFC + TVC and TFC remains constant at all levels of
output, therefore an increase in TC is equal to increase in TVC.
 At zero level of output, TVC = 0 since the firm does not need to
employ any variable inputs. Therefore, TVC curve starts from the
origin. At zero level of output, TC = TFC since TVC = 0 at zero level of
output. Therefore, TC curve starts from Y-axis at a vertical distance of
TFC from the origin.
 Since TC – TVC = TFC and TFC is constant at all levels of output,
therefore the vertical distance between TC and TVC curves
remains the same. In other words, TC and TVC curves remain parallel to
each other.
 As output increases, TVC and TC both initially increase at
decreasing rate and after a point increase at increasing rate.
Therefore, both TVC and TC curve look like inverse S shaped. TC
and TVC curves both are concave in the beginning and convex
afterwards.
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Relationship between TFC, TVC and TC

Output TFC TVC TC

0 20 0 20
1 20 10 30
2 20 18 38
3 20 24 44
4 20 29 49
5 20 33 53
6 20 39 59
7 20 47 67
8 20 60 80
9 20 75 95
10 20 95 115
 INDIAN SCHOOL MUSCAT
Average Fixed Cost (AFC)

Per unit fixed cost of output is known as average

fixed cost.
Therefore, TFC = AFC × q
As output increases, AFC decreases
continuously. It is because when constant value
of TFC is divided by incremental units of output,
the resultant AFC decreases continuously.
When output is very close to zero, AFC is
randomly large, and as output moves towards
infinity, AFC moves towards zero (but AFC can
never be zero since AFC = TFC/q and TFC is
constant and is positive; AFC curve never
touches the X-axis). AFC curve is a
rectangular hyperbola. If we multiply any
level of output with its corresponding AFC, we
always get a constant, namely TFC.
 INDIAN SCHOOL MUSCAT

AverageVariable Cost (AVC)

Per unit variable cost of output is called average
variable cost (AVC).

Therefore, TVC = AVC × q

 AVC is ‘U’ shaped. It decreases in

the beginning when increasing
returns to a factor operates. When
return increases, cost per unit will
diminish.
 After certain level of output AVC
Increases when diminishing returns
to a factor operates.
 When returns diminish cost per unit
will increase.
 INDIAN SCHOOL MUSCAT
Short Run Average Cost (AC)
Average Cost (AC) or Average Total Cost (ATC) is defined as
per unit cost of output.
Therefore, TC = AC × q
OR
AC = AFC + AVC
• AC is the sum of AVC and AFC.
• Initially, both AVC and AFC decrease as output
increases.
• Therefore, AC initially falls. After a certain level of
output production, AVC starts rising, but AFC
continuous to fall.
• Initially the fall in AFC is greater than the rise in
AVC.
• So, AC is still falling.
• But, after a certain level of output production,
rise in AVC becomes larger than the fall in AFC.
From this point onwards, AC is rising.
• AC cur ve is, therefore, ‘U’-shaped.
 INDIAN SCHOOL MUSCAT
Marginal Cost (MC)
Marginal cost (MC) is defined as the change in total cost per
unit change in output.
Marginal cost can also be defined
as the addition to total cost when one
extra unit of output is produced.

Marginal cost is the additional cost that a

firm incurs to produce one extra unit of
output. According to the law of variable
proportions, initially the marginal product of
a factor increases as employment increases, and
then after a certain point, it decreases.

As a result, with the factor price given, initially

the MC falls, and then after a certain point, it
rises. MC curve is, therefore, ‘U’-shaped.
 INDIAN SCHOOL MUSCAT

MC Curve
Relationship between TVC Relationship between TC and
and MC MC
At output level q = 1, TVC = MC MC is the addition to TC when one
because at zero output, TVC = 0. In additional unit of output is
the SHORT-RUN, marginal cost produced. In the LONG RUN, since
(MC) is the increase in TVC due to there is no fixed costs, for any level
increase in production of one extra of output, the sum of marginal costs
unit of output. Therefore, TVC at (MCs) up to that level gives us the
any level of output is equal to sum total cost (TC) at that level. (TC =
of marginal costs (MCs) up to that ∑MC in the long run). Also, at output
level of output, i.e., TVC = ∑MC. level q = 1, MC = TC in the long run.
Therefore, the following relationship
exists between TVC and MC: When MC falls, TC rises at a
decreasing rate.
When MC falls, TVC rises at a  When MC is constant, TC rises at
decreasing rate. a constant rate.
 When MC is constant, TVC rises  When MC rises, TC rises at an
at a constant rate.
increasing rate.
 When MC rises, TVC rises at an
increasing rate.
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Costs Schedule
Output TFC TVC TC MC
0 20 0 20 -
1 20 10 30 10
2 20 18 38 8
3 20 24 44 6
4 20 29 49 5
5 20 33 53 4
6 20 39 59 6
7 20 47 67 8
8 20 60 80 13
9 20 75 95 15
10 20 95 115 20
 INDIAN SCHOOL MUSCAT
Relationship between Marginal Cost
(MC), Average Variable Cost (AVC) and
Average Cost (AC)
AC – AVC = AFC.
Since AFC falls as output increases, therefore difference
between AC and AVC decreases with increase in output.
Hence the vertical distance between AC and AVC curve
keeps on falling. However, AC and AVC can never be
equal. It is because AFC can never be zero since TFC is a
constant and positive.
 AVC reaches its minimum at Oq1 units of output.
 Before the output level Oq1 AVC is falling and MC
<AVC.
 After the output level Oq1, AVC is rising and MC
>AVC.
 MC curve cuts AVC curve at point ‘P’ which is the
minimum point of AVC curve.
Similarly, the minimum point of AC curve is ‘S’ which
corresponds to the output Oq2. It is the intersection point
between MC and AC curves.
 Before the output level Oq2 AC is falling and MC <AC.
 After the output level Oq2, AC is rising and MC >AC.
 The minimum point of AC curve (POINT ‘S”) lies to
the right of the minimum point of AVC curve (POINT
‘P”)
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Relationship between AC and MC Curves

Both AC and MC are derived from TC
Mathematical derivation of AC and MC
values from the TC values is as follows
 Both AC and MC curves are U-shaped,
reflecting the law of Variable
Proportion.
 AC includes both variable cost and
fixed cost since AC = AFC + AVC. But
MC is addition made only to variable
cost when output is increased by one
more unit.
 When AC is falling, then MC < AC.
 When AC is rising, then MC > AC.
 When AC is neither falling nor rising,
then MC=AC
 MC curve cuts the AC curve at its
minimum point.
 INDIAN SCHOOL MUSCAT

COSTS
Output TFC TVC TC AFC AVC AC MC
RISES WITH SUM OF TFC TC/OUTPUT
CONSTANT TFC/OUTPUT TVC/OUTPUT ∆TC/∆OUTPUT
OUTPUT AND TVC AFC+AVC

0 20 0 20 - - - -
1 20 10 30 20 10 30 10
2 20 18 38 10 9 19 8
3 20 24 44 6.67 8 14.67 6
4 20 29 49 5 7.25 12.25 5
5 20 33 53 4 6.6 10.6 4
6 20 39 59 3.33 6.5 9.83 6
7 20 47 67 2.86 6.71 9.57 8
8 20 60 80 2.5 7.5 10 13
9 20 75 95 2.22 8.33 10.55 15
10 20 95 115 2 9.5 11.5 20
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NUMERICALS
Complete the following table:
Output AFC MC TC
1 - - -
2 - 20 164
3 40 16 -
4 - - 198
5 24 20 -

Solution
Output TFC AFC TVC AVC TC AC MC
1 120 120 24 24 144 144 24
2 120 60 44 22 164 82 20
3 120 40 60 20 180 60 16
4 120 30 78 19.5 198 49.5 18
5 120 24 98 19.6 218 43.6 20
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NUMERICALS
If AFC is ₹20 when a producer produces 3 units. Complete the following
table:
Output AVC MC ATC
1 30 - -
2 28 - -
3 32 - -

TFC= AFC × Output = 20×3 = ₹60. At q = 1, MC=TVC

Output TFC AFC TVC AVC TC MC ATC
(q) (AVC × q) (sum of (TC/q)
MCs)
1 60 60 30 30 90 30 90
2 60 30 56 28 116 26 58
3 60 20 96 32 156 40 52
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Multiple Choice Questions

1. Which of the following is a variable cost?

A. Salary of permanent staff
B. Rent of premises
C. License fees
D. Wages
2. Why does AFC curve not touch the X-axis?
A. AFC cannot be zero.
B. AFC cannot be negative.
C. AFC can never be less than 1.
D. None of these.
 INDIAN SCHOOL MUSCAT

Multiple Choice Questions

3. In the short run, with the decrease in output, average

fixed cost .
A. Increases
B. Remains fixed
C. Decreases
D. Increases initially, then decreases
4.Which of the following curve is not a U-shaped curve?
A. AVC curve
B. AFC curve
C. AC curve
D. MC curve
 INDIAN SCHOOL MUSCAT

Multiple Choice Questions

5.What is the behaviour of TVC when MC falls?

A. TVC falls
B. TVC rises at decreasing rate
C. TVC rises at increasing rate
D. TVC rises at a constant rate
6. When output is increased, initially MC falls. It means
.
A. MP of the variable factor increases
B. AC falls
C. AVC falls
D. All of these
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Multiple Choice Questions

7. The cost curve, which is inverse S-shaped is:

A. Average Cost Curve
B. Total Fixed Cost Curve
C. Total Variable Cost Curve
D. Marginal Cost Curve
8.When AC is rising MC is:
A. Equal to AC
B. More than AC
C. Less than AC
D. Constant
 INDIAN SCHOOL MUSCAT

Multiple Choice Questions

9. If total variable cost and total fixed cost of producing 10

units are ₹500 and ₹200, the value of average cost would be?
A. 50
B. 70
C. 20
D. 80
10. When the total fixed cost of producing 100 units is ₹30 and
the average variable cost ₹ 3, total cost is:
A. ₹3
B. ₹30
C. ₹270
D. ₹330
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Multiple Choice Questions

11. The total cost at 5 units of output is ₹30. The fixed
cost is ₹ 5. The average variable cost at 5 units of
output is:
A. ₹ 25
B. ₹6
C. ₹5
D. ₹1
12. A firm’s average cost (AFC) is ₹ 20 at 6 units
of output.What will be AFC at 3 units of output?
A. ₹ 20
B. ₹ 30
C. ₹ 40
D. ₹ 50
 INDIAN SCHOOL MUSCAT

Multiple Choice Questions

If a firm’s production department data says that the total

variable cost for producing 8 units and 10 units of output is ₹
2500 and ₹ 3000 respectively, marginal cost will be:
A. ₹ 100
B. ₹ 150
C. ₹ 500
D. ₹ 250