Microeconomics
Behind the supply: Cost of production
Short run
(From the industry level analysis
we are not towards the firm level analysis)
session 10
September 2022
Why study cost structure – because it determines
supply, and hence revenue and profit
• Every firm has to make 3 key decisions to maximize profits
Profits = Revenue - Costs
– What price to set?
– What quantity to produce?
– When to enter and exit the industry?
• Firms’ cost structure has implications for these decisions and
hence, for the supply curve
Costs
Suppose two of you decide to start your own business.
• One puts his own Rs 2,00,000 savings into it and also for gives up his job
(implicit cost or opportunity cost)
• The other has no job and take a loan of Rs 2,00,000 from a bank
(explicit cost)
• How would their balance sheet differ?
• In Economics unlike accounting, we consider the implicit cost as well
• Economic profit is thus lower than accounting profit. One may have profit
in an accounting sense, but suffer an economic loss.
Why are movies rarely based on original ideas/
innovative plots/formats?
High fixed costs
Fixed Cost
• Costs of inputs whose use does not vary with the firm’s
output level
• Rent, insurance, interest cost,
• Semi fixed - wages, advertising, telephone bill expenses so on
– The short run is the time period in which at least one input
(cost) is fixed.
Solar panels
Which type of costs is high?
Let’s say a company spent $5 million building an airplane.
Before the plane is complete, it is obsolete and no airline will buy
it. Now the airlines want a different type of a plane.
The company can finish the plane for another $1 million, or it can
start over and build the new type of a plane for $3 million.
What should the company do?
Sitting through a bad movie because we have paid for it or overeating
at all-you-can eat buffet are also an example of a sunk cost fallacy
Some part of fixed costs is Sunk cost
Expenditure that has been made and cannot be
recovered.
Because a sunk cost cannot be recovered, it should
not influence the firm’s decisions.
Because it has no alternative use, its opportunity
cost is zero.
Total cost = Fixed cost + Variable cost
(Short run)
Variable cost
• Variable cost: costs of inputs that vary with the firm’s output
level
• Fuel, maintenance, electricity, transportation
– The long run is the time period in which all inputs can be varied
– all costs are variable costs
In their calculation of profit, accountants typically do not take into account:
A)
variable costs.
B)
fixed costs.
C)
opportunity costs.
D)
explicit costs.
When opportunity cost is positive, economic profit ______ accounting profit.
A)
is greater than
B)
is less than
C)
equals
D)
eliminates
Total cost
• In Economics, costs include Implicit cost (opportunity cost)
and explicit cost
• Total cost = Fixed cost + Variable cost
•
•
•
•
Average cost = Total cost/total production
Average Fixed cost = total fixed cost/total production
Average Variable cost = total variable cost/total production
Marginal cost = change in total cost/change in production
Starting a business?
Starting a fast-food restaurant. Rent is Rs 100
wages per worker Rs 10, raw material Rs 1 per unit of production
Number
Variable
of
Production Fixed cost
Total Cost
cost
workers
0
1
2
3
4
5
6
7
0
55
120
190
200
210
215
218
AFC
AVC
ATC
workers Production fixed cost
Variable
cost
Total
Cost
AFC
AVC
ATC
0
0
100
0
100
1
55
100
65
165
1.82
1.18
3.00
2
120
100
140
240
0.83
1.17
2.00
3
190
100
220
320
0.53
1.16
1.68
4
200
100
240
340
0.50
1.20
1.70
5
210
100
260
360
0.48
1.24
1.71
6
215
100
275
375
0.47
1.28
1.74
7
218
100
288
388
0.46
1.32
1.78
Average total and average variation cost
Cost of unit
ATC
AVC
Quantity
Average fixed cost and average Variable Cost
Average fixed cost is the fixed cost per unit of output.
Fixed cost per unit of output falls as output increases
Average variable cost is the variable cost per unit of output.
Variable cost per unit of output first falls and then rises
• First, gains from specialization – the spreading effect
• Then, the law of diminishing returns (holding fixed inputs constant)
• Example: Restaurant
Average Total Cost is total cost per unit of output
To begin with both AFC and AVC fall so ATC cost also falls. After a point, AVC
dominates, resulting in a U-shaped ATC curve
Marginal Cost
the Marginal Cost Curve first slopes downwards..
• Slope downward as a firm increases its production from zero up to
some low level, sloping upward only at higher levels of production.
• A firm that employs only a few workers often cannot reap the
benefits of specialization of labor. This specialization can lead to
increasing returns at first
• Once there are enough workers, diminishing returns set in.
….and then upwards
• Because there are diminishing returns to inputs in this example. As
output increases, the marginal product of the variable input
declines.
• This implies that more and more of the variable input must be used
to produce each additional unit of output as the amount of output
already produced rises.
• And since each unit of the variable input must be paid for, the cost
per additional unit of output also rises.
The Relationship Between the Average Total Cost and the
Marginal Cost Curves
Cost of unit
If marginal cost is
above average total
cost, average total
cost is rising.
MC
MC
ATC
H
B
A
1
A
MC
L
M
B
2
2
1
If marginal cost is
below average total
cost, average total
cost is falling.
Quantity
Minimum cost output
Cost of unit
2. … but diminishing returns set
in once the benefits from
specialization are exhausted
and marginal cost rises.
MC
ATC
AVC
A - Minimum cost output
A
1. Increasing specialization
leads to lower marginal cost…
Quantity
1985 – Coca cola company was faced with
soaring prices of cane sugar
1-cent increase in the price of sugar raised its
cost by $20 million.
1. What were the options for the company?
2. Is sugar a fixed or variable input?
Rather than raise price, the company looked
for cheaper input – corn sugar. Did the switch
in the input lower – TC, VC, FC, ATC,
AFC,AVC?
Shark Tank – Off the Cob
How much is the cost differential compared to the oldstyle corn chips?
What is the price difference?
What do you think is the price elasticity of demand?
Barrel of Oil
Produced
Marginal Revenue
Marginal Cost
Average Costs
1
$50
$4
$34
2
50
6
20
3
50
11
17
4
50
17
17
5
50
23
18.20
6
50
29
20
7
50
36
22.29
8
50
50
25.75
9
50
90
32.89
10
50
124
What is the total cost of producing eight barrels of oil?
A) $50
B) $206
C) $178
D) $336
42
What are the fixed costs of production for this firm?
A) $34
B) $4
C) $30
D) $50
Shrinkflation is the process of items shrinking in size or quantity! - Video
By tweaking the shape, Toblerone reduced its 400 gram
bar down to 360 .The length and the price though
remained the same (Feb 2018)
Home work - Fill in the blanks
Output
VC
0
1
TC
AVC
AFC
ATC
100
25
2
20
3
53.30
4
5
17.5
90
6
30
7
265
8
41.3
9
10
MC
35
425