Business Economics

Unit 5
Prof. Kingshuk Sarkar
Economic Cost
Economic Cost= Explicit Cost+ Implicit Cost

Implicit cost is also known as opportunity cost.

Time Element and Cost
Short Run: Is defined as the period during which production can be
varied only by changing the quantities of variable factors and not the
fixed factors. Land, factory building, heavy capital equipment, services
of manager are some of the factors that can be varied in a short period.

Long Run: Is the period which is long enough for the inputs of all factors
of production to be varied. In this period, no factor is fixed, all are
variable factors.
Comparison
Fixed Cost Variable Cost
Do not vary with the change in quantity of Vary with the change in quantity of output
output
They are related with the fixed factors They are related with variable factors
They do not become zero They can become zero when production is
stopped
A firm can continue production even at the Production is carried on only when variable costs
loss of fixed costs in the short run are met in the short run
Total Cost Curve

Units of TFC
Output5
0 20
1 20
2 20
3 20
4 20
5 20
Shape of TFC
Total Variable Cost
Units of TVC
Output
0 0
1 18
2 30
3 40
4 52
5 65
6 82
7 106
8 140
Shape of TVC
Total Cost
Units of Output TFC TVC TC
0 20 0 20
1 20 18 38
2 20 30 50
3 20 40 60
4 20 52 72
5 20 65 85
6 20 82 102
7 20 106 126
8 20 140 160
Shapes of TFC,TVC and TC
Average Fixed Cost (AFC)
Units of TFC AFC
Production
0 20 -
1 20 20
2 20 10
3 20 6.67
4 20 5
5 20 4
6 20 3.33
Shape of AFC
Average Variable Cost
Units of Production TVC AVC
0 0 -
1 18 18
2 30 15
3 40 13.33
4 52 13
5 65 13
6 82 13.67
7 106 15.14
8 140 17.50
Shape of AVC
Short Run Cost Curves
Relationship between AC, AVC and AFC
• As the output increases, AC curve declines. This is because
AC=AVC+AFC and both AVC and AFC decline with the increase in
output.
• Between output Q1 and Q2, the AVC curve starts rising, however AC is
still declining. This is because the rate of fall in AFC is greater than the
rate of rise in AVC.
• As the output increases beyond Q2, the AVC curve comes closer to AC
curve, however it does not meet AC curve. This is because AC and AVC
is AFC and AFC can never be zero.
Marginal Cost
• Short run marginal cost is the increase in total cost resulting from one
unit increase in output. In short, it may be called incremental cost.

Thus, MC=dTC/dQ
Or
MC=TCn-TCn-1
MC calculation
Units of Output TFC TVC TC MC
0 20 0 20 -
1 20 18 38 18
2 20 30 50 12
3 20 40 60 10
4 20 52 72 12
5 20 65 85 13
6 20 82 102 17
7 20 106 126 24
8 20 140 160 34
MC curve
Why MC curve is U-shaped
• As output rises, the MC curve first falls, reaches a minimum and then
begins a rise. Thus, MC curve has a U-shape.
• The reason behind the U-shape of MC curve is the ‘law of variable
proportion’.
• The law states that with the increase in a variable factor, keeping other
factors constant, the marginal product first increases and then after a
certain level of production, it starts to decline.
• In other words, in the beginning, the shape of increasing returns operates
which increases the MP and MC declines. Then, after reaching a certain
limit, in the stage of diminishing returns, MC rises with further increase in
output. Thus, the short run MC curve becomes U-shaped.
Relationship between AC and MC
Units of Output TC AC MC
0 20 - -
1 38 38 18
2 50 25 12
3 60 20 10
4 72 18 12
5 85 17 13
6 102 17 17
7 126 18 24
8 160 20 34
• When MC is less than AC, the AC curve falls. For, example, units 1 to 5
in table and fig up to point B (OM1 output) depicts this situation.

• When MC is equal to AC, AC becomes constant. This is the minimum

point of AC and it is this minimum point, that MC curve cuts AC from
below. In this regard, 6th unit in table and point B in the figure may be
seen.
• When MC is higher than AC (or MC curve rises above the AC curve),
AC starts rising. It can be seen from 6th unit and thereafter in the table
and point B onwards in the figure.
AC-MC relationship can be summarized as follows: As long as MC is
below AC, it keeps on pulling AC down, when MC gets to be just equal
to AC, AC neither rises nor falls and is at its minimum and when MC
goes above AC, it keeps pulling AC up.
Isoquant
Isoquant Curve Definition. An isoquant is a curve showing all possible
combinations of inputs physically capable of producing a given level of output.
Assumptions
• There are only two factor inputs, labour and capital, to produce a particular
product.
• Capital, labour and goods are divisible in nature.
• Capital and labour are able to substitute each other up to a certain limit.
• Technology of production is given over a period of time.
• Factors of production are used with full efficiency.
Isocost
An isocost line is a curve which shows various combinations of inputs
that cost the same total amount. For the two production inputs labour
and capital, with fixed unit costs of the inputs, the isocost curve is a
straight line. The isocost line is always used to determine the optimal
production combined with the isoquant line.

C=wL+rK
In economics, an expansion path (also called a scale line ) is a path
connecting optimal input combinations as the scale of production
expands. which is often represented as a curve in a graph with
quantities of two inputs, typically physical capital and labor, plotted on
the axes. A producer seeking to produce a given number of units of a
product in the cheapest possible way chooses the point on the
expansion path that is also on the isoquant associated with that output
level.
Long run average cost
Curve relating average cost of production to output when all inputs,
including capital are variable.
LAC as envelop curve
The LAC curve is the locus of all the tangency points. As a consequence
of this, the LAC curve is called the ‘envelope curve’ as it envelops or
supports a family of SAC curves. It is to be remembered here that the
LAC curve, throughout its length, is not tangential to the minimum
points of all the SAC curves.
Economies of scale
• Economies of scale: Situation in which output can be doubled for less
than doubling of cost

• Diseconomies of scale: Situation in which a doubling of output

requires more than doubling of output requires more than a doubling
of cost