Microeconomics

Sultan Qaboos University

Lecture 11

Learning Objectives

Describe how the various measures of

cost are related.
Discuss how economic and accounting
costs are different.
Understand (dis)economies of scale.

Dollar Costs

Total cost (TC): the market value of all

resources used to produce a good or service.
Fixed cost (FC): costs of production that dont
change when the rate of output is altered
(ex. Capital).
Variable cost (VC): costs of production that
change when the rate of output is altered
(ex. Raw materials,
labor).
Total Costs = Fixed costs +
Variable costs
TC
=
VC

FC

Average Costs

Average total cost (ATC): total cost divided by the

quantity of output in a given time period.
ATC

Average fixed costs (AFC): total fixed cost divided

by the quantity of output in a given time period.
AFC

= TC / q

= FC / q

Average variable cost (AVC): total variable cost

divided by the quantity of output in a given time
period.
AVC

= VC / q

Average Costs

Characteristics of the Cost

Curves

Falling AFC: as output increases, AFC decreases rapidly.

Any increase in output will lower AFC. The slop of AFC
is always negative.

U-shaped AVC: AVC decreases at first, hits a minimum,

and then rises as output increases (as a result of
diminishing returns).

U-shaped ATC: at low output, falling AFC dominates and

ATC decreases. As output increases, rising AVC begins
to dominate. ATC hits a minimum, then begins to rise.

Short-Run Costs to the Firm

Question

What do you thinkis there a predictable

relationship between the production
function and AVC, ATC, and MC?

Short-Run Costs to the Firm (cont'd)

Answer

As long as marginal physical product rises,

marginal cost will fall, and when marginal
physical product starts to fall (after
reaching the point of diminishing marginal
product), marginal cost will begin to rise

Short-Run Costs to the Firm (contd)

The relationship between average

and marginal costs:

When marginal costs are less than average

variable costs, the latter must fall

When marginal costs are greater than

average variable costs, the latter must rise

Short-Run Costs to the Firm (cont'd)

There is also a relationship between

marginal costs and average total costs

Average total cost is equal to total cost

divided by the number of units produced

Marginal cost is the change in total cost

due to a one-unit change in the production
rate

Minimum Average Cost

The output at which ATC switches from being

dominated by AFC to being dominated by
rising AVC is the point where average costs
are minimal.
It

is at this output where the firm can produce at

the lowest cost per unit...
and where the firm minimizes the amount of
resources being used.
However, this amount of output is not necessarily
the output where profit is maximized.

Marginal Cost (MC)

Change in total cost
Marginal cost (MC) =
Change in output

As MC rises, it intersects ATC at its

minimum point.
ATC decreases when MC<ATC.
ATC increases when MC>ATC.

Example:

If you have a B average (equivalent to

ATC), and you make a C in the next class
(equivalent to MC below ATC), your GPA
goes down.

If you have a B average (equivalent to

ATC), and you make an A in the next
class (equivalent to MC above ATC), your
GPA goes up.

Summary Discussion

Know how the law of diminishing returns

applies to the production process.

Given a fixed input (usually capital), adding

a variable input (usually labor) will increase
total product but at a diminishing rate.
The

MPP of the variable input tends to decline

as more of it is used in a given production
facility.

As returns diminish and MPP declines,

marginal cost (MC) increases.

Summary Discussion (Contd)

Describe how the various measures of

cost are related.

Total costs equal total fixed costs plus total

variable costs. TC = FC + VC.
Average costs are calculating by dividing
each of the above by quantity produced.
ATC

= TC/q; AFC = FC/q; AVC = VC/q.

MC intersects ATC at its minimum point.

A Guide to Costs

TC = FC + VC
ATC = TC/q
AFC = FC/q
AVC = VC/q
ATC = AFC + AVC
MC =
TC/
q

Summary of the Basic Cost Curves

Problem 1
As a firm increases its output in the short
run, average fixed cost

a. rises steadily
b. falls and then rises
c. falls steadily
d. rises and then falls
e. remains unchanged

Problem 2
Which of the following can you determine
if you know only the total cost at an
output level of zero?

a. marginal cost
b. fixed cost
c. average cost
d. average total cost

Problem 3
Which of the following is true about the
relationships among various cost curves?

a. when MC exceeds ATC, ATC must be rising

b. when MC exceeds ATC, ATC could be rising
or falling
c. when ATC is falling, MC must exceed ATC
d. when TC is rising, MC must exceed TC
e. TC falls when AFC falls

Problem 4
Which of the following costs will always
increase as output increases?

a. total costs
b. average total costs
c. marginal costs
d. fixed costs

Problem 5
The ATC at a given output level multiplied
by the number of units produced at the
output level equals:

a. marginal costs
b. total fixed costs
c. total variable costs
d. total costs

Problem 6
A company could produce 99 units of a
good for $316 or produce 100 units of the
same good for
$320. The marginal cost of the 100th unit

a) is $320.
b) is $3.20.
c) is $4.00
d) cannot be calculated with this
information.

Problem 7
Short-run marginal cost is equal to

a. the change in total cost divided by the change in

output.

b. the change in total variable cost divided by the

change in output.

c. the cost per unit of the variable input divided by

the marginal product of the variable input.

d. all of the above.

Problem 8
Short-run average variable cost is equal to

a. total variable cost divided by output.

b. average total cost minus average fixed cost.

c. the cost per unit of the variable input divided

by the average product of the variable input.

d. all of the above.

Problem 9

If the output levels at which short-run

marginal and average cost curves reach
a minimum are listed in order from
smallest to greatest, then the order
would be
a. AVC, MC, ATC
b. ATC, AVC, MC
c. MC, AVC, ATC
d. AVC, ATC, MC

Problem 10

Which of the following is a variable cost?

a. Interest payments
b. Raw materials costs
c. Property rents
d. All of the above are variable costs.

Problem 11

Which of the following describes the

relationship between the marginal product and
marginal cost in the short run best?

a .As the marginal product increases, the

marginal cost goes up, vice versa.
b. As the marginal product decreases, the
marginal cost declines, vice versa.
c. Both (a) and (b) are correct because they
imply the same correlation.
d. As the marginal product increases, the
marginal cost declines, vice versa.

Problem 12
Which of the following is true about the
relationships among various cost curves?

a. when TC is rising, MC must exceed TC

b. when MC exceeds ATC, ATC could be rising
or falling
c. when ATC is falling, MC must exceed ATC
d. when MC exceeds ATC, ATC must be rising
e. TC falls when AFC falls

Problem 13
Total cost is equal to

a. Variable costs of production

b. Revenues minus total cost
c. Opportunity cost
d. Fixed costs plus variable costs of
production