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BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):COSTS

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Introduction to Economics ­ECO401
VU
Lesson 5.4
BACKGROUND TO SUPPLY/COSTS(CONTINUED..............)
COSTS
Economistsargue that sunk costshould not be included in a rational person's decisionmaking
processwhile opportunity costshould be included.
VariableCost and FixedCosts:
Costswhich vary with thelevel of activity (oroutput) are called variablecosts.
Costswhich do not vary withthe level of activity or output are called fixedcosts. In long run
thereare no fixed costs.
There is an inverserelationshipbetween costs andproductivity, i.e. as productivityrises,
costsfall and viceversa.
TotalCost:
Totalcost (TC) is the sum of all fixed and variablecosts. It plot as a verticalsummation of the
horizontalline total fixed cost(TFC) curve and theupward sloping totalvariable cost (TVC)
curve.
AverageCost:
Averagecost (AC) is the verticalsummation of the AFC & AVC, where
AFC = TFC/Q and
AVC = TVC/Q.
AC = AFC + AVC, whereaverage fixed cost (AFC) is a downward sloping line as you are
dividing a fixed number by an increasingnumber of output units. By contrast, averagevariable
cost(AVC) first falls as outputincreases and thenrises.
Study of AC is necessary for firms to be able to set the price or (average revenue) at which
theywill sell. Also theywill be interested in knowinghow AC is broken down intoAFC & AVC.
Relationshipbetween AC and AVC:
Initially, AC falls more rapidly than AVC because AC is a summation of AFC & AVC and since
bothare falling the effect of two falling curves is greater than the effect of one falling curve.
Afterthe turning point in AVC, both AC and AVC rise butthe gap between themnarrows
because of same reasoning as givenabove.
MarginalCost:
Marginalcost is the addition to TC caused by a unit increase in output. Moregenerally:
MC = ΔTC/ΔQ.
Thesecret of the shape of the MC curve lies in the law of diminishing marginal returns.The
relationshipbetween MC and AC is a reflection of the relationship between MPP & APP. That
is:both MC and AC fall in thebeginning, then MC starts to rise, cutting AC from below at the
latter'sturning point(minima).
In the long run, thelaw of diminishing marginalreturns does not apply to the extent that it does
in short run.
Theequivalent of constant, increasingand decreasing returns to scale in terms of costsare
economies of scale, diseconomies of scaleand constant costs (orconstant returns to scale).
i.   In the case of economies of scale, long run totalcost (LRTC) is an upward
slopingcurve but with fallingslope. Note that theslope can never becomezero or
negative,though.
ii. In diseconomies of scale, LRTC is an upward sloping curve with an increasing
slope.
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Introduction to Economics ­ECO401
VU
iii. In constant costs, LRTC is a positively sloped straightline.
TheLong-Run Average Cost Curve(LRAC):
Thelong-run average cost (LRAC)curve for a typical firm is U shaped.
i.   As a firm expands, it initiallyexperiences economies of scale(due to productive
efficiency,better utilization of resourcesetc.); in other words it faces a downward
slopingLRAC curve.
ii.After the scale of operation is increased further, however,the firm achieve
constantcosts i.e., LRAC becomeflat.
iii. If the firm furtherincreases its scale of operation, diseconomies of scaleset in
(due to problems with managing a very large organizationetc.) and theLRAC
assumes a positive slope.
Thefollowing assumptions aremade while deriving LRACcurves:
Price of factors are constant,technology is fixed, firmschoose that combination of factors at
whichthe MPP of the last dollarspent on each input is equal.
Long-runmarginal cost(LRMC):
In case a firm is enjoyingeconomies of scale, eachincremental unit will costless than the
precedingone i.e., LRMC will be falling. The opposite will be true for diseconomies of scale. In
case of constant costs, eachincremental unit will costthe same, i.e., theLRMC will be
constant.
Relationbetween SRAC and LRACcurves:
TheLRAC curve for a firm is actually derived from itsSRAC curves. The exactshape of the
LRAC is a wave connecting theleast cost parts of theSRAC curves. In practicehowever,
LRAC is shown as a smooth U-shapedcurve drawn tangent to theSRAC. This is alsocalled
an envelope curve.
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Table of Contents:
  1. INTRODUCTION TO ECONOMICS:Economic Systems
  2. INTRODUCTION TO ECONOMICS (CONTINUED………):Opportunity Cost
  3. DEMAND, SUPPLY AND EQUILIBRIUM:Goods Market and Factors Market
  4. DEMAND, SUPPLY AND EQUILIBRIUM (CONTINUED……..)
  5. DEMAND, SUPPLY AND EQUILIBRIUM (CONTINUED……..):Equilibrium
  6. ELASTICITIES:Price Elasticity of Demand, Point Elasticity, Arc Elasticity
  7. ELASTICITIES (CONTINUED………….):Total revenue and Elasticity
  8. ELASTICITIES (CONTINUED………….):Short Run and Long Run, Incidence of Taxation
  9. BACKGROUND TO DEMAND/CONSUMPTION:CONSUMER BEHAVIOR
  10. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….)
  11. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….)The Indifference Curve Approach
  12. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….):Normal Goods and Giffen Good
  13. BACKGROUND TO SUPPLY/COSTS:PRODUCTIVE THEORY
  14. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):The Scale of Production
  15. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):Isoquant
  16. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):COSTS
  17. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):REVENUES
  18. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):PROFIT MAXIMISATION
  19. MARKET STRUCTURES:PERFECT COMPETITION, Allocative efficiency
  20. MARKET STRUCTURES (CONTINUED………..):MONOPOLY
  21. MARKET STRUCTURES (CONTINUED………..):PRICE DISCRIMINATION
  22. MARKET STRUCTURES (CONTINUED………..):OLIGOPOLY
  23. SELECTED ISSUES IN MICROECONOMICS:WELFARE ECONOMICS
  24. SELECTED ISSUES IN MICROECONOMICS (CONTINUED……………)
  25. INTRODUCTION TO MACROECONOMICS:Price Level and its Effects:
  26. INTRODUCTION TO MACROECONOMICS (CONTINUED………..)
  27. INTRODUCTION TO MACROECONOMICS (CONTINUED………..):The Monetarist School
  28. THE USE OF MACROECONOMIC DATA, AND THE DEFINITION AND ACCOUNTING OF NATIONAL INCOME
  29. THE USE OF MACROECONOMIC DATA, AND THE DEFINITION AND ACCOUNTING OF NATIONAL INCOME (CONTINUED……………..)
  30. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME
  31. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME (CONTINUED………..)
  32. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME (CONTINUED………..):The Accelerator
  33. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS
  34. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….)
  35. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Causes of Inflation
  36. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):BALANCE OF PAYMENTS
  37. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):GROWTH
  38. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Land
  39. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Growth-inflation
  40. FISCAL POLICY AND TAXATION:Budget Deficit, Budget Surplus and Balanced Budget
  41. MONEY, CENTRAL BANKING AND MONETARY POLICY
  42. MONEY, CENTRAL BANKING AND MONETARY POLICY (CONTINUED…….)
  43. JOINT EQUILIBRIUM IN THE MONEY AND GOODS MARKETS: THE IS-LM FRAMEWORK
  44. AN INTRODUCTION TO INTERNATIONAL TRADE AND FINANCE
  45. PROBLEMS OF LOWER INCOME COUNTRIES:Poverty trap theories: