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Micro Final

Uploaded by

yitagesyeshitla212
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© © All Rights Reserved
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CHAPTER FOUR

THEORY OF COST

4. 1. Introduction to Theory of Cost


Production and cost are closely linked; profits cannot be made without costs. Costs exist only if
they contribute to production. The cost of production refers to the money spent in producing and
distributing goods and services. It includes all expenses incurred in the production
process. Economic theory separates costs into short-run and long-run categories. Short-run costs
occur when some production factors are fixed, while long-run costs allow all production factors
to change. Total cost is influenced by multiple factors in both the short-run and long-run.

Types of Costs
This section explains different types of costs that businesses face including explicit, implicit,
economic, social, and private costs. It also distinguishes between fixed and variable costs.
A) Explicit vs Implicit Costs
• Explicit Costs: These are direct, out-of-pocket payments made to suppliers for resources like
labor, land, and materials. They are also known as accounting costs.
• Implicit Costs: These represent the opportunity costs of resources owned by the business, like
the owner's salary or estimated rent for owned property. They reflect what could have been
earned if the resources were used elsewhere.

B) Economic or Opportunity Cost


Economic costs are the sum of both explicit and implicit costs. The opportunity cost is the value
of the best alternative that is forgone to produce a good or service.

C) Economic vs Accounting Profits


Profits are calculated differently by accountants and economists due to how they treat costs.
• Economic Profit: Total revenue minus both explicit and implicit costs.
• Accounting Profit: Total revenue minus explicit costs. If economic profit is zero, it means the
resources could not earn more in any other use.

D) Social vs Private Costs


• Social Costs: Costs borne by society due to production, including both private costs and
external costs like pollution.
• Private Costs: Costs directly incurred by an individual or firm for goods and services.

E) Fixed vs Variable Costs


• Fixed Costs: Costs that remain constant regardless of output, such as rent and salaries.
• Variable Costs: Costs that change directly with the level of output, which become zero if
production is zero.
4. 3. Theory of Cost in the Short-Run

In the short-run, production includes at least one variable cost and one fixed cost. Labor costs are
usually variable, while capital costs are fixed. The section explores the nature and behavior of
these short-run costs with tables and graphs

Summary of Cost Concepts


The concepts of costs in production can be broken down as follows:
A) Total Fixed Cost (TFC) is constant at 100 Birr.
B) Total Variable Cost (TVC) is zero at zero output; it increases at varying rates as output
increases.
C) Total Cost (TC) starts at 100 when output is zero and combines TFC and TVC; in the long
run, TC equals TVC as TFC becomes zero.
D) Average Fixed Cost (AFC) decreases as output increases since TFC is constant.
E) Average Variable Cost (AVC) increases with output.
F) Average Cost (AC) is total cost per unit of output and has a U-shape, reaching its minimum
after AVC.
G) Marginal Cost (MC) is the extra cost for producing one more unit.

Theory of Cost in the Long-Run


The key difference between short-run and long-run costs is that some costs are fixed in the short-
run, while all costs are variable in the long-run. This means firms can increase labor and
capital. In the long-run, firms manage output and costs by adjusting the operation of a plant and
changing the size and number of plants, focusing on the relationship between a firm’s size and its
outputs.

Long-Run Average Cost (LAC) Curve


The LAC is illustrated in figure 4. 3. It shows three short-run average cost (SAC) curves for
small, medium, and large plant sizes, labeled SAC1, SAC2, and SAC3. The minimum cost for
the first plant is Q1C1, while the second plant has a lower minimum cost of Q2C2 due to
economies of scale. Larger sizes allow for specialization and increased productivity. However,
the introduction of the third plant leads to diseconomies of scale, causing management
issues. The LAC is formed by connecting the decreasing and increasing parts of the SAC curves
and the minimum of SAC2, referred to as the "Envelope" or "Planning" curve.

1) Which one of the following is an implicit cost?

A)The price of a plane

B) Ticket to a football match

C) Time spent in line buying tickets


D)Rent payment for an apartment E) None of the above

6) The value of resources that belong to the owner of the firm that are employed in the
production but they are not included in the cash flow of the company are:

A) Private cost D) Accounting cost

B) Social cost E) Implicit cost

C) Economic cost

CHAPTER FIVE

PERFECT COMPETITION
4. 1 Introduction:

Definition and Basic Assumptions of Perfect Competition

Perfect Competition is a market structure where many firms exist, leading to no rivalry between them;
individual firms do not get recognized in the market due to their small size.

Key Points

A) Large Number of Sellers and Buyers: The market consists of many firms, so each firm’s output is too
small to affect market prices. Buyers are also numerous, having little influence on total demand,
meaning they cannot negotiate discounts from sellers.

B) Homogeneous Product: All firms produce identical products, making it impossible for buyers to
distinguish between them. This leads to firms acting as price-takers, with their demand being perfectly
elastic and equal to their average and marginal revenue.

C) Perfect Knowledge: All buyers and sellers are assumed to have complete and cost-free knowledge
about market conditions, including prices and product quality.

D) Free Entry and Exit of Firms: Firms can freely enter or exit the industry without legal or market
barriers.

E) No Government Regulation: There is an absence of government interference such as tariffs or


subsidies.

F) Perfect Mobility of Factors of Production: Resources and labor can move freely among firms, with no
monopolization of materials or labor unions present.

Short-Run Equilibrium of the Firm and the Industry

To understand the industry's equilibrium, we need to analyze the market supply by calculating the
supply of individual firms, as the market supply is the total of all firms' supplies.

Short-Run Equilibrium of the Firm


Firms aim to maximize profits, achieving equilibrium when they attain maximum profit or minimum
losses. There are two ways to determine profit-maximizing output levels: Total approach and marginal
approach.
i.e. at the price at which the quantity demanded is equal to the quantity supplied.
Total Approach
A firm reaches equilibrium when it maximizes profit (π), calculated as total cost (TC) subtracted from
total revenue (TR). In a competitive market, the total revenue curve is linear, showing constant price at
all output levels, and marginal revenue equals the market price. Thus, in pure competition, MR=AR=P.

Numerical Example: If the total cost function of a form under perfectly competitive market is given by:
TC = 2Q2 – 28Q + 100

(a) Find the optimum level of output and the corresponding profit when price of the product is Br.
20? Solution: 4 =28

1) One of the following is true about short-run equilibrium of the perfect competitive firm

A) The second order derivative would be equal to zero at equilibrium

B) Slope of MC is less than the slope of

C) Total revenue is a convex to the origin

D) At equilibrium the firm will maximize its losses

E) None of the Above

Assume a profit-maximizing firm in perfect competition industries producing soft.

The firm sells its soft at the prevailing market price, why? Due to the assumption of

A) Large number of sellers and buyers, and producing similar product

B) Producing homogenous product and no individuals influence on the market

C) Cost less information and no government regulation

D) Free entry and exit of firms

E) Perfect mobility of factors of production


Except one, all of the following are true about the long-run equilibrium of perfectly competitive
firms

A) Firms will leave the industry to avoid normal profits

B) Long-run average cost curve is tangent to the demand curve

C) Firms can change their plant size

D) Firms earn a normal profit

E) Price and average cost of the firm are equal due to free entry

y 4) One of the following is not assumption of perfectly competitive market

A) There is a personal recognition

B) Single buyer and sellers cannot affect the market price

C) Any amount of output sells at constant price

D) Consumers have no any room to differentiate the products of different firms

E) Government doesn’t intervene in the market

Firms within perfectly competitive market may encounter one of the following in

short run depending on average cost:

A) Excess profit

B) Normal profit

C) Negative profit

D) All of the above

E) Unknown

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