CHAPTER 1: BASIC CONCEPTS OF ECONOMICS AND ALLOCATION OF

RESOURCES

#Concept of Modern Economics

Lionel Robbins British economist (1898-1984) gives the modern or scarcity definition of
economics in his book “An Essay on the Nature and Significance of Economic Sciences” which
was published in 1932 AD. He said that economics is concerned neither with material means nor
with welfare."

According to him, “Economics is the science which studies human behaviour as a relationship
between ends and scarce means which have alternatives uses."

Major features of definitions are:

 Ends: human wants

 Means: resources
 Alternative uses
 Problems of choice
 Wants differ in Urgency

Economics is the social science that studies how people use their scarce resources to satisfy
unlimited needs and wants. The resources include the factors of production that are land, labour,
capital and entrepreneurship. From a teenager to a homemaker and then to a businessman all face
the same issue of how to spend their income to attain maximum satisfaction. So, the basic
economic problem is scarcity. Wants are unlimited and resources are finite, so choices have to be
made. Resources have to be used and distributed optimally.
The Economic Problem of Scarcity

The fundamental problem of economics is that we have unlimited wants, but limited
resources to satisfy these wants. When wants exceed the resources available we have scarcity.
Scarcity occurs because human wants exceed the limits of available resources. Economics deals
with the basic fact that scarcity exists in our everyday lives and in our economy. Resources such
as raw materials are in finite supply and must be allocated to their best use. Virtually all
resources are scarce, meaning that more of them are desired than is available. Economics is
concerned with the way people have to make choices in order to overcome the problems
of scarcity.

Choice

Given the presence of scarcity, choices must be made as to how resources are allocated. Our
lives are filled with a wide range of choices regarding the use of limited personal funds.
Advertisers constantly inform consumers of their consumption possibilities and the choices
available. The same principle applies for the economy as a whole. We elect politicians who work
with policy makers to allocate government expenditures. Together they make difficult choices
concerning how taxes will be spent.

Opportunity Cost

The relevant cost of any decision is its opportunity cost - the value of the next-best
alternative that is given up. This will mean that if we choose more of one thing, we
will have to have less of something else. Economists use the term opportunity cost to
explain this behavior. The opportunity cost of any action is the value of the next best alternative
forgone. By making choices in how we use our time and spend our money we give
something up. Instead of following the economics classes, what else could you be doing?
Your best alternatives may involve sports, leisure, work, entertainment, and more. Thus,
the concept of opportunity cost is your best alternative to the choice that is made. If you choose
to go to a restaurant this evening, the money that you spend on dinner will not be available for
other uses, even saving.
For example, if you only have Rs.50 and you go to a shop, you can buy either the chocolate bar
or the packet of cheeseball. The scarcity of the resource (the money) means a choice has to be
made between the chocolate and the cheeseball.

This gives rise to opportunity cost. The opportunity cost of a choice is the value of the next best
alternative forgone. In the above example, the opportunity cost of choosing the cheeseball is the
chocolate bar.

If a car was bought for Rs. 15,00,000 and after 5 years the value depreciates by Rs1,50,000, the
opportunity cost of keeping the car is Rs. 1,50,000 (which could have been gained by selling the
car), regardless of the starting price.

Opportunity cost is important to economic agents, such as consumers, producers and

governments. For example, producers might have to choose between hiring extra staff and
investing in a new machine. They cannot do both because of finite resources, so a choice has to
be made for where resources are best spent.

 When producing goods, the following questions have to be considered:

 What to produce: determined by what the consumer prefers. Consumers tell producers
what they prefer by demanding goods and using their ‘spending votes’.
 How to produce it: producers seek profits and aim to minimize production costs
 For whom to produce it: whoever has the greatest purchasing power in the economy, and
is therefore able to buy the good.

#Production Possibility Curve/frontier/transformation curve

Graphical representation of the maximum level of output that can economy can achieve with full
utilization of the existing resources is called production possibility curve (PPC). It gives us the
maximum limit of goods & services that could be produced so, it is also known as Production
Possibility Boundary or Production Possibility Frontier (PPF).The production possibility curve is
also called transformation curve, because when we move from one position to another, we are
really transforming one good into another by shifting resources from one use to another.

Assumptions of PPC
  There is no change in technology.
 Economy is producing only two goods.
 Full employment of resources.
 Factors of production is given and fixed.
 Time period is given.

Table 1: Production Possibilities Curve of soap and pencil

Production Possibilities Soap (Units) Pencil (Units)

A 0 30

B 2 29

C 5 26

D 9 20

E 11 12

F 12 0

The above tabular data (i.e table 1) shows the combination of two products (Soap and Pencil),
production of which can be done optimally with the help of Production Possibility Curve. With
the increase in the production of one product, there is a decrease in the production of others as
the resources are finite/limited.

On the basis of above schedule we can plot al the coordinates of A, B, C, D, E and F, which
show the various combination of two goods, soap and pencils. This is shown in Fig. 1
 Figure 1: Production Possibilities Curve of soap and pencil

Thus, as shown in the above Graph, all the points on the PPC curve are optimal. The
combination could be 0 units of Soap and 30 units of a pencil. It can be 20 units of pencil and 9
units of soap and so on. All the points on the curve equally use all inputs in the finest way. Thus
producing any combination of units on the Graph is fully efficient.

NOTE:

 CAN PPC BE A STRAIGHT LINE

A PPC curve can be a straight line only if the marginal rate of transformation (MRT) is constant
throughout the curve. A MRT can remain constant only if both the commodities are equally
constant and the marginal utility derived from their production is also constant.

 CAN PPC BE CONVEX TO THE ORIGIN

PPC is convex shaped because of decreasing marginal rate of transformation. It implies that less
and less units of commodity sacrificed to gain an additional unit of another commodity.

 WHAT DOES IT MEAN WHEN AN ECONOMY IS OPERTING ON PPC?

Every point on PPC indicates that resources are efficiently and fully utilized for the production
of goods and services in the economy. Therefore, when a country operates on the PPC, the
potential output is achieved, in terms of actual output.

 WHAT CAUSES SHIFT IN PPC?

Shifts in the production possibilities curve are caused by things that change the output of an
economy, including advances in technology, changes in resources, more education or training
(that's what we call human capital) and changes in the labour force. Shift can be either towards
rightward or towards leftward, when there is a change in resources or technology with respect to
both goods.

 RIGHTWARD SHIFT IN PPC:

When there is advancement or upgradation of technology and growth of resources of both the
goods then Production Possibility Curve will shift to the right. This indicates the increase in
production of both the commodities.
  LEFTWARD SHIFT IN PPC:

When there degradation of technology and decrease of resources of both the goods then
Production Possibility Curve will shift to the left that indicates the decrease in production of both
the commodities.

#Allocation of Resources

Unlimited wants Limited resources

Scarcity

What to produce How to produce For whom to produce

Allocation of resources is defined as the process of selection of resources and their proper
utilization various types of resources are required to produce goods and services. Every economy
in the world faces the problem of unlimited wants and limited resources. This economic problem
gives rise to the central problems of an economy which are as follows:

1. What to produce?
2. How to produce?
3. For whom to produce?
1. What to produce?
 The problem such as what goods are to be produces and in what quantities arises directly
from the scarcity of the resources. Since, the resources are scarce, the problem of nature
of goods and services and their quantities has to be decided.

2. How to produce?
The central problem of hoe to produce is the problem relating to the choice of technique
of production to be used for producing different goods and services. There are two types
of production:
 Labour Intensive Technique(LIT)
It means technique of production in which more labour is used than the capital.
 Capital Intensive Technique (CIT)
It means technique of production in which more capital is used than the labour.
3. For whom to produce:
This means how goods and services produced are distributed among the people. In the
other hand, it also means who gets how much of the goods and services produced in the
country.

#Division of Labour and Specialization

Division of labour is the separation of work process into a number of tasks with each other
performed by a separate person or a group of persons. In other words, it refers to a process of
dividing a particular task into several smaller tasks to different works. So, under the division of
labour a task is divided into a number of tasks for different workers.

Types of division of labour and specialization

Division of labour and specialization can be categorized into three types which are follows:

1. Simple Division of Labour:

2. Complex Division of Labour
3. Geographical Division of Labour
 1. Simple Division of Labour:
It means production of a single commodity by a person. In a society where simple
division of labour prevails everyone would be producing only one commodity. Some
will be making shoes; some will be producing other product.

2. Complex Division of Labour

When the production process is divided into many parts and each part is completed by
different workers, it is called complex division of labour. Such division is seen in all
big industries such as car manufacturing.
3. Geographical Division of Labour
It means to the specialization in the production of different commodities at different
place. It is also called the regional division of labour or localization of industries. For
example: tea production in Illam, coffee production in Palpa, apples production in
Jomsom etc.

Advantages of Division of Labour

1. Right man in right place

It is the main advantages and objectives of division of labour. Each workers does
their part of work in which they are best, skilled, talent and experience in field.
2. Reduction in cost
Since the division of labour increases the efficiency and productivity of work which
helps in reduction of cost.
3. Increase efficiency and productivity of labour
Workers doing the same work again and again become an expert in that work. So, it
increase productivity and efficiency of the workers
4. Large scale production
 Division of labour lead to specialization which helps to increase the productivity of
labour and large scale of production is done.
5. High quality production
When each part of the production is accomplished by the best worker, quality product
will be produced by the worker as they become skillful in their tasks.
6. Time saving
The labour employed in same process and no longer have to move from one process
to another. It saves labour time.

7. Invention
When workers are doing same type of work over and over again, they get some ideas
and invention occurs.

Disadvantages of Division of Labour

1. Monotony
It is the major demerits of division of labour. A worker doing the same work all the time
gets bored soon.
2. Absence of responsibility
Since, many workers combine to produce a single product no one can held responsible if
something goes wrong in the production process.
3. Loss of pride
A worker can never be proud of completing the work. He/she cannot claim the full credit
for completing the work as many works combine together in that work.
4. Risk of unemployment
It is worker losses if he is fired from the current job. He may not get the same type of job
because of the limited job efficiency and skill.
5. Intellectual and emotional cost
Over specialization caused by division of labour is not good for intellectual and
emotional development of the workers which leads to narrow mind and feeling of
separation.
 6. Dependency
Workers are dependent to each other as divisions of their works are done. If labour is
absent, the whole production will be stopped.
7. Fear of overproduction
The division of labour increases efficiency and enables to use more machinery which
leads to fear of overproduction.

Specialization

Specialization means doing the same thing over and over until one become expert in doing that
particular task. It is the outcome of division of labour. In the process of specialization, an
individual or firm concentrate on what they are good at.

Advantages

1. Right man at right place

2. Improvement in skills
3. Less training
4. Large scale production
5. Time saving

Disadvantages

1. Monotony
2. Absence of responsibility
3. Loss of skills
4. Dependency
5. Fear of unemployment
 UNIT 2: MARKET AND REVENUE
CURVES

#Concept of Market and Its Features

Economics is an arrangement through which buyers and sellers come in close contact
with each other directly or indirectly. In economics, market means a social system
through which the sellers and purchasers of a commodity or a service can interact
with each other. It does not denote a particular place.

Market

Mechanism/System/Process
Sellers
/Channel/Place Buyers

Figure 1: Market

According to Prof. P.A.Samueslson,” A market is a mechanism by which buyers and

sellers interact to determine the price and the quantity of a good or service.”
 Market includes following essential features:

 Availability of commodity (commodity means goods and services): In

economics, a market is not related to a specific place but to a specific
product. It means that a market can exist if there is one commodity that
will be purchased and sold among the buyers/consumers and
sellers/producers.
 Availability of buyers and sellers: Another feature of a market is the
presence of buyers and sellers. The buyers and sellers must contact
each other in the market. However, it does not mean that they
should meet physically; the contact can be through modern means of
communication, like the internet, mail, telephone, etc.
 Communication:
 Place/Area: In economics, a market is not related to a specific place, instead, it
spreads over an area that becomes the point of contact between the
producers/sellers and consumers/buyers. With the advancement of technology and
modern means of communication, the market area of a product has become wide.
 Medium of exchange (money, card, esewa, fonepay etc.):
Buyers and sellers are scattered and they are in contact with one another through means
of communication like letters, agents, brokers, telegraphs, telephone, newspapers, e-
commerce etc. Transactions are finalized on the basis of samples and the goods are
handed over or transferred from one place to another. Thus, in economics market is a
wider term.

#Classification of Market on the Basis of Competition

To study and analyze the nature of different forms of market and issues faced by them

Market on the basis of Competition

 while buying and selling goods and services, economists have classified the market in
different ways. They are as follows:

Perfect competition Imperfect Competition

Monopoly Monopolistic Oligopoly

Figure 2: Market on the basis of competition

I. Perfect Competition or Pure Competition

A market structure where a large number of buyers and sellers sell homogeneous
products at a uniform price is called perfect competition. A market situation where a
large number of buyers and sellers deal in a homogeneous product at a fixed price set
by the market is known as Perfect Competition. Homogeneous goods are goods of
similar shape, size, quality, etc. In other words, in a perfect competitive market, the
sellers sell homogeneous products at a fixed price determined by the industry, not by a
single firm. In the real world, the situation of perfect competition does not exist;
however, the closest example of a perfect competition market is agricultural goods
sold by the farmers. Goods like wheat, sugarcane, etc., are homogeneous in nature and
their price is influenced by the market.
Features of Perfect Competition
The following are the salient features of perfect competition:
 A Large Number of Buyers and Sellers: There is a large number of buyers and
sellers of a commodity under this market structure. No individual seller or buyer
is in a position to influence the market price as they sell or purchase a small
portion of the total stock available in the market.
 Homogeneous Product: The product sold by various firms in this market is
identical. Identical product means that each unit of the product is perfect
substitute.
 Free Entry and Exist of Firms in an Industry: In this market each individual
firm is free to enter and exit the industry whenever they are interested. There
are no restrictions on the entry and exit of firms in the industry.
 Perfect Mobility of Factors of Production: All the factors of production have
perfect mobility. Whenever there is change in their remuneration they can move
from low paid remuneration to highly paid remuneration in other industries
under this type of market.
 Perfect Knowledge of Market Conditions: Under this type of market buyers and
sellers have perfect knowledge regarding the price of the product, its availability
and who are selling the product and who are buying the product. Perfect
knowledge leads to existence of single price in the market.
 No transport Cost: Under this market there is any transport cost because the
market is adjusted to the area. Commodity is easily carried away from one part of
the market to another that there is no need of transport cost.
 Absence of Artificial Restrictions: Under this type of market there is non-
existence of any artificial restrictions on the demand and supply of the product,
prices of inputs and products and price determination.

II. Imperfect Competition

Another type of market structure based on competition is imperfect competition.
There are a small number of firms selling differentiated products. Under this market
there is a large number of buyers and sellers with product differentiation, there are no
restrictions on the entry and exit of firms but there is an existence of non-price
competition among these differentiated products.
On the basis of definitions of imperfect competition we can say that the following
are the salient features of imperfect competition:

 A small number of buyers and sellers.

  Ignorance of buyers and sellers.
 Product differentiation.
 Differences in prices.
 Non-price competition or advertisement and sales promotion.
Other factors prevailing in the market namely trade mark, behavior of sellers, credit
facility, home delivery and repair services, guarantee, samples etc.

Types/Forms of Imperfect Competition

There are different forms of imperfect competition are as given under:
1. Monopoly Market
2. Monopolistic Market
3. Oligopoly Market

1. Monopoly Market
Monopoly is a completely opposite form of market and is derived from two Greek
words, ‘Mono’ means single and ‘Poly’ means seller. When there is a single seller or
producer of a commodity or service the market structure is called a monopoly market.
He/she has full control of its supply and there is no close substitute. In a monopoly
market, there are various restrictions on the entry of new firms and exit of the existing
firms. Also, there are chances of Price Discrimination in a Monopoly market. For
example: Nepal electricity Board, oil corporation, railways etc.

Characteristics of Monopoly
On the basis of above definitions we can describe the characteristics of monopoly
market structure as given below:

 Single Seller and Large number of buyers: Single sellers and large numbers of
buyers of a commodity or service is the characteristics of monopoly market.
 Individual buyer cannot influence the price of the product.
 No Close Substitute: Under monopoly market the commodity or service sold by
the seller has no close substitute.
 One Firm or One Industry: The seller or producer of a commodity or service is
firm as well as an industry. There is no distinction between the firm and industry
under the monopoly market.
 Restrictions on the Entry: Under monopoly no firm can enter the industry or
market as there is several types of artificial and natural restrictions imposed by the
monopolist. These restrictions may be in the form of copy right, patent, license,
owner of mines etc.
 Control over the Supply: Under monopoly the seller of a commodity has full
control over the supply and he is a price maker. He is free to fix whatever price he
charges in order to attain his objective of maximization of profit.
 Either Price of Supply Fixation: A monopoly either fixes the price or determines
the supply of its product. He does not do both the things simultaneously. In order
to maximize his profit he will either fix the price or control the supply of his
output.

Thus, a monopoly market structure is that where there is a single seller of a

commodity having full control over its supply and there is no close substitute.

2. Monopolistic Market
A Monopolistic Competition Market consists of the features of both Perfect
Competition and a Monopoly Market. A market situation in which there are a large
number of firms selling closely related products that can be differentiated is known as
Monopolistic Competition. The products of monopolistic competition include
toothpaste, shampoo, soap, etc. For example, the market for soap enjoys full
competition from different brands and has freedom of entry showing the features of a
perfect competition market. However, every soap has its own different feature, which
allows the firms to charge a different price for them. It shows the features of a
Monopoly Market.
Features

 A Large number of sellers and buyers: There are a large number of buyers
in the market. All buyers have their unique preferences. These buyers are
divided into selling companies based on their preferences. Buyers buy
products based on their needs.
 Seller control over the Price of the Product, but not over the Market: A seller
has control over the price of the products produced by his company. Unlike
perfect competition, he is not required to maintain the same as other
vendors. For example, the PUMA brand sells its jackets at high prices for its
brand name.
 Product Variation/differentiation: Product variation is an essential feature of
monopolistic competition. For example, different tea brands like Tata Tea,
Tetley Tea, Society Tea, and Taj Mahal Tea sell tea at different prices by
promoting different characteristics of the tea.
 Freedom of Entry and Exit: Take the example of a coffee shop in a shopping
mall. People enjoy coffee as long as it provides services to people. But, if one
day for some reasons the owner of the coffee shop wants to close the business.
This won’t make a big deal out of the mall coffee business. Initially, people
will be surprised and soon move to another nearby coffee shop. Therefore, the
entry and exit of a firm from the trading market do not create turbulence as it
does in a monopoly market.
 Incomplete mobility of products: This means that all products are available
everywhere, regardless of their origin. For example, in monopolistic
competition, it is difficult for companies to change the price of the product by
moving it to a different location to sell it. However, companies often move
products to a perfectly competitive market.
3. Oligopoly
A market situation where the number of big sellers of a commodity is less and the
number of buyers is more is known as Oligopoly Market. As the number of sellers in
this market is less, the price and output decision of one seller impacts the price and
output decision of other sellers in the market. In other words, the interdependence
among the sellers of a commodity is high. For example, luxury car producers like
BMW, Audi, Ford, etc., come under Oligopoly Market, as the number of sellers of
luxury cars is less and its buyers are more.

Features
 Few Firms: There are few firms under an oligopoly market whose number is
not exactly defined. But, each of the firms under this market produces a
significant part of the total output. Each of the firms in the oligopoly market
competes with each other severely and tries to manipulate their product’s price
and volume to outsmart each other. Also, the number of firms in the market is so
small that the action of one firm affects the rival firms.
 Non-Price Competition: The firms under an oligopoly market can influence the
price of the product; however, they try to avoid such influence as it can start a
price war, which none of the firms wants. So, to compete with each other, the
firms use different methods other than pricing, such as after-sales services,
advertising, etc.
 Interdependence: The firms under an oligopoly market are interdependent,
which means that the actions of one firm affect the actions of other firms. A
change in the price or output of one firm changes the reaction of other firms
operating in the same market. For example, if Maruti makes any change in the
price of its cars, then its rival firms such as Tata, Hyundai, etc., will also have
to make respective changes in their activities.
 Barriers to Entry of Firms: There are only a few firms under oligopoly because
of the barriers to the entry of the new firms in this market. The new firms
prevent themselves from entering into the oligopoly market because of the
 large capital requirement, patents requirement, and many other factors.
Therefore, the new firms, which can cross these barriers, enter the market,
which results in earning abnormal profits in the long run.
 Role of Selling Costs: Selling cost is the cost spent on the advertisement,
sales promotion, and marketing of the product. As there is severe
competition and interdependence among the firms, they take help of selling
costs to sell their product in the market.
 Nature of the Product: The firms under oligopoly market may produce
differentiated or homogeneous products. The firms producing homogeneous
products are known as pure oligopolies. Whereas, the firms producing
heterogeneous products are known as imperfect oligopolies.

#Concept of Revenue

The total amount of money received by a firm from the sale of the product is called
revenue. The profit of a firm depends upon the cost and revenue. The profit earned by
the firm is the difference between the revenue and the cost of production. There are
three types of revenue which can be explained as follows:
1. Total Revenue (TR):

Total revenue is the total amount of money received by a firm from the sales
of a given quantity of product. Mathematically, total revenue is the product
of price and quantity sold.
Symbolically;

𝑇𝑅 = 𝑃 × 𝑄

Where,

TR=Total
 Revenue
P=price per
unit Q=
Quantity
sold
2. Average Revenue (AR);

Average revenue is the price per unit. Average revenue is obtained by

dividing the total revenue by the total number of quantity sold.
Symbolically;

𝐴𝑅 = 𝑇𝑅/𝑄

Where,

AR= Average
Revenue TR=
Total revenue
Q= Quantity sold

3. Marginal Revenue (MR):

Marginal revenue is the addition to the total revenue from the sales of an
additional unit of a commodity. Marginal revenue is obtained by dividing
change in total revenue by the change in quantity sold.
Symbolically,

𝑀𝑅 = ∆𝑇𝑅 / ∆𝑄

Where,

∆TR =Change in TR

∆Q= Change in
quantity sold OR,
𝑀𝑅 = 𝑇𝑅𝑛 − 𝑇𝑅𝑛 − 1

Where,

TRn = Current Total

 Revenue TRn-1 =
Initial Total Revenue
#Derivation of TR, AR, and MR under perfect competition:
Perfect competition is a market structure having a large number of buyer and sellers
selling homogeneous products at a uniform price. The TR, AR, and MR under
Perfect competition can be derived as follows:

Table 1: Relationship between TR, MR and AR under Perfect Competition Market

Quantity Price per 𝑻𝑹 = 𝑷 𝑨𝑹 = 𝑴𝑹 =

sold (Q) unit (P) ∗𝑸 𝑻𝑹/𝑸 ∆𝑻𝑹 / ∆𝑸

0 10 0 0 0
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
In the above table, we can see that the value of TR is increasing at the same rate
because every additional of the commodity is sold at Rs.10. Average revenue remains
constant at all levels of output. AR, MR, and price are equal to each other. It can be
graphically explained as follows:
Figure 3: Relationship between TR, MR and AR under Perfect Competition Market

In the above figure, we can see that the TR curve is increasing at a constant rate. AR
and MR curve are the same and they coincide with each other. They are the same at all
levels of output. TR curve is positively sloped whereas AR and MR are a horizontal
straight line parallel to the x-axis.
#Derivation of TR, AR, and MR under Monopoly or imperfect competition:
Monopoly is the market structure having a single seller selling the type of product
which has no close substitute. They are the price makers. Under Monopoly, a
monopolist can increase its revenue by selling few products at a high price and more
products at a low price. The TR, AR, and MR can be derived with the help of the
following table 2:

Table 2: Relationship between TR, AR, and MR under Monopoly or Imperfect Competition:
Quantity Price per 𝑻𝑹 = 𝑷 𝑨𝑹 = 𝑴𝑹 =
sold (Q) unit (P) ∗𝑸 𝑻𝑹/𝑸 ∆𝑻𝑹 / ∆𝑸
0 10 0 0 0
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
 5 10 50 10 10
In the above table, we can see that when the quantity sold is increasing, the price is
decreasing. Total revenue increases at first up to the fifth unit then becomes
maximum and declines thereafter. AR and price are similar. Marginal revenue is
declining, becomes zero and even negative.

The TR, AR and MR Curve can be derived from the above table 2 as follows:

Figure 4: Relationship between TR, AR, and MR under Monopoly or

Imperfect Competition:

In the above diagram TR, MR and AR are shown along y-axis and quantity sold is
shown along x-axis respectively. We can observe that when total revenue is rising
AR and MR are falling. When TR becomes maximum, marginal revenue becomes
zero. When TR starts to fall, then marginal revenue declines to negative.
 CHAPTER 3: COST CURVES

Concept of Cost
In order to produce goods and services, a firm uses raw materials and factors of production
which are called inputs. The expenditure incurred by these inputs is called cost. Cost of
production is a component of determining the profit of a firm. At a certain price of a commodity,
the low cost of production results in high profit and high cost of production results in low profit
or loss.
There are various kinds of cost. Some of them can be explained as follows:
 Fixed cost:
Fixed cost includes the expenses incurred by the fixed factors of production. They are those
factors which cannot be changed in the short run. The cost incurred by the fixed factor of
production remains constant at all levels of outputs. It includes rent of the business premises,
interest on capital, salaries of permanent employees, depreciation of machines and furniture, etc.
It is also known as an overhead cost.
 Variable cost:
Variable cost includes the expenses incurred by the variable factors of production. They are the
factor that can be changed in accordance with the change in production even in the short run. It
includes the cost of raw materials, the wage of workers, cost of power and fuel, etc. If the
quantity of production increases the cost will increase and vice versa. When the output is zero,
the variable cost will be zero.
 Short run cost:
The short run is a time period in which the firm can vary its output by varying only the amount
of variable factors such as labor and raw materials. In the short run, fixed factor such as capital,
equipment, top-level management, etc. cannot increase its output by enlarging the existing plant
and building.
 Long run Cost:
The long run is a time period in which all the factor of production is variable. Thus, in the long
run, the output can be increased by increasing fixed factors of production like a plant,
machinery, building, etc as well as variable factors.
 Explicit Cost:
An explicit cost is an immediate installment made to others throughout maintaining a business.
For example, wage, lease, and materials. The actual cost, likewise called as Real Cost is the cost
really acquired by the firm to make all the physical installments and the legally binding
commitments.
In this way, all the cash costs recorded in the books of records are, for down to earth purposes,
the real or explicit cost. This cost goes under the bookkeeping cost idea, as all the physical and
effortlessly unmistakable costs caused are recorded in the bookkeeping books, which are then
later examined to decide the productivity with which the firm is working.
 Implicit Cost:
An Implicit cost is any cost that has just happened however isn't really appeared or announced as
a different cost. The Implicit or certain or ascribed, or imputed cost can be named as a cost which
comes about because of utilizing the advantage for one's own particular use as opposed to leasing
or offering it, or the salary is salary is inevitable of not deciding to work.
The best case for implicit cost would be an opportunity cost. The credited cost isn't considered
while figuring the profit or loss of the firm, yet be that as it may, is vital to choose whether or not
to proceed with the factor in its present use. The implicit cost is utilized to ascertain the
economic profit. The economic profit is the contrast between the aggregate incomes produced
less aggregate cost.

Derivation of Short-Run Cost Curves

1. Total fixed cost (TFC):

Fixed cost refers to the expenditure incurred by the producer on the fixed factor of production. It
is also known as the total cost made on the fixed factor. In the short run, they do not change with
change in output. It remains fixed although the fixed factors are increased or decreased to alter
the output. It can be explained by the help of following schedule and diagram:
 Table 1: Total fixed cost

Outputs (in units) Total fixed cost (in Rs.)

0 30
1 30
2 30
3 30
4 30
5 30

Figure 1: Total fixed cost curve

In the above diagram, we can see that TFC curve is parallel to x-axis because fixed cost remains
constant at all levels of outputs in the short run.

2. Total Variable Cost (TVC)

Variable cost refers to the cost incurred by the variable factors of production. It does not remain
constant like the fixed cost at different levels of output. Whenever the output increases or
decreases the variable cost will also increase or decrease. It can be explained by the help of
following schedule and diagram:
 Table 2: Total Variable Cost

Output (in units) Total variable cost

0 0
1 20
2 30
3 45
4 80
5 145

Figure 2: Total Variable Cost Curves

In the above figure, we can see that TVC curve increases at a decreasing rate at first and then
increases at an increasing rate after some units of production because of applicability of the law
of variable proportion in the short run.
3. Total cost (TC)

Total cost is defined as the total monetary expenditure incurred in the production process. It is
the sum of the fixed cost and total variable cost.

Symbolically,

TC=TVC + TFC

It can also be explained by the help of following schedule and diagram:

Table 3: Total Cost Curves

Output (in units) Total variable cost Total fixed cost TC=TVC+TFC
(TVC) (TFC)
0 0 30 30
1 20 30 50
2 30 30 60
3 45 30 75
4 80 30 110
5 145 30 175
 Figure 3: Total Cost Curves

In the above figure, costs are shown along y-axis and outputs are shown along the x-axis. TFC is
parallel to x-axis because it is constant at all levels of output. TVC is increasing as the output are
increasing. TC is also increasing because of variable cost is also included in it. The nature of TC
and TVC are similar. They are parallel to each other. The only difference is that TVC starts from
origin and TC starts above the origin

Difference between Fixed Cost and Variable Cost

Basis Fixed cost Variable cost
Definition The cost incurred by the fixed The cost incurred by the variable factor
factors of production is called the of production is called variable cost.
fixed cost.
Output It does not change with output. It changes with output.

Relation It is related to the fixed factor. It is related to the variable factor.

Continuation A firm can continue its production Production will be continued by a firm
even if the fixed cost is not covered only if its variable cost is covered.
in the short run.
Examples Rent, salaries of permanent staff, Cost of raw materials, wages of casual
interest on capital, insurance cost, labor, expenses on petty overheads, etc.
etc.

Derivation of Short-run Average Cost Curves

1. Average fixed cost (AFC)

The average fixed cost is obtained by dividing the total fixed cost by the level of outputs. It is
also known as the per unit fixed cost of output.

Symbolically;

AFC = TFC / Q
It can be explained by the help of following schedule and diagram

Table 4: Average Fixed Cost

Output (in units) TFC (Rs) AFC (Rs)

1 30 30

2 30 15

3 30 10

4 30 7.5

5 30 6

Figure 4: Relationship Average Fixed Cost and TFC

In the above figure, we can see that the AFC curve is a rectangular hyperbola. AFC curve is
downward sloping because, as we produce more units of output, AFC declines. It never touches
the Y axis because, at zero units of production, AFC is infinite. Similarly, it never touches x-axis
because AFC never becomes zero.

2. Average variable cost (AVC)

Average variable cost is obtained by dividing the total variable cost by the corresponding levels
of output. It can be expressed as:

AVC = TVC / Q

We can derive AVC by the help of following schedule and diagram:

Table 5: Relationship between TVC and AVC

Output (in units) TVC (Rs) AVC (Rs)

1 20 20
2 30 15
3 45 15
4 80 20
5 145 29

Figure 5: Relationship between TVC and AVC

In the above figure, we can see that AVC falls at the beginning and then inclines. An AVC curve
is 'U' shaped because of the operation of the law of variable proportion.

3. Average Total Cost (ATC/ AC)

Average total cost is obtained by dividing the total cost by the corresponding level of output. It
can be expressed as;

TC TFC + TVC
ATC= = = AFC + AVC
Q Q

It can be derived with the help of following schedule and diagram:

Table 6: Average Total Cost

Output (in units) AFC (Rs) AVC (Rs) ATC (Rs)

1 30 20 50

2 15 15 30

3 10 15 25

4 7.5 20 27.5
5 6 29 35

Figure 6: Average Total Cost

In the above diagram, we can see that ATC falls at the beginning. It becomes minimum and rises
after that point. Therefore, it is 'U' shaped.
Marginal cost (MC)
Marginal cost is defined as the change in the total cost due to one additional unit of change in the
output. In other words, it is the ratio of change in the total cost and change in the total output.
Symbolically;
MC=∆ TC/ ∆Q
Or,
MC=TC n - TC n-1
Where;
MC = Marginal Cost
∆TC = Change in Total Cost
∆Q = Change in quantity sold
TC n = Current Total Cost
TC n-1 = Initial Total Cost
The concept of Marginal cost can be explained by the help of following schedule and diagram:
Table 7: Marginal cost

Output (Q) TC MC

0 30 30

1 50 20

2 60 10

3 75 15

4 110 35

5 175 65
 Figure 7: Marginal cost

In the above figure, SMC or MC represents the short-run marginal cost curve. Up to the second
unit of output it has declined to become minimum and rises thereafter. It is also ‘U’ shaped
because of the operation of the law of variable proportion in the short run.

Relationship between AC and MC

There is a close relationship between AC and MC. MC is the change in TC resulted from the
change in the production of one more unit of output whereas AC is the total cost divided by the
output. Both AC and MC are derived from TC.

Symbolically;
MC=∆ TC/ ∆Q AC = TC / Q
The relationship between these two can be explained with the help of the following diagram:
 Figure 8: Relationship between AC and MC

In the above figure, SMC represents the short-run marginal cost curve and SAC represents the
short-run average cost curve. SMC and SAC intersect each other at the minimum point of SAC.
It lies to the right of A, the minimum point of SMC i.e. point B. The relationship between these
two can be summarized as follows:

1. Both AC and MC curve are calculated from the total cost.

2. Both AC and MC are ‘U’ shaped.

3. When AC is falling, the MC curve lies below AC and MC falls faster than AC.

4. When AC is rising, the MC curve lies above the AC and MC rises faster than AC.

5. When AC is minimum, MC=AC

6. MC intersects at the minimum point of AC.

7. MC cuts AC from below.