Unit: 3 derivation of cost curves:

Meaning of cost
The sum of the prices paid to the inputs like rent, interest, wages, and others factors of production by the producer to
produce goods and services is known as cost of production.
Cost function
It shows the relationship between cost of production and the level of production. The cost function is expressed as
C= (Q, Pf, T)
Where,
C= cost of production
Pf = price of factors of production
T= Technology
Q= Quantity of output
Different concept of cost
1. Money cost
The value of payments made in terms of money to the inputs used in the production in the form of rent, wages,
salaries, allowances, profit, interest and price of raw materials is known as money cost. Cost of production
generally refers to the money cost. It is also known as nominal cost.
2. Real cost
Real cost is the sacrifice made by the producer while producing goods and services. Discomfort, disutility, pain are
some examples of real cost. The real cost cannot be calculated in terms of money because it is a subjective
phenomenon.
3. Accounting cost
Costs which are necessary for accounting purposes is known as accounting cost. It includes only direct cost or
payment made in terms of money to the factors of production which the firm does not own by itself. It does not
include indirect cost or real cost and the opportunity cost of self–owned resources or self–employed resources.
4. Explicit cost
The monetary payment or cash expenditures which a firm makes to those inputs which are not owned by the firm
itself are called explicit cost. In other words, explicit cost is the payment to non-owners of the firm or payment
given to hired factors of production from outside.
5. Implicit cost
Implicit cost is the contribution made by the producer and his/ her family members but not paid to them in monetary
terms. For example, a producer may use his own land, capital, building, cooperation of family members; but the
producer does not make any payment in money to such contributions. The payment for unhired factors of production
are its example.
6. Economic cost
Economic cost is the aggregate of explicit cost and implicit cost. Such cost covers both monetary cost and non-
monetary services provided by the producer including normal profit.
Short run cost:-
Short run is a period of the time in which the firm can vary its output by varying only the amount of variable factor
such as: labor & raw material. In the short run fixed factors such as capital equipment, top management salary etc
cannot be changed due to change the level of output.
In the short run if the firm wants to increases output, it can do only by overworking and by buying more raw
materials. It cannot enlarge the size of the existing plant.
Long run cost:-
Long run is a period during which the quantities of all factors of production are variable thus in the long run output
can be increases by increasing capital equipment or by increasing the size of existing plant or buy new plants. The
long run cost is the cost incurred which is sufficiently large to allow the variation in all factors of production
including capital equipment, land & building & payment made to managerial staff etc.

#Derivation of short run cost curves:-

• Total fixed cost (TFC)
• Total variable cost (TVC)
• Total cost (TC)
• Total fixed cost
The total amount of cost incurred on the fixed factors in short-run in the production process is known as total fixed
cost. The total fixed cost remains constant whatever be the level of output, i.e. zero or more. It includes the costs
like rent, cost of machinery, technology, insurance charge, etc.

• Total variable cost

The total amount of costs incurred on the variable factors in short-run is known as total variable cost. TVC remains
zero at zero level of output and it increases with increase in output. For example, TVC includes costs of raw
materials, energy and fuel, transport, seasonal labour, etc.
• Total cost
Total cost is self-defining. It is the sum of total fixed cost and total variable cost at each level of output or production.
Therefore,
TC = TFC + TVC.
At zero unit of output, total cost is equal to the firm’s fixed cost. Then for each unit of production total cost changes
by the same amount as does the variable cost.
Tabular & graphical presentation of TFC, TVC & TC:-
Output (q) TFC TVC TC
0 30 0 30
1 30 20 50
2 30 30 60
3 30 45 75
4 30 80 110
5 30 145 175

In the above table TC is obtained by adding TFC and TVC. As output increases, TC also increases when output is zero
TC is Rs.30 because fixed cost Rs.30. Although variable cost is Rs.0 initially TC increases at decreasing rate up to
second unit of output. There after it increases at increasing rate.

In the above figure, output is shown in X-axis and cost on Y-axis. TFC is total fixed cost curve. TVC is total variable
cost curve and TC is total cost curve. Total cost is similar shape with TVC curve. The difference is that TVC curve
begin from above the origin at Rs.30. the difference between TC and TVC curve will always be equal to TFC. Therefore,
these curves are parallel.
TFC is total fixed cost curve. TFC curve is parallel to X-axis. It means the TFC remain same whatever be the level of
output. TFC curve touch Y-axis at cost of rs.30 which means the fixed cost is Rs.30 even output is zero. TVC starts
from the origin which shows that when output is zero, total variable cost is also zero. It increases at a decreasing
rate up to second unit of output beyond that it increases at an increasing rate. Therefore, the shape of TVC curve
is inverse S shape.
Short-run Average Cost Curves or Relationship between Short-run Average Cost Curves or Derivation of
Short-run Average Cost Curves
1. Average Fixed Cost(AFC)
Average Fixed Cost (AFC) is the per unit fixed cost of production. AFC at each level of production
can be found by dividing the total fixed cost by the corresponding level of output (Q). Mathematically,

𝑇𝐹𝐶
𝐴𝐹𝐶 =
𝑄
2. Average Variable Cost(AVC)
Average variable cost is the per unit variable cost of production. It is calculated by dividing total
variable cost (TVC) by the corresponding level of output/production (Q). That is,
𝑇𝑉𝐶
𝐴𝑉𝐶 =
𝑄
3. Average Cost(AC)
Average total cost is per unit cost of production. Average cost, at each level of output is calculated
by dividing total cost by the corresponding level of output/production. So,
𝑇𝐶
𝐴𝐶 =
𝑄
The relationship between AFC, AVC and AC can be shown as below table:
Quantity of TFC TVC TC AFC AVC AC
output(Q)
0 50 0 50 - - -
1 50 20 70 50 20 70
2 50 30 80 25 15 40
3 50 45 95 16.7 15 31.7
4 50 80 130 12.5 20 32.5
5 50 145 195 10 29 39

In this figure, AFC continues to decline with the increase in level of output. AVC and AC both initially decrease,
remain constant and finally both starts to increase. The AFC, AVC and AC curves are shown as below:
In this figure, AFC, AVC and AC represent average fixed cost, average variable cost and average cost curves
respectively. AFC curve is rectangular hyperbola. AFC never touches x and y axes. It never touches x-axis
because it never becomes zero with the level of output. It never touches y-axis because at zero output it
becomes infinite. AC and AVC curve initially start to decline, reach at minimum point and both start to
increase. AC and AVC curves are roughly U-Shaped.

Unit-4 Theory of price and output determination:

Perfect Competition
Perfect competition is a market structure in which large number of sellers to sell the homogenous product to the
large number of buyers. It is the complete absence of control over price by an individual firm. There is complete
absence of rivalry among the individual firms.
Features of Perfect Competition
1. There are large number of buyers and sellers, and single buyer or seller cannot influence the market price.
2. All the firms under perfect competition produce homogenous product
3. Every firm is free to join or leave industry
4. There is perfect mobility of factors of production
5. There is no government intervention in the market
6. The objectives of all the firm is profit maximization
7. There is perfect market information regarding the price and the quantities of the commodity
Monopoly
Monopoly is defined as the market structure where there is single seller of a product having no close substitute
and there are barriers to entry. There are no competitors or rivals in the market. The monopoly firm determines
the price of the product itself. Therefore, it is also known as the price maker.
Features of Monopoly
1. There is single producer or seller of the product
2. There is no availability of close substitute of the product by the monopoly firm or the monopolist
3. A firm is itself an industry and an industry is itself a firm
4. Monopoly can sell its product at different prices to the different consumers, which is known as the price
discrimination.
5. There are legal or natural barriers in entry and exit of the firm
6. The monopoly firm is price maker or monopoly firm itself determines the price of the product

Profit Maximizing Goal of the Firm OR firm’s equilibrium

A firm is maximizing its profit when it is in equilibrium. There are two approaches to analyze firm’s equilibrium or
profit maximization. They are:
1. Total Revenue and Total cost Approach(TR-TC Approach)
2. Marginal Revenue and Marginal Cost Approach(MR-MC Approach)

TR-TC Approach
Under this approach, the firm produces that level of output where the positive difference between total revenue
and total cost is maximum. In this situation, the firm maximizes the profit.
The firm always wants to gain the maximum profit. Profit appears if the total revenue is greater than the total cost.
In this situation, the firm will be in equilibrium with making maximum profit. It can be shown by the following formula.
 = 𝑇𝑅 − 𝑇𝐶
Where,
=Profit
TR= Total revenue
TC=Total cost
Short run equilibrium of a firm under perfect competition market by using TR-TC approach
A perfectly competition firm attains equilibrium at that level of output at which the positive difference between TR
and TC is maximum. It is shown as below figure.
In this figure, TR represents total revenue curve, TC represents total cost curve and  represents total profit
curve. The difference between TR and TC is measured by the vertical distance between TR and TC. Up to output OQ 1,
and beyond output OQ3, TC curve lies above the TR curve, i.e. TC>TR. Therefore, in this situation the firm is bearing
loss. At output OQ1, and OQ3, the firm just covers its cost. It means that at these outputs, TC and TR are equal. Hence,
the point A and point B are break even points. Between output OQ1 and OQ3, TR is greater than TC. Therefore, between
these two levels of output, there is profit. At output OQ2, the vertical distance MN is maximum, i.e. the profit is
maximum. The  curve also shows the maximum profit at output OQ2. Hence, the firm is in equilibrium at the output
OQ2.
MR-MC Approach
MR and MC approach is a very important and useful approach to determining equilibrium of the firm. According to
this approach, the following conditions must be fulfilled in order to attain equilibrium by the firm:
i. Marginal revenue should be equal to marginal cost (MR=MC).
ii. Marginal cost must intersect marginal revenue from the below.

Short run equilibrium of a firm under perfect competition by using MR-MC approach
The determination of equilibrium of the firm under perfect competition by using MR-MC approach is shown as below
figure.
In this figure, MC is intersecting MR at two points E 1 and E2. At theses points, MC and MR are equal. But at point E 1,
the second condition of equilibrium, i.e. MC must intersect MR from below is not satisfied. At point E2, both conditions
of equilibrium are satisfied. Hence, the point E2 is the equilibrium point and the equilibrium output is OQ 2. The firm
will maximize the profit by producing OQ2 level of output.

Short run equilibrium of a firm under monopoly market by using TR-TC approach
A monopoly firm attains equilibrium at that level of output at which the positive difference between TR and TC is
maximum. It is shown as below figure.

In this figure, TR represents total revenue curve, TC represents total cost curve and  represents total profit
curve. The difference between TR and TC is measured by the vertical distance between TR and TC. Up to output OQ 1,
and beyond output OQ3, TC curve lies above the TR curve, i.e. TC>TR. Therefore, in this situation the firm is bearing
loss. At output OQ1, and OQ3, the firm just covers its cost. It means that at these outputs, TC and TR are equal. Hence,
the point A and point B are break even points. Between output OQ1 and OQ3, TR is greater than TC. Therefore, between
these two levels of output, there is profit. At output OQ2, the vertical distance MN is maximum, i.e. the profit is
maximum. The  curve also shows the maximum profit at output OQ2. Hence, the firm is in equilibrium at the output
OQ2.

Short run equilibrium of a firm under Monopoly/Imperfect Competition by using MR-MC approach
The determination of equilibrium of the firm under Monopoly or Imperfect competition by using MR-MC approach is
shown as below figure.

In this figure, MC is intersecting MR at two points E1 and E2. At theses points, MC and MR are equal. But at point E 1,
the second condition of equilibrium, i.e. MC must intersect MR from below is not satisfied. At point E 2, both conditions
of equilibrium are satisfied. Hence, the point E2 is the equilibrium point and the equilibrium output is OQ 2. The firm
will maximize the profit by producing OQ2 level of output.
#Price and Output Determination under Perfect Competition
Price and output determination under perfect competition in the short run (Short run equilibrium)
Short run refers to that time period in which time is so short that a firm cannot change the fixed
factors like plant and machinery. Therefore, a firm cannot change its production process and there
may be abnormal profit or normal profit or even loss depending on the firm’s revenue and cost
conditions. The profit and loss depend on the nature of AC and AR, which can be shown in the
following way:
 i. If AR>AC, the firm receives abnormal profit.
ii. If AR=AC, the firm receives normal profit.
iii. If AR<AC, the firm bears loss.

Condition for equilibrium

i. First order condition MC=MR.
ii. Second order condition, MC must cut or intersect MR from below.

The short run equilibrium of the firm and the industry under perfect competition has been shown
in the following figure.

In this above figure I represents the equilibrium of the industry. The downward sloping curve DD
is the demand curve and upward sloping curve SS is the supply curve. These two curves are
intersecting each other at point E , which is the equilibrium point. Hence, the equilibrium price
and quantity determined by the industry are OP and OQ respectively. As firms under the perfect
competition are price takers, all the firms must sell their product at the price OP.
Equilibrium of the firm
Abnormal profit(Super normal profit/Excess profit)
The figure II shows the abnormal profit earned by the firm. The firm earns abnormal profit when
AR is greater than AC (AR>AC). In this figure, E is the equilibrium point because at this point
MR and MC are equal and MC is intersecting MR from below. Hence, OQ is the equilibrium
quantity of the output determined by the firm. The firm is earning abnormal profit equal to shaded
rectangle area AEPC because AR is greater than AC. The average cost of production is OC or QA
and Average revenue is QE or OP.
Normal profit
The figure III shows the normal profit earned by the firm. Point E is the equilibrium point where
both conditions for equilibrium are satisfied. The equilibrium output determined by the firm is OQ.
At this output, the firm is earning just the normal profit because AR and AC are equal. Normal
profit is the profit which is just sufficient to run the business.
Loss
In the figure IV, the firm is bearing loss which is shown by the rectangle area EACP. Point E is
the equilibrium point where both conditions for equilibrium are fulfilled. The firm produces OQ
quantity of output which is the equilibrium level of output. In this figure, AC is greater than AR.
So, the firm is bearing loss.
Price and output determination under perfect competition in the long run(Long run
equilibrium)
In the long run the firm can make choice for entry and exit from the industry depending on the
profit situation. If profits are high, the new firms enter the industry. If the firms are in loss, they
exit from the industry. In this way, both abnormal profit and loss situations are ruled out in the
long run and the firm will earn just the normal profit.

In the figure, the industry is in the equilibrium at point Eo where demand equals to supply and
determines the equilibrium price OP. The firm follows this OP price. By the following this price,
the firm is in equilibrium at point E1 where LMC=MR and LMC is intersecting MR from below.
At point E1, LAC is tangent to AR curve. This shows that the firm is operating under normal profit.

Price and Output Determination under Monopoly

Price and output determination under monopoly in the short run (Short run equilibrium)
Under monopoly, the profit and loss depend on the nature of AC and AR, which can be shown in
the following way:
 i. If AR>AC, the firm receives abnormal profit.
ii. If AR=AC, the firm receives normal profit.
iii. If AR<AC, the firm bears loss.

Condition for equilibrium

i. MC=MR.
ii. MC must intersect MR from below.

Price and output determination under monopoly in the short run is shown in below figure.

Abnormal profit( Super normal profit/Excess profit)

The figure I shows the abnormal profit earned by the firm. The firm earns abnormal profit when
AR is greater than AC (AR>AC). In this figure, E is the equilibrium point because at this point
MR and MC are equal and MC is intersecting MR from below. Hence, OQ is the equilibrium
quantity of the output determined by the firm. The firm is earning abnormal profit equal to shaded
rectangle area ABPC because AR is greater than AC. The average cost of production is OC or QA
and Average revenue is QB or OP.
Loss
In the figure II, the firm is bearing loss which is shown by the rectangle area PABC. Point E is the
equilibrium point where both conditions for equilibrium are fulfilled. The firm produces OQ
quantity of output which is the equilibrium level of output. In this figure, AC is greater than AR.
So, the firm is bearing loss.
Normal profit
The figure III shows the normal profit earned by the firm. Point E is the equilibrium point where
both conditions for equilibrium are satisfied. The equilibrium output determined by the firm is OQ.
At this output, the firm is earning just the normal profit because AR and AC are equal. Normal
profit is the profit which is just sufficient to run the business.
Price and output determination under monopoly in the long run (Long run equilibrium)
Under the monopoly, the entry of the new firms blocked and there are no any close substitutes of
the product, the firm will remain in the business if there is no loss in the long run.
The equilibrium of monopolist in the long run is explained with the help of below figure:

In this figure, AR is the average revenue curve of a monopoly firm. LAC and LMC are the long
run average and marginal cost curves. In the figure, the monopolist is in the equilibrium at the
point E with OP price, OQ quantity and OC or QA as the long run average cost of production. AS
AR>AC, the monopolist is operating under abnormal profit equal to the shaded are ABPC in the
long run.