Fundamentals of Microeconomics

Vikas Gupta

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 1
Costs of Production
• Industrial Organization- The study of how firms’ decisions about prices and quantities depend on
the market conditions they face
• Basic Concepts
• Total Revenue - The amount a firm receives for the sale of its output
• Total Cost - The market value of the inputs a firm uses in production
• Profit - Total revenue minus total cost
• Explicit Costs - Input costs that require an outlay of money by the firm
• Implicit Costs - Input costs that do not require an outlay of money by the firm

• Opportunity cost of an item refers to all those things that must be forgone to acquire that item
Opportunity Cost = Explicit Costs + Implicit Costs
• When economists speak of a firm’s cost of production, they include all the opportunity costs of
making its output of goods and services
• Examples – foregone interest on capital deployed, wages lost in alternative work, etc.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 2
Economic Vs Accounting Costs

• Accountants - Consider only explicit costs in

calculating financial statements because they focus
on actual costs incurred and flow of money.
• Economists - Consider both explicit and implicit
costs, because they are interested in studying how
firms make production and pricing decisions, which
are based on both types of costs
• Economic profit - Total Revenue minus all
Opportunity Costs, including both explicit and
implicit costs
• Accounting profit - Total Revenue minus Total
explicit cost
Usually, accounting profit is higher than economic profit, but unless the firm makes economic profit it
is likely to shut down eventually.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 3
 The Production Function
Production Function - The relationship between the quantity of inputs used to make a good and the
quantity of output of that good

Marginal Product – The increase in

output that arises from an additional unit
of input

MP(N2) = (Q2 – Q1 ) / (N2 – N1)

Diminishing Marginal Product – The

property whereby the marginal product
of an input declines as the quantity of
that input increases

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 4
 The Production Function Calculations
Cost of factory would be fixed cost at $30

For 1 Worker:
Cost of Worker = $10
Number of Cookies produced = 50
Marginal product MP1 = (Q1 – Q0 ) / (N1 – N0)
MP = (50-0)/ (1-0) = 50
Total cost = $30 + $10 = $40

For 2 workers:
Cost of Workers = $20
Number of Cookies produced = 90
Marginal product MP2 = (Q2 – Q1 ) / (N2 – N1)
MP = (90-50)/ (2-1) = 40
Total cost = $30 + $20 = $50

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 5
 Production Function and Total Cost Curve
Production Function and Total Cost Curve are two sides of the same coin

The slope of the production function

measures the marginal product of a
worker.

As the number of workers increases, the

marginal product declines, and the
production function becomes flatter.

The total cost curve gets steeper as the

amount produced rise.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 6
The Various Measures of Cost
• Fixed Costs (FC) - Costs that do not vary with the quantity of output produced and are incurred
even if the firm produces nothing at all.
• Variable Costs (VC) - Costs that vary with the quantity of output produced, are 0 with no
production
• Total costs (TC) – Sum of Fixed and Variable costs
• Average Total Cost (ATC) - Total cost divided by the quantity of output (ATC = TC/Q)
• Average Fixed Cost (AFC) - Fixed cost divided by the quantity of output (FC/Q)
• Average Variable Cost (AVC) - Variable cost divided by the quantity of output (VC/Q)
• Marginal Cost (MC) - Increase in total cost that arises from an extra unit of production (MC =
∆TC/∆Q)

Average total cost tells us the cost of a typical unit of output if total cost is divided evenly over all the
units produced. Marginal cost tells us the increase in total cost that arises from producing an
additional unit of output.
Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 7
Example – Measures of Cost

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 8
 Cost Calculations
With zero cups produced, Fixed Cost (FC) is given as $3 (will stay constant), and Total Cost = $3

For 1 Cup of Coffee:

Variable Cost (VC) = $0.30
Total Cost (TC) = 3 +0.3 = 3.30 Note: As the quantity produced
Average Fixed Cost (AFC) = FC/ Q = 3/1 = 3 increases,
Average Variable Cost (AVC)= VC/ Q = 0.3/1 = 0.3
Average Total Cost (ATC) = TC/Q = 3.3/1 = 3.3
Marginal Cost (MC) = Additional cost of producing 1st cup = ∆ TC/Q = (3.3-3.0)/1 = 0.3 FC remains constant
VC increases
For 2 Cups of Coffee: TC increases
Variable Cost (VC) = $0.80
Total Cost (TC) = 3 +0.8 = 3.80
Average Fixed Cost (AFC) = FC/ Q = 3/2 = 1.5 AFC decreases
Average Variable Cost (AVC)= VC/ Q = 0.8/2 = 0.4 AVC increases
Average Total Cost (ATC) = TC/Q = 3.8/2 = 1.9 ATC decreases
Marginal Cost (MC) = Additional cost of producing 1st cup = ∆ TC/Q = (3.8-3.3)/(2-1) = 0.5

For 3 Cups of Coffee:

MC increases
Variable Cost (VC) = $1.5
Total Cost (TC) = 3 +1.5 = 4.5
Average Fixed Cost (AFC) = FC/ Q = 3/3 = 1
Average Variable Cost (AVC)= VC/ Q = 1.5/3 = 0.5
Average Total Cost (ATC) = TC/Q = 4.5/3 = 1.5
Marginal Cost (MC) = Additional cost of producing 1st cup = ∆ TC/Q = (4.5-3.8)/(3-2) = 0.7
Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 9
 Total Cost Curve
Total Cost increases with quantity of output, curve gets steeper as output increases due to diminishing
marginal product of input.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 10
Cost Curves and Their Shapes
Marginal cost rises with the quantity of
output (diminishing marginal product).

The ATC curve is U-shaped – At low

output, fixed costs drive total cost, while
at higher output variable costs make
ATC to increase.

The MC curve crosses the ATC curve at

the bottom of ATC curve – This point
minimizes total costs and is called
Efficient Scale of the firm.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 11
Relationship between Marginal Cost and
Average Total Cost
• Whenever marginal cost is less than average total cost, average total cost is falling.
Whenever marginal cost is greater than average total cost, average total cost is
rising.
• MC< ATC ->>>> ATC is falling
• MC > ATC ->>>> ATC is rising
• The reason is that until MC is less than ATC, each extra unit of output adds MC but
since that addition is less than ATC, the ATC decreases (think of ATC calculation).
But opposite is true when MC is greater than ATC.
• The marginal-cost curve crosses the average-total-cost curve at its minimum

Note – In some industries marginal product may increase in the beginning (due to usage of idle
resources for example), and then it begins to fall; in this case MC curve may be U shaped.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 12
Relationship between Marginal Cost and
Average Total Cost
• Whenever marginal cost is less than average total cost, average total cost is falling.
Whenever marginal cost is greater than average total cost, average total cost is
rising : It is true for all firms.
• To see why, consider an analogy.
• Average total cost is like your cumulative grade point average.
• Marginal cost is like the grade in the next course you will take.
• If your grade in your next course is less than your grade point average, your grade point average
will fall.
• If your grade in your next course is higher than your grade point average, your grade point average
will rise.
• The mathematics of average and marginal costs is exactly the same as the mathematics of average
and marginal grades.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 13
MC Curve is U-shaped in reality…
In reality, the firms may benefit
by adding additional workers in
the beginning, so the marginal
product may increase for a while
until the competition for other
resources forces MP to fall

This makes the MC curve U-

shaped which means that the
MC falls during initial period,
and then rises.
AFC also becomes U-shaped for
the same reason

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 14
Costs in Short Run and Long Run
For many firms, the division of total costs
between FC and VC depends on the time
horizon.

The long-run ATC curve is a much flatter U-

shape than the short-run ATC curve.

All the short-run curves lie on or above the

long-run curve. This is because firms have
greater flexibility in the long run.

In the long run, the firm gets to choose

which short-run curve it wants to use. But in
the short run, it has to use whatever short-
run curve it has chosen in the past.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 15
Economies and Diseconomies of Scale
• Economies of scale - The property whereby long-run average total cost falls as the
quantity of output increases.
• Diseconomies of scale - The property whereby long-run average total cost rises as
the quantity of output increases.
• When long-run average total cost does not vary with the level of output, there are
said to be constant returns to scale.
• Economies of scale often arise because higher production levels allow specialization
among workers, which permits each worker to become better at a specific task.
Diseconomies of scale can arise because of coordination problems that are inherent
in any large organization.
• Long-run ATC is falling at low levels of production because of increasing
specialization and rising at high levels of production because of increasing
coordination problems – explains the U- shaped long run ATC curve.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 16
Summary of Cost Types

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 17
Exercise – Luxury Watchmaker
A Luxury Watchmaker has following expenses:
• Rent of watchmaker shop is ₹30000 per month.
• Cost of utilities is ₹10000 per month.
• Salaries of management and security employees is ₹30000 per month.
• The company also pays an external firm to check the quality of watches and they charge a fixed rate of ₹20000
per month for inspecting up to 3 watches and additional amount of ₹10000 per watch beyond that.
• Making each watch requires expensive raw materials that cost ₹ 50000.
• The company hires watchmakers only when they have an order to fill, Each watchmaker can make 1 watch per
month.
• There is short supply of luxury watchmakers in the market so incremental watchmakers become more
expensive. The monthly salaries of watchmakers 1-5 are ₹25000, 30000, 35000, 40000, 50000 respectively.

Calculate average total costs, average fixed costs, average variable costs and marginal costs at each level if the
company gets orders for 1,2,3,4,5 watches per month.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 18
Exercise – Luxury Watchmaker
Should the watchmaker
continue producing
watches?

What is the optimal

number of watches that
should be produced for
the output to be on the
efficient scale?

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 19
Link to Video – TEDx talk
[Link]

Key References : Principles of Microeconomics – N Gregory

Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 20
18th edition
The Competitive Market
The Competitive Market - A market with many buyers and sellers trading identical products so that each buyer
and seller is a price taker.
Three key characteristics of a perfectly competitive market:
1. There are many buyers and many sellers in the market.
2. The goods offered by the various sellers are largely the same.
3. Firms can freely enter or exit the market
Characteristics 1 and 2 conclude that all buyers and sellers in a competitive market are Price Takers.
Characteristic 3 is a powerful force in shaping long-run equilibrium in a competitive market.

Revenue of a Competitive Firm - A firm in a competitive market, like most other firms in the economy, tries to
maximize profit (total revenue minus total cost).
Total Revenue = Price per unit * Total Quantity Sold
Average Revenue = Total Revenue / Quantity Sold
Key Observation – For all firms, Average revenue equals the Price of the good
Marginal Revenue, which is the change in total revenue from the sale of each additional unit of output. For
competitive firms, marginal revenue equals the price of the good

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 21
 Revenue of a Competitive Firm
For a Competitive Firm, Price = Average Revenue = Marginal Revenue P=AR=MR

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 22
Profit Maximization of a Competitive Firm
The goal of a competitive firm is to
maximize profit, which equals total
revenue minus total cost.

Marginal Revenue = Change in Total

Revenue / Change in Quantity Sold

Change in Profit = Marginal Revenue –

Marginal Cost

So, the key decision for a firm to

maximize profit is to produce as long as
Marginal Revenue (Price) exceeds the
Marginal Cost of producing.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 23
Profit Maximization of a Competitive Firm

The marginal-cost curve (MC) is upward

sloping.
The average-total-cost curve (ATC) is U-
shaped.
The MC curve crosses the ATC at curve at
the minimum of average total cost.
Price is fixed and equal to marginal
revenue, as firm is a price taker.

Quantity of Output that maximizes profit

MR = MC, i.e. P = MC
If P (MR) > MC , firm would raise
production to generate profit
If P (MR) < MC , firm would reduce
production to cut losses

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 24
Marginal Cost Curve as Firm’s Supply Curve

If Price prevailing in market rises (may be due to increase in Demand), then MR becomes higher than
MC at previous level of output, so the firm increases production until MR=MC which is new profit
maximizing quantity.

Because the firm’s marginal-cost curve determines the quantity of the good the firm is willing to
supply at any price, the marginal-cost curve is also the competitive firm’s supply curve.
Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 25
 Competitive Firm’s Short- Run Supply Curve
The competitive firm’s short-run supply curve is the portion of its MC curve that lies above AVC curve
Shutdown refers to a
short-run decision not to
produce anything during a
specific period of time
because of current market
conditions.

Exit refers to a long-run

decision to leave the
market.

A firm that shuts down

temporarily still has to pay
its fixed costs, whereas a
firm that exits the market
The firm shuts down if the revenue that it would earn from producing is less than its does not have to pay any
variable costs of production. i.e. P < AVC
costs at all, fixed or
Said another way, the firm shuts down when the total revenue it generates is not enough variable.
to cover the variable cost required to earn it. i.e. TR< VC (Fixed costs have no bearing on
this decision as they are Sunk Costs

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 26
 Competitive Firm’s Long-Run Supply Curve
The competitive firm’s long-run supply curve is the portion of its MC curve that lies above ATC curve

Exit refers to a long-run

decision to leave the
market.

In the long run, the firm

considers all the costs
required to run the firm
and produce the goods.

Fixed costs are also

important for exit
considerations, as once
the firm exits the market, it
incurs no fixed costs
The firm exits the market if the revenue that it would earn from producing is less than its
total costs of production. i.e. P < ATC
Said another way, the firm exits the market when the total revenue it generates is not
enough to cover the total costs required to earn it. i.e. TR< TC
Criteria to enter a market is the reverse, enter if P> ATC

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 27
Profit of a Competitive Firm
Profit equals total revenue (TR)
minus total cost (TC):
Profit = TR – TC

This can also be written as

Profit = (P-ATC) *Q

The area of rectangle between

Price (P) and Average Total Cost
(ATC) at profit-maximizing
quantity (Q) is the firm’s profit.

If Price is less than Average Total

Cost then the firm bears a loss
which is the size of the rectangle
at loss- minimizing quantity.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 28
 The Short-Run Supply Curve in a Competitive Market
The Short- Run Market Supply with a Fixed Number of Firms
For any given price, each
firm supplies a quantity of
output so that its marginal
cost equals the price, That
is, as long as price is above
average variable cost, each
firm’s marginal-cost curve is
its supply curve.

The quantity of output

supplied to the market
equals the sum of the
quantities supplied by each
of the individual firms.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 29
 The Long-Run Supply Curve in a Competitive Market
The Long- Run Market Supply with Entry/Exit of firms
In the long-run, firms are able to enter/exit the market. Assume each firm has access to same technology and same markets, so
every current/potential firm has the same cost curves.
If firms already in the market are profitable è incentive for new firms to enter the market è expands the number of firms è
increase the quantity of the good supplied, and drive down prices and profits
If firms in the market are making losses è , some firms will exit the market. è reduce the number of firms è decrease the
quantity of the good supplied and drive up prices and profits.
At the end of this process of entry and exit, firms that remain in the market must be making zero economic profit.

In a competitive market
P = MC -----> at the Output for profit maximization
P = ATC -----> For Free entry/exit,
Thus, for MC and ATC to be equal, the firm has to operate at minimum ATC – which is the point of Efficient scale (from cost
curves).
Therefore, in the long-run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient
scale.
Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 30
 The Long Supply Curve in a Competitive Market
In the long-run post all entry and exit, firms that remain in the market make zero economic profit.
In the long-run equilibrium of a competitive market with free entry and exit, firms operate at their efficient scale.
The long-run supply
curve is the MC curve
above the ATC.
Firms will produce if P >
ATC and will exit the
market if P <ATC.
At exactly P=ATC, there
is no incentive for firms
to leave or enter the
market.
So, in the long-run, the
price taken by all is the
minimum of ATC,
meaning the supply
curve is horizontal.

Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 31
 Shift in Demand in the Short-Run and Long-Run
In short-run, an increase in Demand shifts it to right
and the short –run equilibrium is at higher price.
So, the firms supply more to meet the demand, and
make economic profit as P> ATC.

In long-run, more firms enter the market as there is

economic profit, so Supply curve shifts right.
This increase in supply drives the price down, and at
long-run equilibrium, the price is back at original
level, but the quantity served is higher.
Thus, an increase in demand expands the market
but does not impact the price in long-run.

There can be reasons why Supply curve slopes upward in long-run – scarcity of resources and difference in cost of
inputs to different firms, which cause new supply to be at higher cost. So, it’s possible that some firms could make
profits while others do not. However, generally speaking, long-run supply curve is more elastic.
Key References : Principles of Microeconomics – N Gregory Mankiw – 6th edition Modern Microeconomics – H L Ahuja – 18th edition 32