Demand and Supply Analysis

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Theory of cost:

Types of Costs 

• Fixed cost – Fixed cost involves all the expenditure done on fixed factors of production. However, the fixed costs remain constant i.e. they do not vary with the level of output. For instance, interest, insurance premium, rent and wages of permanent employees are categorized as fixed costs. 

• Variable cost – Variable cost can be defined as the cost that does remain constant i.e. it varies with the level of output. For example, salaries of employees appointed on day to day basis and expenditure made on fuel, power and raw material. 

• Opportunity cost – It is quite true that the resources are limited; therefore the production of one commodity can only be made possible at the cost of other. The good that is given up is the opportunity cost of the commodity manufactured. 

• Accounting cost – The accounting cost outlines actual expenditure incurred during the production. 

• Economic cost – Aggregate of implicit cost, normal profits and explicit cost. 

• Explicit cost – Explicit cost embraces all the money payments done to the suppliers who provide the company with raw materials or many other equipments used in production etc. 

• Implicit cost – Implicit cost is the aggregate cost of self owned resources. 

Total cost curves in short run 

• Total Fixed Cost (TFC) 

Total Fixed Cost (TFC) is a straight line curve that does not change with the level of output, even in the situation when output is zero unit or one hundred units it remains same all through the course. For example, interest on bonds, insurance premium etc is considered as total fixed cost. 

• Total Variable Cost (TVC) 

Total Variable cost is the cost that is directly proportional to output which implies that TVC increases when output increases and decreases when output decreases. 

• Total Cost (TC) 

Total Cost (TC) is derived by adding Total fixed cost (TFC) and Total variable cost (TVC). All the changes occurring in TC are due to changes in TVC due to the fact that TFC remains constant. 

TC = TFC + TVC 

Where, 

TC = Total Cost 

TFC = Total Fixed Cost 

TVC = Total Variable Cost 

[pic]

The table below highlights the relation between TFC, TVC and TC.

[pic]

Unit cost curves in short run 

• Average Fixed Cost (AFC)

There exist an inverse association between AFC and output which implies that AFC decreases with increase in output and vice-versa. 

AFC = TFC/ Q 

Where,

AFC = Average Fixed Cost

TFC= Total Fixed Cost

Q= Units of output

• Average Variable Cost (AVC)

Average Variable cost can be easily calculated by dividing Total Variable Cost by output.

AVC = TVC/Q 

Where,

AVC = Average Variable Cost

TVC = Total Variable Cost

Q = Units of output 

• Average Total cost (ATC) or Average cost (AC)

Average Total cost or Average cost can be estimated by any of the two methods mentioned below:

First method;

ATC = TC/Q

Where,

ATC = Average Total Cost

TC = Total Cost

Q = Units of output

Second method; 

ATC = AFC + AVC

Where, 

ATC = Average Total Cost

AFC = Average Fixed Cost

AVC = Average Variable Cost

• Marginal Cost (MC)

MC can be defined as the increase in total cost resulting from to one unit increase in the level of output. 

MC = ΔTC /ΔQ

Where,

MC = Marginal Cost

ΔTC = Change in Total Cost

ΔQ = Change in Quantity

[pic] 

The table below highlights the relation between TC, AC and MC:

[pic]

Theory of Production

Meaning of production

Production is an economic activity that makes goods available for consumption. Production at times is also defined as all economic activities minus consumption. It is the process of creating goods or services using various available resources.

Production function and Factors of production

Production function shows the relationship between the quantity of a good/service...
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