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Chapter-2 Part-5
Economic Notes (Self Study)
Long Notes Series
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Admin message  I know what you are thinking about these notes, like it’s a useless Notes etc but if you
have analyzed UPSC CSE 2018 paper ,lots of questions came from microeconomic, every 2 marks is very
important for UPSC Aspirants in Prelims .In this part try to focus more on concept and curve, may be Prelims
question can be asked from these notes

Fixed costs

 Fixed means Fixed ( Lolz Admin I Knew it..hehehehe )

 In simple term  Fixed cost is fixed overhead cannot be avoided. (Example like The Hindu Newspaper
Subscription ..u have to pay for per month or year etc) ..(even you don’t want to read it newspaper)
 So ,Fixed costs are costs which do not vary with the output level. In other words, they do not change
whether the firm increases or decreases output.
 Examples of fixed costs include rent and interest payments on loans.

Variable costs

 in layman term like joining Prelims or Mains test Series (think Boss)
 variable costs are costs which vary directly with the output level. In other words, variable costs
increase when the output level increases, and vice versa.
 Examples of variable costs include the costs of labour and materials.

Key Differences between (Fixed or Variable Cost)

 Fixed cost is a cost that remains same regardless of volume of production while variable cost
changes with the level of production.
 Fixed cost is a time related while variable cost is a volume related.
 Fixed cost are required to pay whether there is production or not. Variable costs only occurred when
there is production.
 Variable costs remains same per unit while fixed cost per unit changes. In case of large production,
per unit fixed cost decrease and vice versa.
 Fixed production is combination of fixed production overhead, fixed administration overhead and
fixed selling and distribution overhead. Variable cost is combination of direct material, direct labor,
direct expenses, variable production overhead, variable selling and distribution overhead.
 Examples of fixed costs are: depreciation, rent, salary, insurance, tax etc. Examples of variable costs
are: material consumed, wages, commission on sales, packaging expenses, etc.
Total Product

 In simple terms, we can define Total Product as the total volume or amount of final output produced by a
firm using given inputs in a given period of time.
 The total product (TP) curve graphically explains a firm’s total output in the short run. It plots total
product as a function of the variable input, labor.

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 The total product (TP) curve represents the total amount of output that a firm can produce with a
given amount of labor. As the amount of labor changes, total output changes.
 The total product curve is a short-run curve, meaning that technology and all inputs except labor are
held constant. This assumption is the familiar ceteris paribus rule.

 The S-shaped total product curve has economic meaning. At the lower end, where labor and output
are low, the curve is convex. Convexity means that as labor is added, the production of TVs is
increasing at an increasing rate.
 This phenomenon is a function of teamwork and specialization: as more workers are added at low
production levels, they can specialize in tasks and more efficiently use the fixed inputs.
 Suppose we vary a single input and keep all other inputs constant. Then for different levels of
employment of that input, we get different levels of output from the production function.
 This relationship between the variable input and output, keeping all other inputs constant, is often
referred to as Total Product (TP) of the variable input.
 The function that explains the relationship between physical inputs and physical output (final output) is
called the production function

Average product
 Average product is the per unit production of a firm.
 Conceptually, it is simply the arithmetic mean of total product calculated for each variable input over a
whole range of variable input quantities.
 Average product is generally considered less important than total product and marginal product in the
analysis of short-run production.
 The formula for specifying and calculating average product from total product is given as:

total product
average
=
product
variable input

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 Average product curve is a graphical representation of the relation between average product and the
variable input. The average product curve for Gargantuan Taco production is displayed to the right.
 The "general" slope of this curve is negative, with per unit output lower for larger workforces.
 However, the average product curve is actually "hump" shaped, with a positive slope giving way to a
negative slope.

Marginal Product

 In layman term  Marginal product, also called marginal physical product, is the change in total output
as one additional unit of input is added to production.
 In other words, it measures the how many additional units will be produced by adding one unit of input
like materials, labor, and overhead.
 This measurement is really a relationship between inputs and outputs.
 It answers the question, how many outputs will we get for a single input?
 The marginal product formula calculates this relationship by dividing the total change in output by the
total change in a particular input.
 For example, when cookie production increases from 50 to 90 after an increase in number of workers
count from 1 to 2, marginal product of 2nd worker would be 40 (90–50) cookies.

Another examples If ten employees produce 100 products each day and an 11th brings the total produced
to 110, the marginal product of labor of that employee would be 10 per day. If a 12th employee brought the
total produced to 118, the marginal product of labor for that employee would only be eight per day.

Note It’s important to only analyze one input at a time and keep all other inputs equal. This way each input
is isolated and can be tested properly.

Law of diminishing marginal productivity?

 The “law of diminishing marginal productivity” is simply another name for what is usually called the
law of diminishing returns, which states that when increasing quantities of the variable factor are
added to fixed quantities of some other factor, first the marginal and then the average returns to the
variable factor will, after some point, diminish.

For example,

 if a farmer applies 20 kg of fertilizer to a 1-hectare field of rice, he will experience some increase in
yields compared with another field of the same size to which he only applied 10 kg of fertilizer, but
otherwise managed similarly.

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 However, if he continues to apply higher and higher dosages of fertilizer to the field, the additional
yield per additional kg of fertilizer (the marginal productivity of fertilizer) will eventually start falling,
and at some point beyond that, additional application of fertilizer will actually start to reduce those
yields. At that point, the average productivity of fertilizer has begun to fall.
 It’s called a “law” because it applies to a very wide range of production processes.
 By extension, if a producer increases the quantity of all but one input, while leaving that last input
unchanged, the additional output produced in response to each additional Rupee worth of the variable
input package will start to diminish. (please Analysis below Figure at yourself)

Another Example (in Layman term)

The law of diminishing marginal product of labor is exactly what it sounds like. After a certain point, every
worker hired will be less productive and contribute less revenue than the previous worker hired.
Let’s say you own a coffee shop with one cash register and one coffee machine, and hire x number of workers
to do three jobs: work the register, make coffee, and give the coffee to waiting customers.
 One worker does all three jobs. Service is slow because the worker can only handle one customer
at a time.
 Two workers can handle one customer each at a time; that is, one worker can be making coffee
while the other worker takes the next order. The marginal product of the second worker is equal
to the marginal product of the first worker, and total productivity is doubled.
 Three workers handle one customer each at a time - one takes an order, one is making coffee, and
one is handing coffee to waiting customers. The marginal product of the third worker is equal to
the marginal product of the second worker, and total revenue is three times what the revenue
would have been with only one worker.
 The marginal product of labor starts decreasing with the addition of a fourth worker because each
station in the coffee shop is already manned by a worker. The fourth worker allows the other
three to take breaks, but otherwise the fourth worker isn’t working when the other three are.
 As more workers are added, the service side of the coffee shop becomes more and more
crowded, and while the workers are less tired, production of coffee cannot increase much more
due to the lack of more cash registers and coffee machines. Hence, each additional worker adds
less revenue than the previous hired worker.
So, the law of labor demand is to keep hiring workers until the marginal product of an additional worker is
equal to the marginal cost of hiring that worker. Productivity is maximized at this point.

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Now we are going to explain Three stages of Law of Variable productions (Concept are same which we
explained above)

 Economists recognize three distinct stages of production, which are defined by a concept known as the
law of diminishing marginal returns.
 This law holds that as you add more workers to the production process, output will increase, but the
size of that increase will get smaller with each worker you add.
 At some point, if you keep adding workers, your output may even start shrinking. The idea of the three
stages of production helps companies set production schedules and make staffing decisions.

Stage One
 Stage one is the period of most growth in a company's production. In this period, each additional
variable input will produce more products.
 This signifies an increasing marginal return; the investment on the variable input outweighs the cost of
producing an additional product at an increasing rate.
 As an example, if one employee produces five Pizza by himself, two employees may produce 15 Pizza
between the two of them. All three curves are increasing and positive in this stage.

Stage Two
 Stage two is the period where marginal returns start to decrease. Each additional variable input will
still produce additional units but at a decreasing rate.
 This is because of the law of diminishing returns: Output steadily decreases on each additional unit of
variable input, holding all other inputs fixed.
 For example, if a previous employee added nine more cans to production, the next employee may only
add eight more Pizza to production. The total product curve is still rising in this stage, while the average
and marginal curves both start to drop.

Stage Three

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 In stage three, marginal returns start to turn negative. Adding more variable inputs becomes
counterproductive; an additional source of labor will lessen overall production.
 For example, hiring an additional employee to produce cans will actually result in fewer cans produced
overall. This may be due to factors such as labor capacity and efficiency limitations.
 In this stage, the total product curve starts to trend down, the average product curve continues its
descent and the marginal curve becomes negative.
In short 

 In Stage I, marginal product is positive and increasing.

 In Stage II, marginal product is positive, however decreasing.
 In Stage III, marginal product is negative.

Cost in Economics

1. Cost of producing a good, in Economics is the sum total of all the,

(a) Direct expenditure (actual money expenditure of a firm on purchasing goods or hiring factor services,
called explicit cost) and
(b) Indirect expenditures (imputed value of the owners estimated value of inputs provided, called ‘implicit
cost’) and
(c) Certain minimum profit (refers to that amount of profit which a producer must get in the long run to
continue to produce the given goods, called ‘normal profit’.)
So, the sum total of explicit cost, implicit cost and normal profit is called economic cost.

2. Explicit Cost:
(a) It refers to the actual money expenditure of a firm on purchasing goods or hiring factor services and non-
factor inputs (like raw material, electricity, fuel etc.)
(b) In other words, “explicit cost are those cash payments which the firm makes to outsiders for their goods
and services.”
(c) For example—explicit cost of biscuit factory consists of flour, milk, sugar etc. purchased from outside and
rent, electricity, wages, interest etc paid to factor of production.
3. Implicit Cost:
(a) Implicit cost is the imputed or estimated value of inputs supplied by the owner of the firm himself.
(b) In other words, Implicit costs are cost of self-supplied factors of production, which are generally not
recorded in firm’s account book.
(c) Implicit costs of a biscuit factory are imputed rent of owner’s own factory building,imputed wages for
owner’s working as a manager himself, imputed interest on his money capital used in the factory,
depreciation.

Short Run Cost

1. Cost function shows functional relationship between output and cost of production. It
gives the least cost combination of inputs corresponding to different levels of output.
Cost function is given as:
C = f(X), ceteris paribus, where, C = Cost and X = Output
2. Short Run cost are those in which some factors of production are fixed and others are variable. So, it is
divided into two parts:

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(a) Fixed costs (b) Variable costs

Total Fixed Cost (Supplement/Indirect/Overhead Cost)
1. Fixed costs are those costs of production which do not change with a change in output.
2. These are the costs incurred on fixed factors, like rent of land and building, interest, etc. These are
unavoidable contractual costs.
3. Fixed costs are also called overhead costs or general costs because these are common for all the units
produced. These costs are also called supplementary costs or indirect costs.
4. The shape of Total fixed Cost is horizontal (Parallel to X-Axis). They have to be incurred when the output is
large or small or even zero.

Total Variable Cost (Prime/Direct Cost)

1. The cost incurred on variable factors of production is known as TVC.
TVC = TC – TFC
2. TVC is very much related with the production and fluctuates with the fluctuation in production. In case of
zero level of production, TVC would also be zero.
3. For example, Wages of casual labour, payment for raw material, etc.
4. The shape of Total Variable Cost is Inverse S-shape because of Law of variable Proportion. There are two
phases on which shape of total variable cost depends.

(a) In the first phase, TVC increase at a to lower cost of production. This is because of proper utilization of
fixed factor by employing more units of variable factor, specialization and division of labour. diminishing rate,
[concave shape] i.e., every additional unit of output produced leads
(b) In the second phase, TVC increase at an increasing rate, [convex shape]
i. e., every additional unit of output produced leads to higher cost of production. This is because of non-
optimal combination of variable factor with the fixed factor.
Total Cost

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1. During production, the expenditure incurred on various factors of production is known as total cost.
2. The thing, is has to remember, is that enterprise is one of the factors of production and the return of
enterprise is normal profit. So, normal profit is also included in total cost.
3. In other words, it is a sum of total fixed cost and total variable cost.
TC = TFC + TVC
4. The shape of Total Cost is Inverse S- shaped because of law of variable Proportion.
(a) TC is divided into two parts TFC and TVC such that
TC = TFC + TVC.

(b) TFC curve is a horizontal line parallel to the x-axis.

(c) TVC is inverse S-shaped starting from the origin due to law of variable proportion.
(d) TC is aggregate of TFC and TVC. TC curve is inverse S-shaped starting from the level of fixed cost. The
reason behind it shape is the law of variable proportion.

The Relationship Between Average and Marginal Costs

 There are several ways to measure the costs of production, and some of these costs are related in
interesting ways. For example, average cost (AC), also called average total cost, is the total cost
divided by quantity produced; marginal cost (MC) is the incremental cost of the last unit produced.
Here's how average cost and marginal cost are related:
 The relationship between average and marginal cost can be easily explained via a simple analogy.
Rather than think about costs, think about grades on a series of exams.
 Assume that your average grade in a course is 85. If you were to get a score of 80 on your next exam,
this score would pull your average down, and your new average score would be something less than
85. Put another way, your average score would decrease.
 If you scored 90 on that next exam, this grade would pull your average up, and your new average
would be something greater than 85. Put another way, your average score would increase.
 If you scored 85 on the exam, your average would not change.
 Returning to the context of production costs, think of average cost for a particular production quantity
as the current average grade and marginal cost at that quantity as the grade on the next exam.
 One typically thinks of marginal cost at a given quantity as the incremental cost associated with the last
unit produced, but marginal cost at a given quantity can also be interpreted as the incremental cost of
the next unit. This distinction becomes irrelevant when calculating marginal cost using very small
changes in quantity produced.
 Following the grade analogy, average cost will be decreasing in quantity produced when marginal cost
is less than average cost and increasing in quantity when marginal cost is greater than average cost.

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Average cost will be neither decreasing nor increasing when marginal cost at a given quantity is equal
to average cost at that quantity.

In short

1. Cost in economics: It is the sum total of explicit cost, implicit cost and certain minimum profit (normal
profit).
2. Explicit Cost: It refers to the actual money expenditure of a firm on purchasing goods or hiring factor
services and non-factor inputs (like raw material, electricity, fuel, etc.)
3. Implicit Cost: Implicit cost is the imputed or estimated value of inputs supplied by the owner of the firm
himself.
4. Cost function: It shows functional relationship between output and cost of production. It gives the least
cost combination of inputs corresponding to different levels of output.
5. Short Run Cost: Short run cost are those in which some factors of production are fixed and others are
variable.
6. Total Fixed Costs: Total Fixed costs are those costs of production which do not change with a change in
output.
7. Total Variable Cost: The cost incurred on variable factors of production is known as TVC.
8. Total Cost: During production, the expenditure incurred on various factors of production is known as total
cost.
9. Average Fixed Cost: The per unit cost incurred on fixed factors of production is known as average fixed cost.
10. Average Variable Cost: The per unit cost incurred on variable factors of production is known as AVC.
11. Average Total Cost/Average Cost (ATC): The per unit cost incurred on various factors of production is
known as average cost. In other words, it is the sum total of average variable cost and average fixed cost.
12. Marginal Cost: The cost incurred on additional unit of output is known as Marginal cost.

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